Untangling the wrap-fee rules.

With wrap-fee programs proliferating at every turn, the SEC has decided it's high time for some regulatory sobriety. Here's a look at the commission's proposed regulations.

Recently, the Chicago Tribune reported that institutional and individual investors have poured an estimated $90 billion into wrap-fee programs. More conservative estimates place the number at $65 billion, but either way, this is still a major jump from the estimated $40 billion invested in 1992. One thing's for certain: Wrap-fee programs are the fastest-growing investment medium in the United States.

Large companies have always been the biggest wrap-fee customers, but now that smaller investors have begun to enter the picture, wrap-fee programs have attracted the attention of the Securities and Exchange Commission, which wants to make sure all wrap-fee clients receive proper disclosure and understand the services they're buying. If your company uses these programs, you should know that the SEC has proposed amendments to regulations in the Investment Advisers Act of 1940.

Under the proposal, investment advisers who are wrap-fee sponsors would have to give their current and prospective wrap-fee clients a concise brochure, which would spell out important information about the costs and services of the wrap-fee program. This brochure would take the place of the disclosure document that all investment advisers now have to give their clients.

By definition, a wrap-fee program bundles or wraps investment advice, custody and execution services under one contract for a single fee. Generally, these programs involve one or more investment advisers and a broker-dealer that provide the client with portfolio management and asset-allocation services, maintain custody of the client's funds and securities and execute client securities transactions. The fee is a flat annual sum based on the amount of assets under management (in contrast to separate fees for each transaction), and the price includes brokerage commissions based on the amount or type of securities transactions executed for a given account.

For companies with actively trading accounts, the main advantage of a wrap-fee program is not having to pay commissions on each transaction. The wrap fee also eliminates any incentive for brokers to "churn" accounts, since they aren't compensated based on the number of securities transactions. But for accounts that aren't actively traded, the program may impose excessive costs. Plus, because the broker's expenses, but not its compensation, are tied to the number of securities transactions executed, the broker may have an incentive to undertrade a company's account.

The SEC's proposal would define a wrap-fee program as "a program under which any client is charged a specific fee or fees not based directly upon the transactions in the client's account for investment advisory services and execution of transactions." However, this definition wouldn't include a so-called managed-account program. This type of program may provide clients with all the same services as a wrap program, but the charges are based on the number of transactions executed for the account.

The term "sponsor" would include any investment adviser that sponsors or organizes a wrap-fee program or that provides advice on selecting other investment advisers to act as portfolio managers in connection with a wrap-fee program. Those portfolio managers would still be required to deliver their disclosure document to clients. But they wouldn't be responsible for providing clients with the brochure describing the wrap-fee program.

The definition of a wrap-fee program would also include programs that charge for advice on allocating assets among mutual funds affiliated with the sponsor. This portion of the definition has raised some concerns in the mutual-fund industry, which fears that any investment adviser who recommends that a client invest in an affiliated mutual fund could be considered a wrap-fee program sponsor. If that's true, the adviser theoretically would be subject to the proposed disclosure requirement, even if he charges a separate fee for investing in the fund.

At the same time, an investment adviser who recommends allocating assets among unaffiliated mutual funds, even if he doesn't charge a separate fee for investing in the funds, isn't considered a wrap-fee sponsor. While the proposal may seem inequitable, it's possible the SEC may change its mind. The commission specifically asked for public comment on this issue and will undoubtedly respond to industry concerns.

The proposal does allow for more than one sponsor. In that case, only one of the sponsors would be required to file the brochure with the SEC and deliver it to prospective clients. The SEC would also permit multiple sponsors to decide how to allocate the responsibility of filing and delivering the wrap-fee brochure. However, all the sponsors would remain liable for making sure the SEC's requirements are executed correctly.

A PROFUSION OF CONFUSION

One part of the proposal could cause plenty of confusion. The text suggests that brokers and registered representatives, as well as financial planners who solicit clients for a wrap-fee program and help them develop investment objectives, are investment advisers and may be defined as wrap-fee program sponsors. But under the SEC's cash solicitation rule, Rule 206(4)-3 of the Advisers Act, a solicitor does not, based on its solicitation activities alone, have to register as an investment adviser.

Although the commission didn't specifically address the issue of solicitors, this wording further confuses their status. In many instances, solicitors are already required under state securities laws to register as associated persons of an investment adviser. In the context of a wrap-fee program, only one sponsor would need to provide a client with a copy of the wrap-fee brochure, but a solicitor required to register as an investment adviser and deemed a sponsor could be required to furnish clients with as many as three different disclosure documents.

What's more, the proposed wrap-fee brochure would be in narrative format, instead of the check-the-box format typical of an investment adviser's disclosure document. Although narrative disclosure brochures have been permitted for a long time, this proposal is significant because it requires the narrative format. In light of recent comments by both members of the commission and of Congress on the need for better investment-adviser disclosure documents, it's likely that the wrap-fee brochure requirements, if adopted, will serve as the model for revised brochure requirements applicable to all investment advisers.

However, the SEC staff has indicated that it doesn't plan to change the brochure requirements for all investment advisers. That's fortunate, because a change like that could mean that all 21,000 registered investment advisers would have to file revised registration statements until after 1995, when the proposed centralized filing system for all state and federal investment-adviser registration statements will be in place.

The wrap-fee brochure would include only information related to the sponsor's wrap-fee program. Therefore, an investment adviser/wrap-fee program sponsor couldn't use a single document that contains information about both its wrap-fee program and its other advisory services.

The one exception to this provision is in the case of a single investment program that has a choice of fee arrangements, either a wrap-fee or a traditional arrangement, which would entail separate fees for advisory services and brokerage transactions. In that case, both fee arrangements must be described in the wrap-fee brochure. An investment adviser sponsoring two or more wrap-fee programs wouldn't have to prepare a separate brochure for each program, unless it wanted to do that. Instead, the sponsor would have the option of using a single brochure to describe all of its wrap-fee programs.

Whether or not the proposal ultimately becomes final, make sure your company receives all the required information from your broker. And it's always a good idea to have the program sponsor spell out all of its relationships to the various funds and portfolio managers. If you see a potential conflict of interest, you may want to reevaluate your wrap-fee program sponsor and your company's use of wrap-fee programs as investment vehicles.

WRAP-FEE PLANS MAKE A BUNDLE

What They Charge

Broker                          Max. Annual Fee for Accounts

                                  Equity       Fixed-Income

Dean Witter                         3%             1.5%
A.G. Edwards                        3%             1.5%
Kemper                              3%             1.25%
Merrill Lynch                       3%             1.75%
Paine Webber                        2.8%           1.25%
Prudential                          3%             1.25%
Smith Barney Shearson               3%             1.25%

Note: The annual fee is reduced as assets in the account increase. An equity
account with more than $2 million in assets typically would have an annual fee
of less than 2%.

Source: Fortune Investors' Guide 1994

ALL WRAPPED UP

Here's what the proposed wrap-fee brochure would disclose, in a nutshell:

* The name, address and telephone number of the sponsor

* The amount of the wrap fee

* Whether the wrap fee is negotiable

* The portion of the wrap fee that's paid to the portfolio manager

* The fact that the wrap fee may be more or less than the cost of the same services purchased separately

* Any fees a client may have to pay in addition to the wrap fee

* How portfolio managers are recommended or chosen

* If performance information is included, the standards under which it's calculated and whether the sponsor or a third party has verified it

* How often the sponsor apprises the portfolio manager of a client's investment objectives and financial circumstances, and the nature of any such information

* If the sponsor is the portfolio manager, the nature of the portfolio management services it offers

* Information on potential conflicts of interest that an investment adviser would currently be required to disclose in an investment adviser's brochure

Mr. McGuire is counsel in the Washington, D.C., office of Reed, Smith, Shaw and McClay.