April 12, 2018: The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert to highlight recurrent deficiencies observed in their recent examinations of investment advisers’ policies and procedures governing client fee and expense assessments. The deficiencies were identified by OCIE while conducting more than 1,500 investment adviser examinations over the past two years. This Risk Alert emphasizes the importance of advisers’ provision of clear and thorough disclosures in Form ADV and client investment advisory agreements. The Risk Alert further underscores prior Commission guidance relating to adviser obligations to develop, implement, and test effective risk-based compliance policies to minimize the risk of misrepresentation in client communications and the risk of misappropriation in the management of client assets.
Most Frequent Compliance Issues – Advisory Fees and Expenses
The following issues were deemed to be significant and prevalent in nature, although they do not constitute all fee and expense-related findings detected by OCIE.
Fee-Billing Based on Incorrect Account Valuations
Most investment advisers assess client fees based on the market value of client accounts. In this respect, incorrect portfolio valuations will produce an incorrect client fee assessment. OCIE observed that in most cases these client fee assessment errors resulted in client overcharges. Examples of observed errors related to client account valuations include:
- The application of acquisition cost rather than fair market value for illiquid security holdings
- Fee assessment methodologies which differ from those specified in client investment advisory agreements and/or in Form ADV disclosures, such as
- Asset values based on end-of-quarter balances rather than month-end average balances
- Assessing fees on designated asset classes that are carved out of the account value in the advisory agreement, such as cash or alternative investments.
We believe that if an adviser is found to have systemically overcharged clients for an extended period of time, the Commission would likely regard this circumstance as misappropriation of client assets. Further, if the client was an ERISA qualified plan, the adviser would be deemed to have engaged in a prohibited transaction pursuant to Section 406(b) of ERISA wherein a plan fiduciary is prohibited from using the plan’s assets in their own interest, thereby creating a breach of fiduciary duty.
Billing Fees in Advance or with Improper Frequency
The timing and/or frequency of fee billings which diverge from disclosures in the advisory agreement and/or Form ADV can lead to errors, such as:
- Billing monthly rather than quarterly
- Billing in advance rather than in arrears
- Overbilling fees for partial periods, such as when the account inception date occurs mid-billing period, or when the account terminates mid-billing cycle
Applying Incorrect Fee Rate
OCIE staff observed situations where the fee rate used to calculate client fees was incorrect, often resulting in overcharges or double-billing. In some cases, staff observed the application of a performance fee in accounts where clients did not meet the qualification requirements for performance fees under Section 205(a)(1) of the Investment Advisers Act.
Omitting Rebates and Applying Discounts Incorrectly
Common deficiencies observed by OCIE staff related to fee overcharges when advisers did not honor rebates, discounts, or breakpoint schedules as disclosed within advisory agreements or Form ADV disclosures. For example, advisers:
- Failed to house-hold client account values which would have resulted in fee discounts
- Failed to step down fees in accordance with pre-arranged breakpoint schedules
- Charged additional fees or expenses, such as brokerage fees, when clients were already paying bundled fees within, for example, advisory wrap programs
Disclosure Issues Involving Advisory Fees
Examinations detected incongruencies between investment adviser disclosures and actual billing practices in the following circumstances:
- Failure to honor disclosed fee cap agreements
- Failure to disclose fee mark-ups or add-ons, including advisers who:
- Collected expenses for third-party execution and clearing services that exceeded actual expenses charged by the outside clearing broker
- Earned additional compensation on certain asset purchases, or implemented fee sharing arrangements with affiliates without disclosing same to clients
Adviser Expense Misallocations
The final category of deficiency highlighted by OCIE staff was expense allocation observed in the private fund space. Most commonly, staff observed advisers that allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to fund clients instead of to the adviser, in contravention of governing documents and prior disclosures.
With this guidance in hand, advisers should evaluate their compliance testing programs to ensure that internal controls are effectively designed to identify the risk sets highlighted in the Risk Alert. Secondly, advisers should ensure that compliance policies and testing programs are truly risk-based, designed with a thorough understanding of your firm’s unique business model and fee/expense practices in mind.
In all things compliance, it is wise to follow the money. That is what your regulators do, and you should follow suit. And remember to mix things up. In the spirit of managing risk, policies and testing methodologies should be dynamic, hopefully to stay one step ahead of issues and problems.
Finally, effective compliance testing programs find errors. When fee overcharges are identified, resolve them immediately. If fee overcharges are discovered to be systemic, redesign the billing system.
The Risk Alert is available by following this link: https://www.sec.gov/files/ocie-risk-alert-advisory-fee-expense-compliance.pdf.