Compliance for WRAP Programs

The subject of WRAP fee compliance is becoming increasingly focused on suitability and the fiduciary obligation that advisors have to their clients. As regulatory agencies continue to scrutinize advisor trading practices, advisors who choose to recommend WRAP programs are wise to pay special attention to both the recommendation and ongoing supervision for these types of programs. Sure, WRAP programs can be great for clients who have certain portfolio management needs, but far too often advisors are choosing to push clients towards WRAP arrangements for the wrong reasons. Here are a few things to note about compliance for WRAP programs.

Know the Difference

Oftentimes, advisors gain their understanding of WRAP programs from their days working at a broker dealer or wirehouse. This understanding often leads to the juxtaposition between a fee-based arrangement and commissions paid on a per-transaction basis as the source of the advisor's understanding. But what happens when the advisor leaves the broker dealer and begins operating an independent RIA for which no commissions are received? Then, it can become a bit more complicated to explain the difference between WRAP and Non-WRAP fee accounts to regulators and clients. Advisors who wish to offer WRAP arrangements would be wise to document their view of the difference between the two account types, and utilize the tools provided by their custodian as it pertains to asset-based vs. transaction-based pricing options. Most custodians will allow for either option on client transactions, so the firm should have some tools to determine which will be most suitable for the client. Equally as important as documenting the differences is to take time to explain those differences to the client and documenting that conversation.

Watch Out for Reverse Churning

Generally speaking, reverse churning occurs when an advisor incepts an account into a fee-based portfolio management relationship, and then doesn’t execute trades in the account. When recommending a WRAP account, the firm should have controls in place to establish that the trading activity in the firm’s WRAP accounts will be substantially higher than the trades being executed in accounts that carry transaction-based charges. There is no set rule that I am aware of the dictates what constitutes “substantially higher” trading volume, but the firm should have some leeway to put into place policies and procedures designed to reasonably detect instances of reverse churning. For all intents and purposes, an effective ongoing trade supervision procedure should include suitability of both products and the individual trades being recommended and executed.

Assess the Fees

Anytime an advisor offers multiple fee structures for what regulators may view as essentially the same service, the advisor will need to show ongoing compliance supervision to monitor the delivery of services and the collection of fees. This becomes an issue in many financial planning arrangements, when portfolio review is included in the services being provided. We discuss this in detail in our blog Combining Investment Management and Financial Planning Fees. But for the purposes of this conversation, we are highlighting the firm’s responsibility to determine if it makes sense to leave the client in a WRAP program. Portfolio turnover becomes the focal point of this conversation. For example, it doesn’t make sense to leave a client in a fee-based product, if they are simply holding securities without sufficient trading activity. Then, it would make more sense to have the client pay for trades using a transaction-based pricing structure. If this is the case, regulators want to see that the advisor has controls in place to detect low portfolio turnover, and remove the client from the WRAP program as necessary.

Maintain Standard Trading Compliance

Another key point here, is for advisors to remember that if they sponsor a WRAP program, it does not alleviate best execution compliance responsibilities. Many advisors disclose that they do not sponsor or act as portfolio managers for WRAP programs, but they may recommend WRAP programs. This is fine, but as long as the advisor is collecting a fee for portfolio management, the firm’s compliance program is responsible for all elements of trading compliance. This also pertains to instances in which a third-party manager is responsible for executing the trades. When using outside managers, the advisor should remain in compliance with all elements of trade supervision, including code of ethics adherence and best execution compliance.

What To Do?

With the expansion of fee-based investment advisory business and a shift away from a focus on commission-based relationships, we can expect an increased regulatory focus on WRAP programs. It is likely that regulators will begin to expect quantitative comparisons between the cost of portfolio management under a transaction-based arrangement versus an asset-based pricing model. Therefore, the recommendation is for advisors who utilize WRAP programs to implement a workflow in the form of an ongoing compliance task (no less than quarterly), where transaction fees are reviewed and portfolio turnover is calculated. Take a look at the total fee paid for the quarter for a small sample of clients. Then, take the total number of trades executed in the client’s portfolio during the quarter, and multiply it by the custodian’s transaction fee. Which fee is higher? Document the review.

If the difference between the two fee calculations is substantial, and there is no change in the client’s objectives and risk profile, it may be time to reach out to the client to recommend they take a look at another method by which you can service their financial needs. If the difference between the two fee calculations is minor, then a documentation of the calculation should be sufficient, along with plans to review the account again in subsequent quarters. If the client ended up paying less under the asset-based pricing model, then clearly the arrangement is in the client’s best interest.

About the Author

Scott is a formerly licensed Securities Principal with experience in both RIA and broker-dealer compliance. He began his financial services career in 2006 as a Registered Representative with E*Trade Financial in Alpharetta, GA. He has also worked with J.P. Morgan Private Banking in Chicago, IL and with Wells Fargo Advisors in Chapel Hill, NC. Scott’s most recent role before joining Team XYPN was as Compliance Officer of Carolinas Investment Consulting in Charlotte, NC. He’s a graduate of The University of North Carolina at Chapel Hill and formerly held FINRA Series 7, 63, 65, 24, 4 and 53 Licenses. Scott lives in Charlotte, NC with his wife Meredith, and their two sons Tyson and Jackson and daughter Eva. In his free time, Scott enjoys watching sports, exercising, and operating the charitable organization he created upon his father’s passing.