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Wrap Fee Programs and Separately Managed Accounts ALI-ABA Investment Adviser Regulation Fordham University School of Law January 15-16, 2009 Steven W. Stone Partner Morgan, Lewis & Bockius LLP 1111 Pennsylvania Avenue NW Washington, DC 20004 Wrap Fee Programs and Separately Managed Accounts* ALI-ABA Investment Adviser Regulation January 2009 Steven W. Stone Morgan, Lewis & Bockius LLP I. Introduction Over the past thirty-two years, the wrap fee and separately managed account industry has developed and matured as program sponsors have, to their credit, accumulated over $604 billion in assets as of September 2008.1 Securities regulators have largely kept pace, starting with a skeptical if not critical view of wrap fee arrangements that has evolved into a more balanced approach that has allowed innovation around a basic regulatory framework. This relatively “hands off” approach by securities regulators reflected the fact that wrap fee arrangements have generated far fewer investor protection concerns and controversies than many traditional brokerage arrangements. This outline discusses the principal regulatory framework for wrap fee and separately managed account programs under the federal securities laws, including under the Investment Advisers Act of 1940 (“Advisers Act”), the Investment Company Act of 1940 ( “Investment Company Act”), and the Securities Exchange Act of 1934 ( “Exchange Act”). The outline also discusses some of the current issues confronting participants in wrap fee and separately managed account programs. Wrap fee programs are arrangements between broker-dealers, investment advisers, banks and other financial institutions (typically acting as sponsors of the programs) and affiliated and unaffiliated investment advisers (or portfolio managers) through which the customers of such firms receive discretionary investment advisory, execution, clearing, and custodial services in a “bundled” form. In exchange for these “bundled” services, customers pay an all-inclusive – or “wrap” – fee determined as a percentage of the * Copyright © 2009 Morgan, Lewis & Bockius LLP. All rights reserved. This article provides general information on the subject matter discussed and it should not be relied upon for legal advice on any matter. Mr. Stone would like to thank Jared Minsk for his assistance in preparing this outline. 1 Money Management Institute Interim 3Q 2008 Data Flash, available at http://www.mminst.org/downloads/2008/11/3q-2008-flash-10282008-104.pdf . assets held in the wrap fee account. SEC Rule 204-3, governing written disclosure statements of investment advisers, defines a wrap fee program as “a program under which any client is charged a specified fee or fees not based directly upon transactions in a client’s account for investment advisory services (which may include portfolio management or advice concerning the selection of other investment advisers) and execution of client transactions.” See Advisers Act Rule 204-3(g)(4). Separately managed account programs are not defined by SEC rules and include wrap fee programs, as well as programs where the customers receive the same compliment of services in unbundled form. II. Principal Regulatory Framework for Wrap Fee Accounts A. “Investment Adviser” Status of Sponsors Wrap sponsors generally are subject to investment adviser registration, although there could conceivably be circumstances in which investment adviser registration ought not to be required. SEC statements on the subject point more starkly at the need for registration. For instance, in the SEC’s 1995 release reproposing Rule 3a-4 under the Investment Company Act (“Rule 3a-4 Reproposing Release”), the SEC stated that a broker sponsoring a wrap fee program “generally cannot rely” on the broker exception from the definition of investment adviser in Advisers Act Section 202(a)(11)(C) because that exception is available only to a broker-dealer that provides investment advice that is “solely incidental” to its brokerage business and that does not receive special compensation for such investment advice. According to the SEC, “the staff is of the view that a [wrap fee program] generally is not incidental to a sponsor’s broker-dealer business and . . . the sponsor’s portion of the wrap fee is special compensation.” This principle was left undisturbed in the SEC’s 1997 release adopting Rule 3a-4 (“Rule 3a-4 Adopting Release”) and the SEC’s 1999 rule proposal (and no-action position) clarifying the scope of the broker-dealer exception from the definition of investment adviser . In that 1999 rule proposal, the SEC stated that, even if broker-dealer sponsors do not have discretionary authority, the advice the sponsor provides on asset allocation or selection of portfolio managers could not be viewed as incidental to its brokerage services. The SEC re-affirmed this view in guidance in the release adopting (now vacated) Rule 202(a)(11)-1, stating that “advisory services provided by certain brokers in connection with wrap fee programs are not solely incidental to brokerage for the purposes of the broker-dealer exemption.” Release No. 34-51523 (April 12, 2005). In the wake of the D.C. Circuit’s decision in Fin. Planning Ass’n v. SEC,2 vacating Rule 202(a)(11)-1, the SEC re-proposed an interpretive rule reinstating several interpretive provisions of the vacated rule to clarify that certain types of advice are not solely incidental to brokerage services. Advisers Act Release No. 2652 (September 24, 2007). Although the release did not make any mention of the application of the exception to wrap fee programs, that should not necessarily be taken to mean that the SEC has abandoned its previously held view that advisory services provided by sponsors of wrap fee programs are incidental to brokerage services..3 B. 2 “Investment Company” Status of Wrap Programs Fin. Planning Ass’n v. SEC, 482 F.3d 481 (D.C. Cir. 2007). 3 This statement was also made in an SEC guide to the regulation of investment advisers update through November 2006, prior to the D.C. Circuit’s decision in FPA. “The SEC staff has stated a broker-dealer that receives a ‘wrap fee,’ i.e., a fee based on a percentage of assets that compensates the broker-dealer for both advisory and brokerage services, will receive ‘special compensation.’” The Regulation of Investment Advisers, by the Securities and Exchange Commission. Robert E. Plaze, updated to November 22, 2006. http://www.sec.gov/about/offices/oia/oia_investman/rplaze-042006.pdf -2- The SEC and its staff have long taken the position that certain discretionary investment management programs fall within the definition of “investment company” and are subject to registration as such unless they are exempt.4 Specifically, in the Rule 3a-4 Reproposing Release, the SEC stated that under these programs: “[A] customer’s account typically is managed on a discretionary basis in accordance with preselected investment objectives. Customers with similar investment objectives often receive the same investment advice and may hold the same or substantially the same securities in their accounts. In light of this similarity of management, some of these Investment Advisory Programs meet the definition of investment company.” The SEC and its staff’s position in this area developed over the course of more than two decades in which the SEC brought two significant enforcement cases and submitted two rule proposals. The area has come under increased scrutiny over the past two years, as the Investment Company Institute submitted a rulemaking petition to the SEC that might scale back the scope of Rule 3a-4 and the SEC staff launched two examination sweeps to inform itself of practices in the area and possible concerns. Rule 3a-4 has its origins in an enforcement action brought by the SEC in the early 1970s, which was followed by a study of small account investment management services conducted by the Advisory Committee on Investment Management Services (“Advisory Committee”). A number of the Advisory Committee’s recommendations were incorporated into the original Rule 3a-4 proposal in 1980, which would have provided a safe harbor for investment management services affording clients individualized treatment. The rule was not adopted at that time, however, due to public opposition. Thereafter, the SEC’s staff issued a series of no-action letters relating to investment management programs offered to individuals, in which the relief granted was based on the conditions of the proposed rule. Some twenty years later, in June 1995, the SEC brought its second enforcement action in the area, which was followed by the SEC’s reproposal of Rule 3a-4 later that year. 1. Clarke Lanzen Skalla In In the Matter of Clarke Lanzen Skalla Investment Firm, Inc., Advisers Act Release No. 1501 (June 16, 1995) (“Clarke Lanzen”), the SEC sanctioned an investment adviser and its principals for operating a mutual fund asset allocation program that constituted a de facto unregistered investment company. Under the Clarke Lanzen program, customers were provided with a choice of six different investment strategies, ranging from aggressive to defensive, each with a predetermined investment formula. Once a strategy was selected, the investment adviser invested customer funds in no-load mutual funds on the same basis for all customers who chose the same investment strategy. The investment adviser’s principals had investment discretion and made all investment decisions for program customers. The SEC found in Clarke Lanzen that the program violated the Investment Company Act because it failed to register as an investment company. While the SEC did not identify the specific factors that led to its conclusion that the program was an unregistered investment company, the program failed to meet many of the requirements of reproposed Rule 3a-4. In particular: 4 A corollary of the proposition that a discretionary investment management program is an “investment company” is the concept that a customer’s interests in the program are “securities.” The SEC stated in the Rule 3a-4 Reproposing Release that such programs “can be deemed to be issuing securities for purposes of the Securities Act of 1933.” The release refers to Clarke Lanzen, discussed below, in which program interests were deemed unregistered securities. Rule 3a-4, as adopted, provides that “[t]here is no registration requirement under section 5 of the Securities Act of 1933 with respect to programs that are organized and operated in the manner described in rule 3a-4.” -3- • There were no records in the investment adviser’s files indicating that customers were contacted periodically to ascertain whether investments in their accounts continued to meet individual investment needs or goals; • Customers did not receive fund proxies, prospectuses, semi-annual and annual reports for the mutual funds in which they were invested; • Customers could not pledge, hypothecate or unilaterally request from the mutual funds the withdrawal of shares from their accounts; and • Customers had no contractual right to instruct the adviser to refrain from purchasing particular mutual fund shares. 2. Proposed Rule 3a-4 The SEC first proposed Investment Company Act Rule 3a-4 in 1980. See Individualized Investment Management Services, Investment Company Release No. 11391 (October 10, 1980) (the “1980 Proposing Release”). The proposed rule would have provided a safe harbor from the definition of “investment company” for programs meeting the following conditions: • The investment manager provides continuous investment advice based on each customer’s individual needs; • A person who is authorized to make investment decisions for a customer’s account (i) interviews the customer regarding his or her financial situation and needs at the opening of the account and at least annually thereafter; (ii) attempts to determine, at least quarterly, whether there has been a change in the customer’s financial situation and needs; (iii) provides the customer with an account statement at least quarterly; and (iv) is reasonably available to the customer during normal business hours; • Each customer maintains, to the extent practicable, every indicia of ownership of his funds, including the right to withdraw, vote, hypothecate and pledge the securities in his or her account and the right to receive a confirmation of each security transaction; and • Each customer has the opportunity and authority to instruct the investment adviser to refrain from purchasing particular securities. 3. Intervening SEC Staff No-Action Letters Following the initial proposal of Rule 3a-4, the SEC staff issued more than 20 no-action letters to persons requesting assurance that the SEC staff would not recommend enforcement action with respect to advisory programs not registered under the Investment Company Act. Each of these letters was conditioned on representations primarily based on the terms of the 1980 version of proposed Rule 3a-4.5 5 See, e.g., Wall Street Preferred Money Managers, Inc. (April 10, 1992); Rauscher Pierce Refsnes, Inc. (April 10, 1992); Westfield Consultants Group (December 13, 1991); Atlantic Bank of New York (June 7, 1991); Morgan Keegan & Company (October 2, 1990); Jefferies & Co., Inc. (June 19, 1989); Strategic Advisers Inc. (December 13, 1988); Scudder, Stevens & Clark (August 17, 1988); Balliett, Blackstock & Stearns, Inc. (August 19, 1987); Shearson/American Express (July 13, 1983); Paley & Ganz, Inc. (December 6, 1982). -4- a. Application of the 1980 Version of Proposed Rule 3a-4 to Novel Invest- ment Advisory Programs The SEC staff, in its June 14, 1995 letter to Benson White & Company, granted no-action relief to permit the operation of what was then a novel mutual fund asset allocation program that would not meet all the requirements of then proposed Rule 3a-4. See Benson White & Company (June 14, 1995). Under the proposed program, a participant’s assets would be allocated between two or more mutual funds, in accordance with predetermined age-based asset allocation ratios. These ratios would be compulsory for virtually all participants. The investment adviser would determine the program’s asset allocation policies and serve as investment adviser to the mutual funds. The staff’s “no-action” response was conditioned, in particular, on the following representations by the investment adviser: • The composition of each participant’s account would differ unless the participants were in the same age bracket; • Program participants would receive a prospectus for each mutual fund; • Participants would approve any change to the asset allocation ratios before implementation; • The investment adviser would reasonably be available to participants for consultation; • Participants would receive required confirmations of securities transactions and quarterly statements containing a description of all account activity; • Participants would be provided with current prospectuses, annual and semi-annual reports, proxies and any other required information and disclosures for each mutual fund; • Participants would have the right to pledge and vote the securities in their accounts and to redeem all or part of their mutual fund shares at any time; and • Participants would retain all rights under the federal securities laws to proceed directly against any mutual fund in which they own shares, and would not, by participating in the program, be obligated to join the investment adviser as a condition to proceed against a mutual fund. Benson White is distinguishable from prior no-action letters for several reasons. First, prior no-action letters suggested that an asset allocation program sponsor (or another person) must interview participants regarding their financial circumstances when the account is opened and at least annually thereafter, and attempt to determine whether a participant’s circumstances have changed at least quarterly. The staff concluded that participant contact is not mandatory given the unique nature of the program. Second, prior no-action letters were conditioned on participants having the right to instruct the investment adviser to refrain from purchasing certain securities on their behalf. The staff stated that it continues to believe individualized treatment is a critical distinction between an investment company and an advisory program outside the scope of the Investment Company Act. Nonetheless, despite the lack of individualized treatment, given the totality of the circumstances and the unique nature of the program, including the participants’ ability to consult with the investment adviser, the individual consent required before changing the asset allocation formula for participants’ accounts and the retention of individual indicia of ownership of securities, the SEC staff agreed that the program need not be registered as an investment company. -5- Finally, earlier no-action letters created some confusion concerning the confirmation delivery requirement that must be met to avoid investment company status. Some letters required confirmations to be delivered to participants on a transaction-by-transaction basis while other letters permitted the delivery of monthly confirmations. 4. Reproposed – and Final – Rule 3a-4 The SEC reproposed Rule 3a-4 in 1995 and adopted the rule substantially as reproposed two years later in 1997. Like the earlier version, the adopted rule provides a non-exclusive safe harbor from the definition of investment company for investment advisory programs that comply with the terms of the rule. The rule states that it is “a nonexclusive safe harbor from the definition of investment company” and that it “is not intended . . . to create any presumption about a program that is not organized and operated in the manner contemplated by” the rule. (Nevertheless, any program operating outside the requirements of Rule 3a-4 will invite scrutiny.) Both the Rule 3a-4 Reproposing Release and the Rule 3a-4 Adopting Release state that the adoption of the rule does not affect the status of no-action letters previously issued by the Division of Investment Management with respect to investment advisory programs. a. Rule 3a-4’s “Safe Harbor” Conditions. While the terms of the final rule generally followed the proposed rule, it was modified to reflect changes since the initial proposal in 1980. The conditions of the final rule are as follows: (i) Management Based on Customer’s Circumstances. Each client’s account in the program is managed on the basis of the client’s financial situation and investment objectives and in accordance with any reasonable restrictions imposed by the client on the management of the account. (ii) Customer Contact At the opening of the account, the sponsor6 (or other person designated by the sponsor) obtains information from the client regarding the client’s financial situation and investment objectives, and gives the client the opportunity to impose reasonable restrictions on the management of the account; (a) (b) At least annually, the sponsor or another person designated by the sponsor contacts the client to determine whether there have been any changes in the client’s financial situation or investment objectives, and whether the client wishes to impose any reasonable restrictions on the management of the account or reasonably modify existing restrictions; (c) At least quarterly, the sponsor or another person designated by the sponsor notifies the client in writing to contact the sponsor or such other person if there have been any changes in the client’s financial situation or investment objectives, or if the client wishes to impose any reasonable restrictions on the management of the client’s account or reasonably modify existing restrictions, and provides the client with a means through which such contact may be made; and 6 The rule defines “sponsor” as “any person who receives compensation for sponsoring, organizing or administering the program, or for selecting, or providing advice to clients regarding the selection of, persons responsible for managing the client’s account in the program. If a program has more than one sponsor, one person shall be designated the principal sponsor, and such person shall be considered the sponsor of the program under this section.” -6- (d) The sponsor and personnel of the manager of the client’s account who are knowledgeable about the account and its management are reasonably available to the client for consultation. (iii) Reasonable Restrictions. Each client has the ability to impose reasonable restrictions on the management of the client’s account, including the designation of particular securities or types of securities that should not be purchased for the account, or that should be sold if held in the account. (a) Limited SEC Guidance The SEC stated that whether a particular restriction is reasonable depends on all of the facts and circumstances, including the client’s stated investment objectives, the difficulty of complying with the restriction, and the specificity and number of such restrictions. The fact that a restriction puts some administrative burden on the manager or may affect performance does not make it per se unreasonable. But, the SEC said that a restriction could be unreasonable if it is “clearly” inconsistent with the client’s investment objective or is “fundamentally” inconsistent with the adviser’s program. A group of restrictions may be deemed unreasonable in the aggregate, even if individually they are reasonable. Likewise, reasonable restrictions can become unreasonable if the client insists on changing them so frequently that it interferes with the orderly management of the account. That said, the SEC has made it clear that restrictions excluding specific securities, securities of an industry, or securities from a specific country generally would be considered reasonable.7 If the adviser’s program involved investments in mutual funds, a restriction based on the specific securities held by the funds might be unreasonably burdensome. As noted above, prior to reproposing Rule 3a-4, the SEC staff had issued a series of no-action letters based on the original rule proposal and its conditions, and these letters continue to be valid. The noaction letters generally required or assumed that the adviser would comply with restrictions on specific securities or groups of securities. The SEC staff granted no-action relief to an adviser that permitted clients to restrict purchases of specific securities, but reserved the right to deem the program to be unsuitable for investors who wanted to invest primarily in fixed income securities.8 The staff also granted no-action relief to an adviser that permitted clients to restrict investments in specific securities or entire industries, while conceding the adviser’s right to terminate clients who wanted to have “continuous, frequent substantive . . . participation” in the management of their accounts.9 (b) Practical Procedures Generally, a wrap sponsor should have procedures to ensure that its wrap program is operated to accommodate reasonable client restrictions. The existence and operation of these procedures will permit a more orderly consideration and administration of client requests in this area. 7 By contrast, a restriction on all foreign securities might be unreasonable if the adviser’s strategy involves investments exclusively or primarily in foreign securities. Likewise, restricting an account to short-term debt instruments might be unreasonable if the manager’s strategy is long-term capital appreciation through investment in equity securities. 8 See Rauscher Pierce Refsnes, Inc. (available April 10, 1992). 9 See Morgan Keegan & Company (available October 2, 1990). -7- Clients generally seek to impose restrictions for various reasons, including the client’s investment or social preferences (for example, clients may wish to bar investments in tobacco, firearms or alcohol related companies). Other reasons include restrictions to which the client is subject by virtue of his or her employment (for example, the client may be employed within the securities industry or the accounting or legal profession and be subject to certain restrictions on what particular securities he or she may invest in; similarly, the client may be an officer of a public company and may, therefore, want to limit investments in that public company) or non-employment affiliation (for example, the client may serve as a director or be a significant stockholder in a public company and may, therefore, want to limit investments in that public company). When considering client requested restrictions, a firm should consider whether the restrictions can be administered in a practical way, without the need to resort to manual processes. For example, a sponsor may reject as impractical such restrictions as bars on stocks subject to third-party social rating services that may be hard to both monitor and react to rating changes, and bars on stocks based on shifting economic or financial criteria (e.g., a bar on any company deriving more than X% of its revenues or profits from tobacco, firearms or alcohol related businesses). Firms should consider placing the administration of client restrictions under the supervision of a client restriction committee, the mission of which is to articulate a list of client restrictions that it regards as reasonable and to work with operations personnel to ensure that acceptable restrictions are accommodated in the wrap program. Such a committee should meet periodically to review a report of client restriction requests (both those accepted and those rejected as unreasonable) and the firm’s experience in administering client impose restrictions to determine whether the listing of acceptable restrictions should be modified. (iv) Customer Reporting. The sponsor or person designated by the sponsor provides each client with a statement, at least quarterly, containing a description of all activity in the client’s account during the preceding period, including all transactions made on behalf of the account, all contributions and withdrawals made by the client, all fees and expenses charged to the account, and the value of the account at the beginning and end of the period. (v) Indicia of Ownership. Each client retains, with respect to all securities and funds in the account, to the same extent as if the client held the securities and funds outside the program, the right to: • Withdrawal of securities or cash; • Vote securities, or delegate the authority to vote securities to another person; • Be provided in a timely manner with a written confirmation or other notification of each securities transaction, and all other documents required by law to be provided to the security holder; and • Proceed directly as a security holder against the issuer of any security in the client’s account and not be obligated to join any person involved in the operation of the program, or any other client of the program, as a condition precedent to initiating such proceeding. b. Current Focus on Rule 3a-4 and Industry Practice (i) ICI Petition Rule 3a-4 and industry practice under it has come under increased scrutiny recently. This scrutiny has been triggered, in part, by the Investment Company Institute’s submission, in March 2001, of a rulemak- -8- ing petition to the SEC urging the adoption of a definitional rule that would clarify that certain portfolio investment programs are “investment companies” within the meaning of the Investment Company Act. See . While this rulemaking petition was aimed primarily at so-called “folio” or “basket” products popularized by Foliofn and E*TRADE, many viewed the petition as potentially undermining Rule 3a-4, even as applied in the traditional wrap fee context. In its June 14, 2001 letter to the SEC opposing the ICI’s rulemaking petition, the Securities Industry Association warned that the ICI’s proposed definitional rule could possibly “cause other types of investments to be deemed investment companies under the Investment Company Act of 1940 and thus subject them to the provisions of that statute.” . (ii) SEC Sweep While the SEC ultimately rejected the ICI’s rulemaking petition, in the summer of 2001, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) conducted a sweep – ostensibly focused on Internet based investment advisory programs – that sought to scrutinize whether these programs are providing individualized investment advice and ascertaining whether they are operating outside Rule 3a-4. More recently, in late 2001 and early 2002, OCIE conducted a sweep of large wrap sponsors that, among other things, sought to gauge compliance with Rule 3a-4. While reportedly neither sweep uncovered significant problems, the SEC continues to be concerned that changes in technology may require modification to the Rule. In his December 6, 2001 address before the ICI’s Securities Law Developments Conference, Paul Roye, then Director of the SEC’s Division of Investment Management, stated “I think we should consider whether the conditions of rule 3a-4 continue to provide effective assurance that clients in those programs receive truly individualized treatment and whether the conditions of rule 3a-4 should be revisited.” (iii) Recent SEC Statements on Rule 3a-4 The SEC staff has continued to indicate that they intend to reconsider the substance of Rule 3a-4 in light of enhanced technologies and investor protection concerns. In an October 19, 2007 speech to the Money Management Institute Managed Account Solutions Conference, Andrew Donohue, director of the Division of Investment Management, stated that the SEC should “periodically review the conditions in Rule 3a-4 to consider whether they provide for an appropriate level of individualized treatment to support an exception from the definition of investment company for certain types of managed accounts or investment advisory programs.” In a March 21, 2008 speech before an IA Week and the Investment Adviser Association Summit, Donohue reiterated this statement and further stated that he has previously “expressed concerns with whether firms were complying with Rule 3a-4.” C. Suitability Issues Among the first cited concerns about wrap fee programs is the issue of whether wrap fee program sponsors and portfolio managers are honoring their duty to make sure that such arrangements are suitable for customers. Despite the decades’ worth of experience with wrap fee programs, there is surprisingly little regulatory guidance on the suitability obligations of wrap sponsors and portfolio managers, including the question of when suitability obligations arise in the context of wrap fee programs and who is responsible for satisfying these obligations. 1. Sources of Obligations a. Broker-Dealers -9- The rules of the securities self-regulatory organizations “(SROs”) require a broker-dealer to ensure that its recommendations are suitable for the customer. See, e.g., NASD Rule 2310 (suitability of recommendations); NYSE Rule 405 (same). For example, NASD Rule 2310 provides that a member, when making a recommendation to a customer, “shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs.” Many states have codified a broker-dealer’s suitability obligations in their securities statutes and rules. b. Investment Advisers As fiduciaries, investment advisers similarly have a general obligation to ensure that, before making a recommendation to or taking action for a customer, the investment adviser has reasonable ground to believe that the recommendation or action is suitable for the customer based on information furnished by the customer after reasonable inquiry concerning the customer’s investment objectives, financial situation and needs, and any other information known or acquired by the investment adviser after reasonable examination of the customer’s financial records as may be provided to the investment adviser. As in the case of broker-dealers, many states have codified this suitability obligation in their securities’ statutes or rules. See, e.g., Uniform Securities Act Rule 102(a)(4)-1(1) (adopted September 3, 1987). The SEC proposed a rule under the Advisers Act in 1994 that sought to, in essence, codify an investment adviser’s suitability obligation. The proposed rule, which was patterned after the SRO suitability rules, would have specifically prohibited an investment adviser from giving investment advice (other than impersonal advice) to a customer, unless the adviser (1) has made reasonable inquiry into the customer’s financial situation, investment experience and investment objectives; and (2) reasonably believes the advice is suitable for the customer. Suitability of Investment Advice Provided by Investment Advisers, Investment Advisers Act Release No. 1406 (March 16, 1994). The SEC withdrew the rule from its regulatory agenda in 1996, but indicated that the rule would receive further consideration. If the SEC adopts the rule – which after fourteen years appears unlikely – investment advisers would be required to retain customer questionnaires or other documents obtained in making suitability inquiries as part of their required records. The SEC release proposing the rule did not discuss the application of the rule to wrap fee arrangements. 2. Suitability Issues in Wrap Programs Suitability in the contexts of wrap fee accounts typically breaks down into at least five different questions. a. Is the Portfolio Manager Suitable for the Program? A wrap sponsor may, depending on the circumstances, be viewed as explicitly or implicitly recommending the portfolio managers participating in its program. A wrap sponsor may, therefore, be obligated under applicable SRO rules to ensure that it has a reasonable basis to believe the portfolio managers are suitable for participation in the programs before it admits the portfolio managers into the program or refers customers to them. There is no “bright line” as to what suffices as a “reasonable basis.” Firms vary on the type and degree of “due diligence” performed on portfolio managers. Rather than impose a minimum degree of due diligence in this area, the SEC has imposed a “say what you do” approach by requiring that wrap sponsors disclose in their Schedule H how they choose participating portfolio managers, as discussed below. b. Is the Program Suitable for the Client? - 10 - Firms have an obligation to ensure that wrap fee programs are suitable for customers before recommending customer participation. In a letter from the SEC’s Division of Investment Management to James Edmunds Wilson, President of the National Association of Personal Financial Advisers (September 20, 1989) ( “NAPFA Letter”), the SEC staff said that an investment adviser must carefully consider whether a wrap fee arrangement is suitable for its customer before entering into such an arrangement, and that the investment adviser probably has a continuing obligation to ensure that the arrangement is suitable for the customer. The SEC staff also made clear that an investment adviser must consider each customer’s investment goals and proposed investment in determining whether a wrap fee arrangement is suitable. Recently, Andrew Donohue, director of the SEC’s Division of Investment Management, stated that the SEC would be “interested in how firms determine that a managed account is the appropriate account for a client and how firms determine that clients are receiving the full value of these accounts and particularly of the ‘bundled’ brokerage services.” < http://www.sec.gov/news/speech/2008/spch032108ajd.htm> There may be a disincentive to trade for wrap fee accounts because the profit from the wrap fee retained by the wrap sponsor is reduced each time a trade is done and the resulting execution costs are incurred. A participating portfolio manager may have an incentive to keep trading down to promote a continuing stream of referrals from the wrap sponsor. Similarly, a wrap sponsor may have an incentive to limit referrals to or outright exclude from its program any investment adviser that trades actively. The SEC staff has expressed concern that the portfolio manager’s and wrap sponsor’s fiduciary duties to customers may be compromised by these trading disincentives, although no hard evidence of abuse in this area has emerged. c. Is the Chosen Strategy Suitable for the Client? Where a wrap sponsor recommends an investment strategy to a customer as part of a wrap program (or otherwise), it has an obligation to make sure that strategy is suitable for that customer. Sometimes a customer may reject a recommended strategy and request, for example, a strategy that is more aggressive than the customer’s circumstances might seem to warrant (possibly to seek the advisory services of a particular portfolio manager). Many firms will scrutinize these “out of category” requests and either reject them or at least seek written confirmation from the customer that the “out of category” request was not recommended by the firm (or its representative) and that the customer understands the added risk carried by the request. d. Is the Portfolio Manager Suitable for the client? As with recommended strategies, where a firm recommends a specific portfolio manager to a customer, it has an obligation to make sure the portfolio manager is suitable for the customer. This includes considering whether the portfolio manager is able to accommodate investment restrictions imposed by the client. Some wrap sponsors seek to limit the scope of any express or implicit recommendation of a portfolio manager by (1) clearly stating the precise basis of any recommendation of a portfolio manager (including the methods used in screening portfolio managers); and (2) adopting the practice of recommending several different portfolio managers (“Rule of Three”) for the customer’s consideration, and leaving it to the customer to make the final selection. Whether these steps ultimately succeed in avoiding or narrowing a recommendation depends on the particular facts. Special issues arise where a sponsor places a portfolio manager on a “watch list” or suspends referrals of new customers to the portfolio manager pending review but before a decision is reached on termination. This may happen because of such factors as lackluster performance, a series of seemingly imprudent investment decisions, the departure of key personnel, or regulatory and legal problems. In this context, - 11 - sponsors generally should consider whether to notify customers of these events to reduce the possibility that further problems will surface after customers have lost money. Special issues also arise where clients elect to stay with portfolio managers that have been terminated from the wrap program. As with “out of category requests,” it is prudent for a wrap sponsor to document that the election was not recommended by the firm (or its representative) and that the customer understands the added risk. Some firms will also seek to lessen possible misunderstandings by transferring the customer’s account outside the wrap fee program and carrying the account as a fee-based brokerage account. e. Are the Portfolio Manager’s Investments Suitable for the Client? Wrap sponsors often take the position – which is often reflected in their client agreements and Schedule Hs – that they are not responsible for monitoring a portfolio manager’s day-to-day trading of a customer’s account. Although this position seems reasonable generally, special issues are posed where a sponsor assumes the role of tactically allocating or rebalancing among disciplines and portfolio managers, such as in the context of so-called “multi-discipline account” (or “MDA”) arrangements. For example, does the sponsor’s more frequent and in-depth involvement heighten a higher suitability obligation on its part? Further, does the sponsor take on greater responsibility for monitoring for conflicts among disciplines and portfolio managers – where one manager’s strategy negates another manager’s strategy or makes it more risky (e.g., where two managers load up on the same issuer resulting in a more concentrated portfolio)? Similarly, contemporaneous purchases and sales of the same stock by the portfolio managers could raise wash sale issues. The extent of a portfolio manager’s suitability obligations beyond investments is less clear and should turn on the specific circumstances. In this regard, the SEC staff have questioned whether – if not hinted that portfolio managers still have a level of responsibility to perform a suitability analysis for each client. On a March 2007 panel at the IAA/IA Week Conference, Robert Plaze, associate director of the SEC’s Division of Investment Management, noted that a wrap fee client is a client of the portfolio manager “as if they were a direct client” of the manager. Accordingly, the manager may maintain overall responsibility for suitability determinations, although that responsibility may be delegated to the sponsor. IM Insight, Wrap Fee Compliance: Beyond Rule 3a-4, April 9, 2007. 3. “Due Diligence” A wrap sponsor’s suitability obligations are viewed as imposing on the wrap sponsor the task of conducting some form of “due diligence” review of the portfolio managers to ensure they are appropriate participants in the wrap sponsor’s program. The thoroughness of any review should correspond to the nature of any recommendation (i.e., a mere referral may not warrant the same amount of “due diligence” as a full fledged recommendation). Also, the more a referral takes the form of a recommendation, the more necessary it may be to conduct routine follow-up due diligence. Wrap sponsors are required to disclose in their wrap fee brochures how portfolio managers are selected and reviewed, as discussed below. Topics that may be appropriate in portfolio manager screening include the following: • Style. Does the portfolio manager actually manage customer accounts in line with its purported style? • Personnel. Who are the key players, and does the portfolio manager have sufficient staffing to handle an increased volume of customer work? - 12 - • Performance Numbers. What is the portfolio manager’s performance for each of its composites over the last five years, and how was the performance calculated (e.g., using GIPS, using performance of portfolio managers at other firms, etc.)? The validity of portfolio manager performance calculations have been a matter of some concern for regulators and wrap sponsors. See Susan Antilla, This Money Manager Can’t Count, New York Times, June 20, 1993, at F15; In the Matter of Seaboard Investment Advisers, Inc., Advisers Act Release No. 1431 (August 3, 1994) (enforcement action against a portfolio manager in various wrap programs that the SEC alleged to have used misleading performance). Wrap sponsors are required to disclose in their wrap fee brochures what they do to review portfolio manager performance information. • Legal & Compliance. Is there adequate assurance that the portfolio manager has adequate internal controls to ensure compliance with applicable law? Wrap sponsors should screen portfolio managers to ensure they are not subject to disqualifications. Wrap sponsors can accomplish this in many ways, including through a combination of reviewing the portfolio managers’ Form ADVs, running a search through the disciplinary databases made available through LEXIS-NEXIS, and contracting with thirdparty consultants. D. Trading and Best Execution Issues 1. Issues for Portfolio Managers Making trading and best execution decisions for wrap accounts can pose special issues for portfolio managers, including complications in the choice of brokers to execute wrap trades and the conflicts that can arise among clients where a portfolio manager needs to direct trades to multiple brokers. a. Best Execution in the Choice of Brokers Most wrap programs are structured so that the portfolio manager is, in theory and by contract, responsible for placing client trades with those broker-dealers that will provide best execution. In practice, most wrap program trades end up being executed through the sponsoring broker-dealer because generally commissions charged by the sponsor for executing transactions are included in the wrap fee and, conversely, the client will be separately charged for any commissions or charges on transactions a portfolio manager places with other broker-dealers. In addition to the actual cost of the execution, an investment adviser also must consider other factors that bear on best execution, including the quality, speed and reliability of the execution, to determine whether the customer is receiving best execution. The SEC staff emphasized this duty in the NAPFA Letter. Nevertheless, even factoring in the various factors relevant to best execution, most managers direct trades to the sponsoring broker-dealer based on the view that so doing is generally consistent with seeking best execution. The appropriateness of this practice has been acknowledged by members of the SEC staff. Recently, for example, Andrew Donahue, the director of the SEC’s Division of Investment Management, acknowledged that there are “very legitimate reasons for an asset manager to place an SMA client's trades with the SMA's sponsor.” As he acknowledged, because the client is paying a single fee for both asset management and trade execution services, execution of trades by a broker-dealer other than the sponsor may result in “possibly a charge the client was not expecting.” Donahue cautioned that portfolio managers must still consider the “possibility that a non-SMA sponsor broker-dealer may be in a position to provide better execution in a particular circumstance.” At a minimum, market participants should consider “the extent to which clients are informed of the way that trade placement decisions are made in the SMA context.” Speech of Andrew J. Donohue to the 2007 Managed Account Solutions Conference http://www.sec.gov/news/speech/2007/spch101907ajd.htm. In a minority of wrap programs, the customer instructs the portfolio manager to direct all trades to the wrap sponsor. This direction effectively absolves the portfolio manager of its best execution obligations - 13 - if the customer has been fully informed of all material facts concerning this type of trading arrangement (i.e., the portfolio manager will not be able to select brokers based on best execution, and the arrangement may limit the portfolio manager’s ability to bunch trades and may result in less favorable net prices). See, e.g., In the Matter of Mark Bailey & Co., Advisers Act Release No. 1105 (February 24, 1988). b. Trading Conflicts Participation in wrap programs can raise challenging trading issues for a portfolio manager that also manages non-wrap accounts. The fact that wrap orders tend – by economics or client direction – to be directed to the sponsoring broker-dealer can force a portfolio manager to break up – across several brokers – orders it might otherwise send to a single broker. Rather than broadcast orders across multiple brokers, a portfolio manager may wisely seek to limit market impact by placing orders with one broker and, once those orders have been executed, then place orders with the next broker. This leads to situations in which some of the portfolio manager’s clients are relegated to trade at the “back of the bus,” very possibly on less favorable terms. Many portfolio managers seek to deal with these issues by implementing a rotational process in which wrap accounts, directed accounts and “unrestricted accounts” take turns going first. While rotation seems a sensible measure to ensure – as portfolio managers must – that clients are treated fairly and equitably over time, it can place institutional orders “at the mercy” of wrap orders especially where large wrap orders may take time to be executed by the sponsor. See What Money Managers Need to Know About Wrap Trading, TraderForum Executive Summary (May 2001). The use of “step outs” may ease this problem, but many sponsors are unwilling or unable to accommodate step outs. Portfolio managers should ensure that they have appropriate Form ADV or other disclosure informing clients of these sorts of trading conflicts. The need for disclosure in this area is illustrated by a recent opinion of Florida’s First District Court of Appeal that held that the City of Gainesville Consolidated Police Officers’ and Firefighters’ Retirement Plan may seek an accounting against the plan’s former investment adviser for an alleged failure to obtain “best execution” on trades for the pension fund. In its complaint, Gainesville alleged that the adviser failed to disclose it would execute Gainesville’s directed stock trades only after it had bought or sold hundreds of millions of dollars’ worth of stocks for the adviser’s other clients. See Court Rules Gainesville Public Pension Fund May Hold Its Former Investment Adviser Accountable, Business Wire (August 6, 2002). Finally, given the SEC’s emphasis in the release adopting Rule 206(4)-7 that advisers’ policies and procedures should reflect conflicts unique to their business, portfolio managers’ policies and procedures, and the process for their periodic review under the rule, should include consideration of these trading conflicts.10 These policies should address trading practices, including procedures by which the adviser satisfies its best execution obligation. 2. Issues for Broker-Dealer Sponsors As broker-dealers, wrap sponsors too have obligations to seek best execution when executing client transactions, even those directed by unaffiliated portfolio managers responsible for the choice of brokers. In addition, when wrap sponsors or their affiliates themselves serve as portfolio managers or otherwise exercise investment discretion, this may result in the wrap sponsors becoming subject to restrictions on 10 Advisers Act Release No. 2204. 68 Fed. Reg. 74714 (December 24, 2003). - 14 - agency-cross and principal transactions under the Advisers Act and restrictions under the Exchange Act on exchange members executing discretionary transactions. In 1996, the SEC instituted proceedings against a wrap sponsor and its president for, among other things, failure to obtain best execution of customer transactions. See In the Matter of Portfolio Management Consultants, Inc. and Kenneth S. Phillips, Exchange Act Release 37376 (June 27, 1996) . The SEC alleged that the wrap sponsor breached its duty of best execution by failing to pass on to its clients superior prices that the sponsor obtained in contemporaneous offsetting transactions. Specifically, the SEC alleged that PMC routinely executed client orders as principal at the prevailing national best bid or offer ("NBBO") and then, in contemporaneous offsetting principal trades, sought and obtained better prices for itself by routing limit orders to third market dealers at prices more favorable to PMC than NBBO prices. According to the SEC, the majority of the offsetting orders were in fact filled at more favorable prices. “Under the circumstances of its arrangement with its clients, PMC had a duty, absent meaningful disclosure and consent, to provide its clients with the superior prices that were reasonably available. In its failure to pass on the superior prices to its clients, PMC breached its obligation of best execution.” PMC and its president, without admitting or denying the SEC’s allegations, consented to the entry of an order imposing remedial sanctions. Contemporaneously with the PMC settlement, the SEC instituted proceedings against PMC’s chairman and CEO, Marc N. Geman. See Exchange Act Release No. 37375 (June 27, 1996) . One year later, an administrative law judge ruled that PMC had “fulfilled its best execution obligation by executing its trades with clients at the NBBO.” The administrative law judge pointed to the court’s decision in In re Merrill Lynch Securities Litigation, 911 F. Supp. 754 (D.N.J. 1995), aff’d sub nom., Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 115 F.3d 1127 (3d Cir. 1997), which addressed the issue of whether failure to provide best execution occurred where trades were effected at the NBBO, without any effort to obtain better prices through other possible sources of liquidity. As recounted by the administrative law judge, “[a]fter an extensive review of the jurisprudence of best execution, which the court noted did not provide clear standards and was evolving, the court found that the duty of best execution, at the time that the defendants executed their trades, was ambiguous, so it could not hold the defendants liable for failing to provide best execution when they had effected trades at the NBBO.” See In the Matter of Marc N. Geman, Initial Decision (August 5, 1997) . On appeal, the SEC sided with the administrative law judge in the SEC’s Valentine’s Day 2001 opinion. See In the Matter of Marc N. Geman, Opinion of the Commission, 43963 (February 14, 2001) . While agreeing “that routine execution of customer orders at the NBBO when better prices are reasonably available can be a violation of the duty of best execution,” the SEC went on to conclude that the record did not establish that prices better than the NBBO were reasonably available for the particular customer trades or that they would have been eligible for price improvement. Nonetheless, the SEC stated that it was “deeply troubled by the Firm's trading practices, particularly its failure to utilize a price improvement service on behalf of its customers.” The SEC went on to caution that, “notwithstanding any ambiguity that may have once existed regarding the matter, it should now be clear that a firm must consider the potential for price improvement in carrying out its best execution obligations.” a. Agency-Cross and Principal Transactions Where a wrap sponsor or one of its affiliates effects agency-cross transactions (that is, transactions in which the sponsor, or any person controlling, controlled by or under common control with the sponsor, acts as broker for the party or parties on both sides of the transactions), the wrap sponsor must disclose the capacity in which it is acting and obtain the customer’s informed consent pursuant to the requirements - 15 - of Section 206(3) and Rule 206(3)-2 under the Advisers Act. Accordingly, wrap sponsors frequently incorporate into their customer agreements provisions whereby the client prospectively authorizes the sponsor and its affiliates to effect “agency cross” transactions and acknowledges that (i) the sponsor or its affiliates may receive compensation from the other party to such transactions; (ii) as such, the sponsor will have a potentially conflicting division of loyalties and responsibilities; and (iii) the client can revoke his or her consent anytime by written notice. By contrast, where a wrap sponsor or one of its affiliates, acting as principal for its own account, effects a sale or purchase of a security for the account of a customer, the investment adviser must disclose the capacity in which it is acting and obtain the customer’s informed consent to the particular transaction under Section 206(3). See Advisers Act Release No. 1732 (July 17, 1998) ; Advisers Act Release No. 881 (September 9, 1983); Advisers Act Release No. 40 (January 5, 1945). Section 206(3)’s restrictions on principal transactions apply to so-called “riskless” principal trades, see, e.g., In the Matter of The Feldman Investment Group, Inc., Advisers Act Release No. 1538 (November 27, 1995), and to transactions effected in a principal capacity by an affiliate, see, e.g., Hartzmark & Co., Inc. (November 11, 1973). Unlike customer consent for agency-cross transactions (which, as noted, may be obtained prospectively), customer consent for principal transactions must be obtained, on a trade-by-trade basis, before the “completion of [each] transaction.” The SEC has brought enforcement actions against wrap sponsors for effecting principal transactions in violation of Section 206(3). See, e.g., In the Matter of Gruntal & Co., Incorporated, Advisers Act Release 1560 (April 9, 1996) . Significantly, Section 206(3) does not apply to any transaction, whether principal or agency cross, with a customer of a broker-dealer if the broker-dealer is not acting as an investment adviser in relation to such transaction. Since in most wrap fee programs the wrap sponsor acts as investment adviser only by counseling customers on the selection of a portfolio manager and then monitoring the portfolio manager’s performance, the wrap sponsor is not acting as an “investment adviser” in relation to trades made at the portfolio manager’s direction. Therefore, Section 206(3)’s restrictions on agency cross and principal trades should not apply to the wrap sponsor in these circumstances. This position was confirmed by the SEC staff in an April 16, 1997 letter to Morgan, Lewis & Bockius LLP. In this letter, the SEC staff determined that, when a transaction is directed to a broker-dealer sponsor by an unrelated portfolio manager that has investment discretion to manage the account, and the broker-dealer does not recommend, select or play any role, direct or indirect, in the portfolio manager’s selection of particular securities to be purchased for, or sold on behalf of program clients, then the brokerdealer would not be acting as an investment adviser in relation to the transaction for purposes of Section 206(3). As a result, many wrap sponsors incorporate into their client agreements provisions whereby the client prospectively authorizes the sponsor to effect principal transactions “to the extent permitted by law and subject to applicable restrictions.” Despite the SEC staff’s Morgan, Lewis no-action letter, wrap sponsors generally have refrained from executing retirement account trades as principal because of open questions concerning the possible applicability of the prohibited transaction provisions of the Employee Retirement Income Security Act of 1974 (“ERISA”) and corresponding provisions of the Internal Revenue Code. In May 1998, the Investment Adviser, Investment Company, Federal Regulation and Retirement Products and Estate Services Committees the Securities Industry Association (“SIA”) together wrote the Department of Labor (“DOL”) urging the DOL “to clarify that it interprets Section 406(b)(2) of ERISA in a manner consistent” with the views of the SEC staff in the Morgan, Lewis no-action letter, stating that under the circumstances, “whether the trades by such a Dual Registrant are executed on a principal or agency cross basis, the concerns that underlie Section 406(b)(2) clearly are not present.” - 16 - . The DOL has not formally acted on this request. b. Discretionary Trades by Exchange Members Where a wrap sponsor is a member of a national securities exchange and effects a transaction on the exchange in which it or an associated person exercises investment discretion, the wrap sponsor must comply with Section 11(a) of the Exchange Act. Section 11(a) of the Exchange Act prohibits a member of a national securities exchange from effecting transactions on the exchange for its own account, the account of an associated person, or an account in which it or an associated person exercises investment discretion (collectively, “covered accounts”), unless an exception applies. Section 11(a) was substantially revised by the Securities Acts Amendments of 1975 to address trading advantages enjoyed by exchange members and conflicts of interest in money management.11 In particular, as the SEC has stated, Congress was concerned about members benefiting in their principal transactions from special “time and place” advantages associated with floor trading – such as the ability to “execute decisions faster than public investors.”12 Section 11(a) excepts from its prohibitions certain transactions, including (i) under paragraph (E), “any transaction for the account of a natural person, the estate of a natural person, or a trust created by a natural person for himself or another natural person”; and (ii) under paragraph (H), “any transaction for an account with respect to which [the] member or an associated person thereof exercises investment discretion if such member: • “Has obtained, from the person or persons authorized to transact business for the account, express authorization for such member or associated person to effect such transactions prior to engaging in the practice of effecting such transactions”; • “Furnishes the person or persons authorized to transact business for the account with a statement at least annually disclosing the aggregate compensation received by the exchange member in effecting such transactions”; and • “Complies with any rules the Commission has prescribed with respect to the requirements of clauses (i) and (ii).”13 11 See Securities Reform Act of 1975, Report of the House Comm. on Interstate and Foreign Commerce, H.R. Rep. No. 94-123, 94th Cong., 1st Sess. (1975) (“House Report”); Securities Acts Amendments of 1975, Report of the Senate Comm. on Banking, Housing and Urban Affairs, S. Rep. No. 94-75, 94th Cong., 1st Sess. (1975). 12 See Securities Exchange Act Release No. 14563 (March 14, 1978); Securities Exchange Act Release No. 14713 (April 27, 1978); Securities Exchange Act Release No. 15533 (Jan. 29, 1979); House Report at 54-57. 13 SEC Rule 11a2-2(T), the so-called “effect-versus-execute” rule, also permits an exchange member, subject to certain conditions, to effect transactions for discretionary and other covered accounts by arranging for an unaffiliated exchange member to execute the transactions directly on the exchange floor. To comply with the “effect-versusexecute” rule’s conditions, a member: (i) must transmit the order from off the exchange floor; (ii) may not participate in the execution of the transaction once it has been transmitted to the member performing the execution (the member may, however, participate in clearing and settling the transaction.); (iii) may not be affiliated with the executing member, and (iv) with respect to an account over which the member has investment discretion, neither the member nor its associated person may retain any compensation in connection with effecting the transaction without express written consent from the person authorized to transact business for the account in accordance with the rule. - 17 - Although technically client authorization only needs to be obtained from non-natural person clients (i.e., institutional clients), practically speaking, most sponsors subject to Section 11(a) incorporate the authorization into their client agreements (and indicate in the contractual language that it applies to “certain” accounts). c. Limit Order Protection Wrap sponsors must also comply with the NASD’s Limit Order Protection Rule, NASD Rule 2110 and Interpretation IM-2110-2, which generally prohibits NASD members from trading ahead of unexecuted customer limit orders. The rule’s prohibition also applies to orders for which the wrap sponsor acts as agent by sending the order to another NASD member for execution. Thus, if an order that the wrap sponsor sends to another market maker is triggered at the wrap sponsor because the wrap sponsor has traded as principal, the wrap sponsor must protect the order by ensuring that it is executed immediately. The broker-dealer holding the order, however, may not be ob