On April 12, 2018, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a National Exam Program Risk Alert related the risks and issues associated with advisory fees and expenses charged by registered investment advisers. The risk alert reflects issues identified in deficiency letters from over 1,500 adviser examinations completed during the past two years. OCIE highlighted, “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.” While Private Equity and Hedge Fund managers have faced recent scrutiny related to fees and expenses, the most recent risk alert seems to address advisers more generally, from traditional investment advisers to large asset managers. This risk alert ties in well with OCIE’s 2018 examination priorities as the staff highlighted their continued focus on retail investors and wrap-fee programs.
Most Frequent Compliance Issues Related to Advisory Fees and Expenses
The exam staff highlighted that violating terms detailed in investment advisory agreements and disclosures, or otherwise engaging in inappropriate fee billing and expense practices, may violate the Investment Advisers Act of 1940 (“Advisers Act”), and the rules promulgated thereunder, including the antifraud provisions. Specifically, OCIE called attention to the following frequent deficiencies:
Fee-Billing Based on Incorrect Account Valuations
OCIE staff observed that managers overbilled clients due to incorrect valuations of underlying assets, such as based on cost instead of current market value/fair value. Advisers that valued client accounts using different metrics or processes than that which is disclosed in advisory agreements, or used other than fair-market values, ran afoul.
Billing Fees in Advance or with Improper Frequency
Another area in which deficiencies were commonly identified related to the timing and frequency for which advisory fees were billed. Advisers should ensure that the timing of billing corresponds to that which is outlined in advisory agreements (i.e., monthly vs. quarterly and in advance vs. in arrears). In addition, the staff noted that advisers failed to pro-rate fees for clients that entered into or terminated advisory agreements during a billing cycle.
Applying Incorrect Fee Rate
Advisers that applied an incorrect fee rate – either higher than what was agreed upon in the advisory agreement or double-billing a client – received deficiency letters. ACA also notes that recently, firms have also been fined for overbilling.1 OCIE staff also noted charging a non-qualified client performance fees based on capital gains in violation of the prohibition under set forth in Section 205(a)(1) of the Advisers Act.
Omitting Rebates and Applying Discounts Incorrectly
Another issue that resulted in clients being overbilled occurred when advisers did not apply certain discounts or rebates to their clients’ advisory fees, as specified in the advisory agreements. Such instances included the failure to aggregate client account values for members of the same household for fee-billing purposes pursuant to the advisory agreement or Form ADV disclosures, reducing a client’s fee rates when the client’s account reached a prearranged breakpoint, and charging additional fees, such as brokerage fees, when a client was in an adviser’s wrap fee program.
Disclosure Issues Involving Advisory Fees
It should come as no surprise that the OCIE staff also noted deficiencies in disclosure documents. Specifically, OCIE staff highlighted that certain advisers’ Form ADVs were inconsistent with their actual practices, and in some instances, lacked disclosures regarding additional fees or markups.
Adviser Expense Misallocations
While the risk alert seemed to be primarily tailored to traditional investment advisers, OCIE staff noted instances where advisers to private and registered funds misallocated expenses to the clients instead of the adviser, contrary to the advisory agreements, operating agreements, and disclosures. Specifically, the OCIE staff called attention to fees and expenses related to distribution and marketing, regulatory filings, and travel.
How ACA Can Help
If you have any concerns about your firm’s fee billing and expense policies, procedures, historical practices, and disclosures, and would like an independent assessment, ACA can help. Our staff provides customized process assessments as well as detailed testing of historical fee billing and expense allocation practices for all types of clients, including traditional investment advisers, private fund managers, and large asset managers.
For More Information
For more information, please contact Jack Rader, (973) 631-1085 or Charlie Stout, (866) 279-0750.