What just happened?
The SEC and Morgan Stanley Smith Barney LLC (MSSB) settled charges that MSSB provided misleading information to clients in its retail wrap fee programs regarding trade execution services and transaction costs.i Without admitting or denying the SEC’s findings, MSSB has agreed to pay a $5 million penalty that will be distributed to harmed investors and to a cease-and desist order.
This case is the latest in a series of casesii in which the SEC found that clients in wrap fee programs were not receiving sufficiently detailed information about the additional costs incurred when managers in the wrap fee programs traded away from the broker-dealers sponsoring those programs.
The SEC defines a wrap fee programiii as any advisory program under which a specified fee or fees not based directly upon transactions in a client’s account is charged for investment advisory services (which may include portfolio management or advice concerning the selection of other investment advisers) and the execution of client transactions. A wrap fee program “sponsor” generally organizes and/or administers the program, and may also select or advise clients regarding the selection of other investment advisers in the program (“subadvisers”), who will manage the client’s account through the sponsor’s program.
Wrap fee programs can be attractive to clients because they often will not incur commission charges or other transaction costs on trades placed in their wrap fee program account. However, wrap fee program sponsors typically bundle brokerage trading costs in wrap fee program accounts only when those trades are executed with a designated broker, often the sponsor itself or an affiliate. If a subadviser executes a trade away from the designated broker, the client will typically incur additional costs. As noted above, the SEC has found that failure to describe the amount and frequency of these additional costs is misleading to wrap fee investors.
The case covers the period from 2012-2017. It appears that MSSB had agreed to bring its practices into line with SEC expectations in 2015; however, as of 2017 MSSB had still not made costs of trading away from the sponsor fully transparent to its wrap fee clients. Specifically, MSSB:
- Marketed its wrap fee program using terms like “transparency” and “simplifying and streamlining the expense associated with such a portfolio”;
- Trained its Financial Associates to tell clients that the wrap program provided “fee transparency” although not all fees were visible to clients;
- Did not indicate on confirms and statements which trades were placed with other brokers and any additional fees incurred from trading away;
- Stated on client agreements that it expected that “most” trades would be made with the sponsoring broker-dealer, although it knew that some subadvisers often traded away;
- Did not state in Form ADV and client agreements that not all additional trading costs would be visible on confirms and account statements;
- From 2015 – 2017, MSSB’s ADV disclosure brochure stated, “[O]nce you have selected a manager, you should carefully review the manager’s trading for your account to understand any additional trading costs that may be incurred.” However, the trading costs were not visible on confirmations and account statements;
- In 2015 MSSB added a disclosure to its website titled “Step-out Trade Information,” which included a chart that reported the dollar-weighted percentages that managers traded away based on the information provided by the wrap managers. The disclosure stated that the client could incur additional charges, but did not specify what those charges were. In addition, the disclosure repeated the language from the ADV (see previous bullet point) urging clients to “carefully review the manager’s trading.” As noted above, costs for trading away were not visible on confirmations and account statements.
Based on this, the SEC concluded that, “as the result of MSSB’s conduct, certain clients in MSSB’s retail wrap fee programs lacked complete and accurate information needed to assess the value of the services rendered by MSSB and the costs incurred in wrap fee program accounts.”
The SEC also found that MSSB failed to develop policies and procedures to prevent these violations. In particular, the SEC noted that MSSB would sometimes charge a client on a trade placed by a wrap fee manager with an MSSB-affiliated broker-dealer, even though trades with affiliates were supposed to be included in the wrap fee.
Altogether, the SEC found that MSSB had violated Sections 206(2) and 206(4) of the Advisers Act, along with Rule 206(4)-7.
In accepting MSSB’s offer of settlement, the SEC noted that the penalties were mitigated by MSSB’s modifying its practices to address the issues the SEC had found.
Even with this mitigation, however, MSSB was penalized $5 million and agreed to a cease-and desist order.
What does this mean?
For one thing, it means that the SEC continues to demand full transparency for all charges associated with wrap fee accounts.
It is important to recognize that, as in the previous wrap fee cases, the SEC does not address whether or not the subadvisers achieved best execution for their wrap fee clients by trading away. This case, and its predecessors, are not about execution per se; they are all about full and fair disclosure. Subadvisers will (and should) continue to trade away to achieve an optimal combination for price and service for the wrap fee clients.
It is also worth noting that much of the case revolves around changes that MSSB had started to make in 2015 but did not adequately achieve by 2017. Reading between the lines, this looks as though the SEC had raised these issues with MSSB in 2015 (when similar cases were being referred to Enforcement) but that MSSB had promised to make changes to address the SEC’s concerns. It may be that the SEC took a second look in 2017 and found that the promised changes had not been made, and so MSSB paid a hefty penalty.
Finally, consider how far this trading-related issue reaches. Contracts, disclosure brochures, the firm website, advisements, and FA training materials all contributed to this case. This is a potent reminder that whenever a compliance-related problem is found, a savvy CCO will work with all departments to identify any facet of the firm’s business that may be impacted.
What should firms do now?
First and foremost, BDs and IAs involved in sponsoring wrap-fee programs should carefully review all trading in wrap fee accounts to make sure that any and all costs associated with the program are clearly and fully disclosed. This is especially important on confirmations and account statements.
Wrap program subadvisers should take this opportunity to ensure that they are regularly and accurately reporting all additional trading costs in wrap programs to program sponsors and to their wrap clients (if not in account statements, then on the firm’s website or through the sponsor).
Remember that inadequate policies and procedures were a key part of this case. Make sure that your policies and procedures are complete and current, and be especially certain that they incorporate any promises you may have made to the SEC the last time you were examined.
This is also a good time to review and compare the agreements, marketing materials, disclosures and policies & procedures for wrap fee programs to be certain that they are consistent with each other and reflect what is actually going on in your shop. NRS calls this exercise “Closing the Circle,” and we recommend that you do it regularly.
How can NRS help?
NRS Compliance Consulting helps ensure that compliance programs are ready to meet demanding regulatory challenges in today’s changing environment. Our decades-long experience and expertise in testing and assessing the effectiveness of firms’ compliance efforts provides peace of mind and fosters compliance confidence.
Contact us today to find out more.
i In the Matter of Morgan Stanley Smith Barney LLC (May 12, 2020) Release No. IA-5499;
ii See: In the Matter of RiverFront Investment Group, LLC (July 14, 2016) Release No. IA-4453;
https://www.sec.gov/litigation/admin/2016/ia-4453.pdf; In the Matter of Robert W. Baird & Co. Incorporated (September 8, 2016) Release No. IA-4526; https://www.sec.gov/litigation/admin/2016/ia-4526.pdf; In the Matter of Raymond James & Associates, Inc. (September 8, 2016) Release No. IA-4525; https://www.sec.gov/litigation/admin/2016/ia-4525.pdf
iii Form ADV Instructions and Glossary at 36. https://www.sec.gov/about/forms/formadv-instructions.pdf