SEC takes deep dive on conflicts of interest

Wrap fee accounts, rollovers and dually registered advisers crown list of examination priorities for 2014

Jan 10, 2014 @ 12:32 pm

By Mason Braswell and Mark Schoeff Jr.

The SEC's annual list of examination priorities, which was released Thursday, included some surprising topics as the commission said that it will work to uncover different ways that business models, practices and products may provide incentive for financial advisers to act outside their clients' best interests.

The letter echoed concerns of other regulators around areas such as retirement account rollovers while also adding some focuses such as wrap fee accounts, issues around dually registered advisers and compensation of investment advisers.

“It's a piece of a larger trend over the last three or five years,” said Mark Costley a partner in the investment management practice group at the law firm of Drinker Biddle & Reath. “We're seeing a continued focus on conflicts of interest and the variety of ways these conflicts arise.”

Firms should use the letter as a guide as they contemplate unintended consequences or conflicts of interest that underlie common practices, Mr. Costley said.

“It's another good thing for folks in the industry to be mindful of,” he said.

“Have I identified conflicts of interest? Have I made robust disclosures? Have I taken steps to minimize it?” Mr. Costley said.


As fee-based managed accounts grow in popularity, they have also made their way onto the Securities and Exchange Commission's radar.

In the letter, the regulator said that it plans to review firms' processes for monitoring wrap fee programs and “will assess whether advisers are fulfilling their fiduciary and contractual obligations to clients.”

Wrap accounts generally include separate accounts, unified managed accounts, and discretionary accounts and other managed platforms where the adviser receives an annual fee for directing the investments rather than making commissions for trades.

The accounts are most popular among the wirehouses, which oversee around 55% of the total $3.25 trillion in assets held in managed accounts, and wraps represent a major growth area for the industry as a whole, according to data from consulting firm Cerulli Associates Inc.

Year-over-year growth of total managed accounts in the industry was 20.7% from the third quarter of 2012 to the third quarter of 2013.

Although they can help safeguard against churning and can save money for investors who are very active traders, firms have to be on the lookout for areas where the advisers may move money into a fee account unnecessarily, Mr. Costley said.

“There is a potentially a bigger risk of a conflict there if the portfolio manager is putting client accounts in there that don't really do a lot of trading and is getting a higher fee,” he said. “The larger, more sophisticated firms do have some procedures around that and monitoring systems in place to try to keep to be mindful of that.”

The SEC's emphasis on wrap-fee programs is a way for the commission to delve into the issue of “reverse churning,” where clients who rarely make securities trades are charged a fee while the adviser picks up the cost of the transaction, said Brian Hamburger, president of MarketCounsel, a compliance consulting firm.

Clients could end up spending more on the fee than they would have paying commissions.

“They're making sure the services the adviser is providing are in line with the way the adviser is being compensated,” Mr. Hamburger said.

The wrap-fee emphasis caught Todd Cipperman, managing principal of Cipperman Compliance Services, by surprise.

“It's a fairly sleepy area of the securities market,” Mr. Cipperman said. “It's not hedge funds or derivatives.”


Meanwhile, another potential conflict area that that SEC is emphasizing again — dually registered advisers — could have broad impact in the industry, according to Mr. Costley.

“That's all tied into the broker fiduciary standard that we've had so much talk about,” Mr. Costley said. “You've got two sides of the house operating on a different standard.”

A growing trend is for advisers in an advisory firm also to be registered representatives of a separate broker-dealer.

So-called hybrid advisers managed some $1.09 trillion in assets in 2012, up from $898 billion in 2011, according to the most recent Cerulli data.

The SEC is concerned that clients may be put into inappropriate accounts under the arrangement.

“It's become a much more significant issue over the last year,” Mr. Hamburger said.

By putting that topic and the others on its examination priority list, the SEC essentially is issuing a straighten up and fly right warning to advisers, Mr. Cipperman said.

In prior years, there has been a feeling that a compliance deficiency would get a first warning and then sanctions on the next occurrence. That isn't the case anymore.

“You don't get a bye,” Mr. Cipperman said.

Another message he sees is that the SEC wants a tone of compliance set from the top and followed through in the rest of the advisory firm.

“It's not just OK to do the right thing,” Mr. Cipperman said. “You have to have a compliance program in place.”


Conflicts of interest surrounding retirement plan advice has been a major focus recently among a number of regulators. In December, the Financial Industry Regulatory Authority Inc. released a letter detailing potential hot spots for advisers recommending rollovers of 401(k) plans. Finra included retirement rollovers in its annual priority letter, released this month.

The SEC's annual letter brings up similar concerns, indicating that the regulator will be taking a closer look at retirement products and rollovers — especially advisers who ask clients to roll over their 401(k) plan into higher- cost individual retirement accounts.

The SEC said it also plans to investigate “improper or misleading marketing and advertising, conflicts, suitability, churning, and the use of potentially misleading professional designations when recommending the movement of assets from a retirement plan to an IRA rollover account in connection with a customer's or client's change of employment.”

The notices follow efforts by the Labor Department, which last year indicated that it was seeking to propose rules that would apply a fiduciary standard to brokers who oversee retirement plans.

“Their focus on retirement plans is really about conflicts of interest,” Mr. Costley said. “From my perspective, the issue is a bit more in flux right now in terms of who's going to take the lead.”


The SEC's targeting of brokers who have been registered for more than three years but never examined comes at a time when the commission has requested funding from Congress to increase its number of investment adviser examiners by 250.

Making the lack of resources a priority is a way for the SEC to demonstrate that it is listening to criticism from Capitol Hill and elsewhere about the fact that the commission hasn't examined about 40% of the nearly 11,000 registered advisers.

“They're bowing to pressure they've received,” Mr. Hamburger said.

“It's a big weakness they've had,” he said. “They're going to work to plug that hole.”

The priority list underscores the emphasis that SEC Chairman Mary Jo White has put on the matter during congressional appearances.

As Congress struggles to reach an omnibus budget agreement this weekend, the SEC is unlikely to get all the funding it is seeking.

David Tittsworth, executive director of the Investment Adviser Association, praised the SEC for taking steps now to address the problem, calling the adviser exam gap a “critically important issue.”

“I'm pleased to see their decision to make this a priority, no matter what their resources are,” he said.


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