On April 12, 2018, the Securities and Exchange Commission (SEC) issued a risk alert outlining certain compliance issues identified by the regulator's Office of Compliance Inspections and Examinations (OCIE) related to advisory fee and expense compliance.
The issues detailed in the alert were those most frequently identified by OCIE in deficiency letters sent to SEC-registered investment advisers as part of its examination program. By highlighting the most commonly encountered shortcomings, OCIE encouraged advisers to review their practices, policies and procedures to ensure compliance with their advisory agreements and representations to clients regarding fees and expenses made in Form ADV and other disclosures. Further, OCIE reminded advisers that failing to do so may violate the Investment Advisers Act of 1940 (the Advisers Act) and related rules, including its anti-fraud provisions.
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Most Frequent Compliance Issues
The most frequently identified deficiencies related to advisory fees and expenses include:
- Fee-Billing Based on
Incorrect Account Valuations – OCIE observed
advisers assigning incorrect values on clients' assets, which
resulted in incorrect advisory fees in instances where fees are
calculated as a percentage of the value of assets managed. This has
included miscalculating assets by using a different metric or
process than that described in the client's advisory
agreement.
- Billing Fees in Advance or
With Improper Frequency – Among the examples
observed by OCIE staff were advisers billing fees on a monthly
basis, rather than the quarterly basis stated in the advisory
agreement or in Form ADV Part 2; advisers billing advisory fees in
advance, despite representing to clients they would be billed in
arrears; advisers billing a new client in advance for an entire
billing cycle, instead of prorating fees for advisory services that
began mid-billing cycle; and advisers failing to reimburse to a
client a prorated portion of their advisory fees when the client
terminated the advisory services mid-billing cycle, despite
disclosing that they would do so in Form ADV Part 2.
- Applying Incorrect Fee
Rate – Advisers were observed, for example, applying
a rate higher than what was outlined in the advisory agreement,
double-billing clients or charging a nonqualified client a
performance fee based on a percentage of their capital gains
inconsistent with Section 205(a)(1) of the Advisers Act.
- Omitting Rebates and
Incorrectly Applying Discounts – OCIE staff
observed advisers failing to apply rebates or discounts as
specified in advisory agreements, including not combining account
values for clients in the same household, when doing so would have
resulted in discounted fees; failing to reduce a client's fee
when their account reached a specified threshold that should have
resulted in a lower fee; and charging additional fees, such as
brokerage fees, to wrap fee program clients who qualified for the
program's bundled fee.
- Disclosure Issues Involving
Advisory Fees – For example, certain advisers'
actual practices were inconsistent with those outlined in their
Form ADV disclosures, such as charging an advisory fee rate higher
than the disclosed maximum rate or not disclosing certain fees or
markups in addition to their advisory fees, such as those from
third-party execution and clearing services.
- Adviser Expense Misallocations – Certain advisers to private and registered funds were observed misallocating expenses to the funds they advise, including allocating distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the adviser, in contradiction of the advisory agreement, operating agreements or other disclosures.
How to Respond
In response to these observations, OCIE staff reported that some advisers elected to "change their practices, enhance policies and procedures, and reimburse clients by the overbilled amount of advisory fees and expenses," while others "proactively reimbursed clients for incorrect fees and expenses that they identified through the implementation of policies and procedures that provided for periodic internal testing of billing practices." All advisers should take the opportunity to reassess their own advisory fee and expense practices and related disclosures to confirm their compliance with the Advisers Act and all related rules and responsibilities, and also review the adequacy and effectiveness of their compliance programs.
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