The SEC’s Office of Compliance Inspections and Examinations (OCIE) this week provided investment advisers with a summary of frequent compliance issues related to advisory fees and expenses that the staff is seeing in their examinations of registered investment advisers.

The Risk Alert, published April 12, 2018, is the latest in a series of similar alerts published by OCIE to educate advisers and other market participants regarding consistent risk themes it identifies in its examination program and to promote compliance. OCIE said that its objective in publishing this Risk Alert is to “encourage advisers to assess their advisory fee and expense practices and related disclosures to ensure that they are complying with the [Investment] Advisers Act, the relevant rules, and their fiduciary duty, and review the adequacy and effectiveness of their compliance programs.” The Risk Alert summarizes deficiencies identified in more than 1,500 examinations completed during the past two years.

Advisory Agreements

OCIE said that the terms of an agreement under which an adviser provides advisory services to its clients and the disclosure of fee and expense policies in Part 2A of Form ADV represent critical information upon which clients rely to make informed decisions, including about whether to engage or retain an adviser. Accordingly, an adviser that does not adhere to the terms of these agreements and disclosures, “or [who] otherwise engages in inappropriate fee billing and expense practices,” may be subject to enforcement action under the Investment Advisers Act.

Disclosure Deficiencies

The most frequent deficiencies OCIE identified include:

  • Calculating Fees Based on Incorrect Account Valuations. Valuation of securities is a consistent priority for OCIE staff, in part because incorrectly valuing client assets can result in overbilled advisory fees. In the Risk Alert, OCIE said that its staff observed advisers that valued client assets using both different metrics and different processes than those outlined in the relevant advisory agreements.
  • For example, certain advisers valued illiquid assets using original cost rather than fair market value. OCIE also identified advisers that used the market value of an account’s assets at the end of the billing cycle, instead of using the average daily balance of that account over the entire billing cycle, or that included certain types of assets in the management fee calculation that should have been excluded from the calculation under the terms of the advisory agreement. OCIE noted that because advisers generally assess fees as a percentage of the value of assets under management, incorrect valuation will result in incorrect advisory fees being assessed to clients. In addition, such valuation approaches may be inconsistent with the disclosure in client agreements and in Form ADV, which could be a violation of Rule 207 under the Advisers Act.
  • Billing Fees in Advance or with Improper Frequency. OCIE cautioned against certain billing practices related to the timing and frequency of billing advisory fees. For example, OCIE said that some advisers billed advisory fees on a monthly basis, instead of on a quarterly basis as stated in the advisory agreement or disclosed in Form ADV Part 2A. OCIE staff also took issue with advisers that billed advisory fees in advance, despite disclosure stating that clients would be billed in arrears or that failed to appropriately prorate advisory fees for new clients who opened accounts mid-billing cycle or that did not reimburse a client a prorated portion of advisory fees when the client terminated the advisory services mid-billing cycle.
  • Applying the Incorrect Fee Rate. OCIE said that certain advisers applied an incorrect fee rate when calculating management fees charged to certain clients, either applying a higher rate than that agreed upon in the client’s advisory agreement or double-billing a client. OCIE also identified concerns with registered investment advisers charging non-qualified clients performance fees based on a percentage of their capital gains inconsistent with Section 205(a)(1) of the Advisers Act.
  • Omitting Rebates and Applying Discounts Incorrectly. OCIE said that it identified some clients who were overcharged because advisers did not apply available discounts or rebates. For example, some advisers failed to aggregate client account values for members of the same household for fee-billing purposes or did not reduce a client’s fee rate when the value of that client’s account reached a prearranged breakpoint level. OCIE noted that such clients were entitled to a lower fee rate according to the adviser’s Form ADV or advisory agreement. Similarly, OCIE identified some advisers that charged additional fees, such as brokerage fees, to clients in a wrap fee program when the transactions qualified for the program’s bundled fee.
  • Disclosure Issues Involving Advisory Fees. OCIE identified certain issues with respect to advisers’ Form ADV Part 2A disclosure of fees or billing practices that were inconsistent with actual practices. For example, OCIE identified advisers that entered into agreements with certain clients to charge a fee rate exceeding a disclosed maximum fee rate or did not disclose additional fees or markups in addition to advisory fees. OCIE also identified disclosure deficiencies related to advisers who collected expenses from a client for third-party execution and clearing services that exceeded the actual fee charged for those services by the outside clearing broker, or who earned additional compensation on asset purchases for client accounts or had fee sharing arrangements with affiliates.
  • Adviser Expense Misallocations. OCIE said that advisers to both private and registered funds misallocated expenses to such funds. According to OCIE, some advisers allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to clients, which was inconsistent with applicable advisory agreements, operating agreements, or other disclosures.

Our Take

OCIE has stated that its Risk Alerts are designed to promote compliance by educating advisers about consistent issues its staff sees during its examination program. In other words, Risk Alerts provide advisers with the opportunity to proactively address such issues if they are present in their own shops.

Advisers should take the time to carefully evaluate their advisory agreements, Form ADV disclosure, and compliance policies and procedures to determine whether any of the identified risks are present and consider changing compliance and operational policies and procedures or proactively reimbursing clients by the amount of any overbilled advisory fees and expenses. These steps would likely mitigate the possibility that an adviser would receive a deficiency related to failure to comply with or adequately disclose its fee and expense policies in an OCIE exam. Conversely, advisers that ignore this opportunity are more likely to be the recipients of significant deficiencies or possible enforcement referrals.

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