On 12 April 2018 the Office of Compliance Inspections and Examinations (the "OCIE") released a Risk Alert outlining the most common advisory fee and expense compliance issues encountered in over 1500 investment adviser examinations conducted over a two-year period1. These practices potentially apply to a broad range of investment advisers, including managers of retail, private equity and hedge funds. A summary is below.
Fee Billing Based on Incorrect Account Valuations. The staff observed that advisors had been valuing assets in client accounts using either a different metric or a different process than what had been agreed in the advisory agreement. Compliance officers should consider an audit of their client agreements for these valuation methods and, where an agreement is silent, the adviser's disclosed method should apply.
Billing Fees in Advance or with Improper Frequency. OCIE staff highlighted situations where the timing and frequency of advisory fees charged were not in line with what had been agreed with the client in the advisory agreement or disclosed in the Form ADV Part 2. The examples provided by the staff (billing on a monthly instead of quarterly basis, billing in advance instead of arrears, or failing to pro-rate fees when services were provided mid-billing cycle) underscore the need to tailor Form ADV disclosure to an adviser's actual practices2.
Applying Incorrect Fee Rates. The staff noted double-billing and advisers charging non-qualified clients performance fees based on a percentage of capital gains3.
Omitting Rebates and Applying Discounts Incorrectly. Some clients were overcharged due to: (i) failing to apply applicable discounts or rebates, (ii) assets of clients in the same household not being aggregated for the purposes of determining eligibility for discounts or rebates, (iii) advisers failing to reduce a client's fee rate when clients were eligible for a discount or a rebate disclosed in the adviser's Form ADV or advisory agreement, and (iv) charging clients additional fees when they qualified for a bundled fee.
Disclosure Issues. The OCIE staff observed inconsistencies between advisers' billing practices and what had been disclosed in their Form ADVs. For example, advisers disclosed a certain maximum advisory fee rate in their Form ADVs but, nonetheless, charged clients a fee rate in excess of that rate pursuant to another agreement. The issue highlighted by OCIE staff was not that such clients were unaware of the higher rate--the Risk Alert notes that the rate was contained in the client agreement. Instead, the OCIE staff is emphasizing the importance of Form ADV disclosure as a compliance issue in its own right; in this view, disclosure elsewhere does not "cure" incorrect disclosure in a Form ADV. Advisers were also found not to have disclosed certain additional fees, fee sharing arrangements or markups of services provided by third parties.
Advisor Expense Misallocations. Expenses related to marketing, regulatory filings and travel were charged to the fund contrary to what had been disclosed in the applicable advisory agreements, operating agreements and elsewhere.
The OCIE's motivation for releasing the Risk Alert was to encourage advisers to review their expense practices and related disclosures. They also noted that some advisers had changed their practices, policies and procedures, and reimbursed their clients (where applicable), both in response to the OCIE's findings and proactively. The Risk Alert follows years of scrutiny from the staff of the SEC that began with examinations at the start of this decade and that has resulted in more than a dozen enforcement actions. Despite changing enforcement priorities at OCIE, the Risk Alert suggests that expense and fee allocation practices remain a focus.
With some exceptions, the issues identified by the OCIE in the Risk Alert were ones where the relevant adviser either did not comply with its stated policies or investor agreements or made inaccurate disclosures. The nature or quantum of the fees and expenses themselves was not at issue. While not explicitly stated, the Risk Alert is a reminder that advisers cannot treat even routine regulatory disclosures about fees as boilerplate language. Taken together with other SEC releases, including the SEC fiduciary rule, the Risk Alert puts added pressure on registered advisers to actively review their offering documents and regulatory disclosure and ensure that counsel, auditors, accountants and internal team members collaborate closely to ensure that disclosure matches current practices.
1 Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers at https://www.sec.gov/files/ocie-risk-alert-advisory-fee-expense-compliance.pdf. This Risk Alert applies directly only to SEC-registered investment advisors but have some relevance to exempt advisers. Any adviser selling funds or services to U.S. persons is subject to anti-fraud rules, and these risk alerts give some sense of what kind of disclosure issues the staff views as material and therefore what kinds of disclosure issues could, in extreme cases, give rise to anti-fraud liability.
2 For example, where an adviser's actual practice is to bill in advance instead of in arrears, the adviser must disclose on its Form ADV how a client may receive a refund of fees, including fees for partial periods. In addition clients who agree to advance billing may require an adviser to true-up fees (e.g. if overbilled, the credit is applied to the next fee owed) in the next billing cycle. Advisers should ensure that the true up mechanic takes in to account their operational timing.
3 Under Section 205(a)(1) and Rule 205-3 under the Advisers Act, a registered adviser may charge performance-fees only to "qualified clients".