Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News April 23, 2018 Issue

Fees and Expenses: OCIE Wants Advisers to Focus on the Nuts and Bolts

Sometimes it’s the basic things that get overlooked, like fees and expenses. When that happens in the asset management community, problems occur and examiners notice – which may be why the SEC’s Office of Compliance Inspections and Examinations this month issued a Risk Alert offering an "Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers." Chief compliance officers would be wise to pay attention.

"OCIE’s 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 Advisers Act, the relevant rules, and their fiduciary duty, and review the adequacy and effectiveness of their compliance programs," the SEC’s examination arm said in releasing the Risk Alert. The Alert is based on fee and expense issues identified in deficiency letters from more than 1,500 advisers’ exams completed during the past two years, the agency said.

"This is basic stuff, not mistakes that advisers should be making," said Mayer Brown partner Adam Kanter, "but OCIE does find these mistakes from time to time when examining advisory firms."

"The whole piece might be summarized as having the following theme: attention to detail matters," said Dechert partner Michael Sherman. "If you agree to charge a fee, value assets or allocate expenses in a certain way, the SEC is going to expect that you will do that. If you disclose in your private placement memorandum or in your Form ADV that you are going to do things a certain way, the agency is going to expect you to do things that way – even if another way would have been equally fine had that other way been agreed to and disclosed."

At the core of OCIE’s findings is what appears to be inconsistencies between the terms of a client’s advisory fees and expenses as detailed in its advisory agreement and described in its Form ADV and other materials, and what actually happens in practice. "An adviser that fails to adhere to the terms of these agreements and disclosures, or otherwise engages in inappropriate fee billing and expense practices, may violate the Investment Advisers Act of 1940, and the rules promulgated thereunder, including the anti-fraud provisions," OCIE said.

When this occurs, the SEC may bring enforcement action. In the Alert, OCIE identifies two examples of such actions: the May 10, 2017 Barclays Capital settlement, in which the agency found that the adviser allegedly violated Adviser Act Section 206(2) by incorrectly calculating advisory fees when it used a billing method that differed from the advisory agreements; and the January 13, 2017 Morgan Stanley Smith Barney settlement, in which the SEC alleged that the adviser violated Section 206(2) when it charged clients fees that did not reflect negotiated discounts.

"The disclosure that clients receive, especially regarding advisory fees and expenses, is critical to their ability to make informed decisions, including about whether to engage or retain an adviser," OCIE said.

The Risk Alert also notes that some advisers, in response to what OCIE found, have already "elected to change their practices, enhance policies and procedures, and reimburse clients by the overbilled amount of advisory fees and expenses." In addition, the examination agency said, some advisers have pro-actively reimbursed clients for incorrect fees and expenses.

"Advisers should consider how they can organize themselves to assure that they meet the Risk Alert’s attention-to-detail expectation," Sherman said. For example, he said, this might include maintaining a "cheat sheet" of how various accounts are charged fees and expenses, as well as periodically reviewing contractual arrangements and disclosure documents to assure consistency and accuracy.

"Advisers should test periodically that they are charging fees, valuing assets and allocating expenses in a manner that is consistent with the relevant documentation," he said.

Disclosure findings

Kanter said that the common errors listed in the Alert that center on disclosure are among the more interesting. "They represent more of a fiduciary issue for advisers, more than a rote, ‘You didn’t do what you said you would do.’"

Nonetheless, he said, all the fee-and-expense mistakes listed in the Alert "are worth advisers looking at and including in their annual review. There could be a coding formula put into an adviser’s billing system 20 years ago that, in fact, is wrong. The adviser may not have reviewed it to make sure it was right since then. It might be a good idea to periodically review the billing system versus the contractual language to make sure it’s properly handled in the system. Just because you’ve been doing it for 15 years doesn’t mean you’ve been doing it correctly."

The disclosure observations in the Risk Alert involved advisory fees. Specifically, according to the Alert, examiners observed advisers that:

  • Made a disclosure in Form ADV "that was inconsistent with their actual practices." For instance, according to the Alert, there were "advisers that disclosed in the Form ADV a maximum advisory fee rate, but nevertheless had an agreement with a certain client to charge a fee rate exceeding that disclosed maximum rate."
  • Did not disclose certain additional fees or markups in addition to advisory fees. Here, the Risk Alert said that examiners found advisers that did not disclose that they collected expenses from a client for third-party execution and clearing services that exceeded the actual fee charged for those services, and advisers that earned additional compensation on asset purchases for client accounts or that had fee-sharing arrangements with affiliates.

Following are some of the other fee-and-expense errors that examiners frequently found.

Fee billing based on incorrect account valuations

"OCIE staff has observed advisers that incorrectly valued certain assets in clients’ accounts resulting in overbilled advisory fees," the Alert says. It noted that, since advisers generally assess fees as a percentage of the value of assets they manage in each client’s account, "an incorrect account valuation will lead to an incorrect advisory fee being assessed to that client." OCIE then provided the following examples found by examiners:

  • Valuing assets in a client’s account using a different metric than those specified in the client’s advisory agreement. An example here would be using the asset’s original cost to value an illiquid asset, rather than valuing the asset based on its fair market value today.
  • Valuing a client’s account using a different process than that specified in the client’s advisory agreement. An example OCIE provided here included using the market value of the account’s assets at the end of the billing cycle, rather than using the average daily balance of that account over the entire billing cycle, as specified in the client’s advisory agreement. A second example provided was including assets in the fee calculation "that were excluded by the advisory agreement from the management fee, such as cash or cash equivalents, alternative investments, or variable annuities," OCIE said.

Billing fees in advance or with improper frequency

According to the Risk Alert, OCIE staff has observed "issues with advisers’ billing practices relating to the timing and frequency for which advisory fees were billed." Specifically, the examination agency found
advisers that:

  • Billed advisory fees on a monthly basis, rather than on a quarterly basis, as stated in the advisory agreement or disclosed in Form ADV Part 2. "Similarly, staff observed advisers that billed advisory fees in advance, despite the advisory agreement specifying that clients would be billed in arrears," the Risk Alert says.
  • Billed a new client for advisory fees in advance for an entire billing cycle, instead of pro-rating such charges to reflect that the advisory services began mid-billing cycle. OCIE also noted examiners found advisers that did not reimburse a client a pro-rated portion of the advisory fees when the client terminated the advisory service mid-billing cycle, "despite disclosing that they would do so in Form ADV Part 2."

Applying the incorrect fee rate

"OCIE staff has observed advisers that applied an incorrect fee rate when calculating the advisory fees charged to certain clients," OCIE said in the Risk Alert. Specifically, according to the Alert, staff found some advisers that:

  • Applied a higher rate than what was agreed upon in the advisory agreement or double billed a client, and
  • Charged a non-qualified client performance fees based on a percentage of their capital gains "inconsistent with Section 205(a)(1) of the Advisers Act." That section prohibits compensation for the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client, unless the client meets certain specified criteria.