On Oct. 1, Charles Schwab & Co. announced that it would be reducing its commission rate for online trading for U.S. equities and exchange-traded funds (ETFs) from $4.95 to zero beginning with the start of trading on Oct. 7. Shortly after that announcement, TD Ameritrade announced its intentions to eliminate its commissions on the same types of securities. The following day, E-Trade announced its intentions to do the same thing.
It remains to be seen if the likes of Fidelity, Pershing, State Street, Royal Bank of Canada, TradePMR, and Interactive Brokers will follow suit for investment advisers. While Interactive Brokers introduced a light version of its platform that does not charge commissions, it is unclear whether that service is available for investment advisers and their clients.
What remains clear is that these announcements have legal and regulatory implications for most investment advisers. First, investment advisers that have negotiated asset-based pricing with their clients’ qualified custodian should review those agreements and consider whether those agreements result in achieving best execution for their clients. Second, investment advisers that sponsor or participate in wrap fee programs should review the implication of these announcements by their custodians. Lastly, investment advisers should more generally consider all of the effects of the recent news.
Asset-based pricing is precisely what it sounds like: a negotiated agreement between an investment adviser and one of its qualified custodians that its clients will pay a single, asset-based charge for trade execution instead of incurring commissions each time the investment adviser trades in the client’s account. Investment advisers who enter into these arrangements have made a calculated judgment that their clients participating in asset-based pricing will trade frequently and will benefit from pricing based on a percentage of the assets held in their account as opposed to the number of transactions that the investment adviser expects to make. This rate is a low-to-middle single digit basis point fee.
Given the news that certain qualified custodians are reducing their commission schedules on trading in U.S. equities and ETFs, investment advisers that maintain asset-based pricing arrangements should immediately review whether these arrangements make sense for their clients. If the bulk of their trades involve U.S. equities and ETFs, it would seem that these arrangements are not in keeping with their obligation to seek best execution.
Another area investment advisers should spend time analyzing in light of the recent news from Schwab and other qualified custodians is their sponsorship and participation in wrap fee programs. A wrap fee program, as defined by the Glossary of Terms to Form ADV, is “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.” Put simply, a wrap fee program is an arrangement where clients pay a single asset-based fee and do not pay separately for transactions (i.e., commissions).
Wrap fee programs that involve U.S. equities and ETFs could potentially be priced incorrectly. In addition, investment advisers sponsoring these programs may need to consider notifying participants about the recent news and the effects it may have on the program, if deemed material.
On the plus side, the recent news could eliminate one of the conflicts of interest inherent in a wrap fee program — the disincentive for the manager to trade — because trading costs will not be passed on to the manager in U.S. equities and ETFs. Therefore, investment advisers should review their universe of securities used in their wrap fee program and revise their Wrap Fee Program Brochures to the extent necessary.
In conclusion, now is the best time for investment advisers to more generally review their custodial relationships and determine whether they are meeting their obligations to seek best execution on behalf of their clients. In addition, investment advisers should review their investment advisory agreements and Form ADV brochures to ensure that they are still accurate.
Max Schatzow is an Associate at Stark & Stark and a member of its Investment Management & Securities Group, where he concentrates his practice on counseling financial service entities including investment advisers, broker-dealers and private investment companies on registration, compliance, liability and litigation issues. Max’s practice also focuses on the formation of private investment funds. He advises fund managers with respect to day-to-day legal, fund maintenance and operational matters, including internal general partner and management company issues.