RIA Compliance Blog
On August 26, 2022, the U.S. Securities and Exchange Commission (“SEC”) issued an order settling charges against Kovak Advisors, Inc. (“Kovak”), for compliance failures related to its wrap fee program. The case highlights how important it is for an investment adviser to adopt and follow policies and procedures relating to any wrap fee program, to ensure that the adviser’s services are in the client’s best interest.
From 2015 through August 2018, Kovak offered advisory services to clients through a wrap fee program. Clients that participated in the wrap fee program paid a fee that included asset management, trade execution, and other costs. The SEC made three findings during the time Kovak offered the wrap fee program.
First, Kovak failed to review accounts in the program for inactivity to determine if a wrap fee remained in the best interest of clients who traded infrequently. Specifically, Kovak’s brochures and some client agreements provided that it would conduct periodic reviews of advisory accounts to determine whether the wrap fee program was suitable. The SEC found that Kovak failed to conduct these reviews in a timely manner, which resulted in some wrap clients having to pay fees despite having little or no activity in their accounts.
Second, Kovak failed to sufficiently disclose certain transaction costs clients would pay in addition to the wrap fee. Some of the clients who participated in the wrap program were charged transaction costs by clearing brokers that participated in Kovak’s wrap program. Some clients were also charged transaction costs applicable only to non-wrap accounts. While Kovak did disclose that wrap clients may incur costs on top of the wrap fee for certain types of transactions, some wrap clients paid transaction fees on types of securities other than those listed in the disclosures. Based on this, the SEC found that Kovak failed to adequately disclose that wrap clients may be exposed to additional transaction costs.
Third, Kovak failed to adopt policies and procedures reasonably designed to prevent violations related to the wrap fee program. Kovak had policies and procedures in place designed to conduct reviews of client accounts, including volume of trading. However, at the time of the SEC exam in 2017, Kovak had not conducted a review in two years. After the exam, they conducted a review, but then failed to have policies and procedures in place designed to monitor inactivity or to provide parameters for assessing whether a wrap account remained suitable for a client. The SEC further found that Kovak failed to adopt policies and procedures regarding the accuracy of its disclosures on reviewing for account inactivity and the additional transaction costs accrued by wrap clients. Finally, the SEC found that Kovak filed to complete its annual compliance review for at least 2012 to 2015.
Based on these failures, the SEC found that Kovak violated the Investment Advisers Act of 1940 and ordered that the firm cease and desist these violations; be censured; and pay disgorgement of $166,239, prejudgment interest of $33,274, and a civil penalty of $700,000. In determining these sanctions, the SEC took into consideration remedial efforts made by Kovak, including hiring outside counsel and compliance professionals to draft improved disclosures and revise compliance policies and procedures.
Investment advisers whose clients may participate in a wrap fee program should take note of this enforcement action and ensure that disclosures concerning wrap and transaction fees are sufficient and that there are adequate policies and procedures in place to review and assess the suitability of wrap fee programs for participating clients.
Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.