N.Y. Attorney General (and Governor-Elect) Sues UBS for Wrap Accounts

Eliot Spitzer, current Attorney General and incoming Governor of New York, has long been the bane of Wall Street nogoodniks. With only two weeks to go in office, Spitzer sued the largest financial services firm on the planet, Union Bank of Switzerland (more commonly known as UBS), for allegedly overcharging customers in fee-based accounts. As with many Spitzer actions, the suit has been greeted with calls of over-reaching and headline pursuit. Seeing as my firm's eschews commissions in favor of this type of fee-based business, I find myself in a unique position to comment on the merits. If you are wondering what type of relationship is proper for your situation, read on.

Traditionally, brokerage customers were charged commissions when they made a transaction. If you bought 100 shares of XYZ, the broker probably tagged you for a few hundred dollars. When brokerage commissions were de-regulated in the 1970's, and especially since the 1990's when technology has made it possible to process trades for a few pennies, competition has pretty made it difficult for the army of Merrill Lynch-style brokers who had to convince their customers that their advice was worth $300 when several online brokers were charging $9.99. Additionally, this problem created a conflict of interest when brokers had the incentive to recommend more trades than would be suitable for most, a practice known as churning.

To respond to these competitive pressures, brokerage firms unveiled so-called "wrap" accounts. In these programs, customers generally get trades at low or no-cost, but instead pay the firm a small percentage of assets under management. A typical wrap fee is in the 1.5 - 2 % range, so a customer with a $100,000 balance would be dinged for $1,500 to $2,000 per year. This might be a good deal for a customer that trades a lot. These accounts are also suitable for someone who truly wants somebody else to make all the financial decisions. For that type of service, 1.5% - 2% is neither unhead of, nor unreasonable.

The abuses on Wall Street happen when brokers put their wrap customers into vehicles that already have steep fees, and without having read the lawsuit, I am almost certain this is where Spitzer found his outrage. Very few brokers these days are calling about individual stocks. Instead, most commission-based brokers are selling vehicles such as mutual funds or annuities, which themselves have steep fees of up to 3% per year, and maybe even front-end loads of up to 8.5%. Theoretically, at least, these fees are supposed to pay for the professional management and decision-making. So, why pay an additional wrap fee on top of this? Piling on fees on top of fees is unethical, but many of our sterling, white-shoe firms get away with it.

When faced with increasing quotas, and decreasing trading commission income, moving low maintenance, self-directed customers into wrap accounts is an easy way for a sales manager to meet his goals. Trust me on this, as I've witnessed it firsthand. This type of practice is one reason I chose to open my own practice, rather than be conflicted between clients and my boss.

Now, to be certain, Spitzer is himself only telling half-truths. Wrap accounts are not the problem in and of themselves, and for many, many people, they are absolutely appropriate. A wrap fee is appropriate under two circumstances: 1) When you have a Separately Managed Account (SMA) which consists of a broad pool of individual equities, and 2) When you have no desire whatsoever to make the financial decisions, but you want your broker to take advantage of the opportunities that arise. At First Sustainable, the Folio method of investing allows an investor to buy an underlying index of stocks, thereby cutting out the mutual fund structure. It is more tax efficient, usually less expensive, and better able to handle social screening. We charge customers nothing (or a nominal ticket charge, depending on the security) for trades, and instead assess a wrap fee that is still less expensive than the average actively managed mutual fund.

In their defense, UBS has 2 million wrap accounts. At that scale, finding a few instances of inappropriate behavior is a given. They will claim that the practice is not widespread. I can not comment for UBS, but I can say definitively that unscrupulous operators, some of whom reside in this country's largest firms, are everywhere. On balance, Spitzer's move is once again positive news for investors. Anything that can raise an awareness about when these practices are appropriate will be useful.