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SEC Staff Issues Risk Alert on the Six Most Frequent Fee and Expense Compliance Issues

On April 12, 2018, the SEC's Office of Compliance Inspections and Examinations ("OCIE") issued a risk alert listing the most common compliance issues concerning fees and expenses charged by SEC-registered investment advisers. This follows remarks delivered on September 14, 2017 by Peter B. Driscoll, now Director of OCIE, announcing that the SEC staff was planning on issuing more risk alerts that summarize common exam findings across an array of topics. Recently, OCIE has issued risk alerts on advertisements, cybersecurity and supervision practices.

This latest risk alert cited six different types of deficiencies involving client fees and expenses identified by OCIE staff, and was accompanied by a reminder that advisers must adopt and implement written policies and procedures reasonably designed to prevent such violations. The six areas cited are as follows:

  1. Fee-Billing Based on Incorrect Account Valuations

Common deficiencies in this area involved incorrect valuation of client assets, resulting in collection of excessive advisory fees. OCIE observed that certain advisers had (i) valued assets in a client's account using a different metric than specified in the advisory agreement, such as use of original cost rather than fair market value, and (ii) valued a client's account using a process that differed from the process specified in the client's advisory agreement, such as using the account value at the end of the billing period rather than the average daily balance.

  1. Billing Fees in Advance or with Improper Frequency

The risk alert noted that the staff had observed deficiencies related to the timing and frequency for which advisory fees were billed, such as (i) billing advisory fees on a monthly basis, instead of on a quarterly basis as stated in the advisory agreement or disclosed in Form ADV Part 2, and (ii) failure to pro rate fees for periods during which the adviser provided advice for only a portion of the period.

  1. Applying Incorrect Fee Rates

The OCIE staff observed advisers that had applied an incorrect fee rate when calculating advisory fees, including a "performance fee" calculated inconsistently with the requirements of the advisory contract.

  1. Omitting Rebates and Applying Discounts Incorrectly

The OCIE staff noted overcharging by advisers as a result of failing to apply certain discounts to the advisory fee charged. Overcharges resulted from the failure to (i) aggregate client account values for members of the same household for fee-billing purposes, (ii) give effect to breakpoints when the value of that client's account reached an agreed-upon level, and (iii) rebate fees that were supposed to be covered by a wrap fee arrangement.

  1. Disclosure Issues Involving Advisory Fees

Instances of non-compliance in this area included (i) disclosures in Form ADV that were inconsistent with advisers' actual billing practices, and (ii) failures to disclose certain additional fees or markups that clients were required to pay in addition to the advisory fees.

  1. Adviser Expense Misallocations

The OCIE staff had observed advisers to private and registered funds that misallocated expenses to the funds they advised that presumably should have been properly allocated to the adviser or another client. For example, staff observed advisers that allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the adviser, in contravention of the applicable advisory agreements, operating agreements, or other disclosures to clients.

Takeaways

The principal takeaway from this risk alert is that investment advisers must follow what their documents say they are going to do, including, without limitation, as to how fees are calculated and how expenses are allocated. Further, all investment advisers should periodically review their offering documents, constituent documents, advisory agreement, management agreement, managed account agreements, other client agreements, Form ADV and marketing materials to insure that they are consistent with each other.

The latest risk alert noted that, in response to OCIE staff's observations, some advisers had elected to change their practices, enhance policies and procedures, and reimburse clients by the overbilled amount of advisory fees and expenses. OCIE staff also observed advisers that 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.

Although it is discussed in the risk alert, presumably miscalculation of fees is only a violation of Section 206 of the Advisers Act when the miscalculation results in the adviser obtaining a larger fee from a client than it is entitled to collect. Nonetheless, poor calculation and billing practices may be deemed to be a violation of the rule 206(4)-7, the compliance rule, regardless of whether the adviser benefits from the miscalculation. Advisers should review their practices, policies, and procedures to ensure compliance with their advisory agreements and representations to clients in light of the fee and expense issues noted in the risk alert.

© 2018 Proskauer Rose LLP.

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About this Author

Robert G Leonard, Proskauer Rose Law Firm, Private Investment Attorney
Partner

Robert G. Leonard is a Partner in the Hedge Funds Group. For more than 25 years Rob has been structuring, organizing and representing hedge funds, funds of funds and other private investment funds (both domestic and offshore) and investment advisers.

212-969-3355
Joshua Newville, Proskauer Rose, regulatory enforcement attorney, industry compliance legal counsel, securities exchange commission lawyer
Partner

Joshua M. Newville is a partner in the Litigation Department in New York. His practice focuses on commercial litigation and regulatory investigations. Mr. Newville advises companies and individuals in securities litigation and compliance matters. He also focuses on internal investigations and enforcement matters. Prior to joining Proskauer, Josh was senior counsel in the U.S. Securities and Exchange Commission’s Division of Enforcement, where he investigated and prosecuted violations of the federal securities laws. Josh served in the Enforcement Division’s Asset Management Unit, a specialized unit focusing on investment advisers and the asset management industry.  His prior experience with the SEC provides a unique perspective to help private investment funds and their advisers manage risk and handle regulatory issues.

212-969-3336
Partner

Robert E. Plaze is a partner and a member of the Investment Management team. He advises investment advisers and investment companies on an array of matters, with a particular focus on regulatory and compliance matters arising under the federal securities laws.

Bob previously served as Deputy Director of the Division of Investment Management of the U.S. Securities and Exchange Commission. During his nearly 30 years of service with the Commission, he was responsible for policy development and management of many of the key regulatory initiatives during that period affecting investment...

202.416.6692
Anthony M. Drenzek, Special regulatory Counsel, Proskauer Rose, Attorney, Finance Policy Lawyer
Special Regulatory Counsel

Anthony Drenzek is a special regulatory counsel in the Corporate Department and a member of the Private Investment Funds Group. His background includes more than a decade of comprehensive agency experience in the registration and regulation of securities market participants in coordination with state, federal and self-regulatory organizations nationwide.

Prior to joining Proskauer, Anthony was associate director of the Massachusetts Securities Division, with supervisory responsibility for the Division’s Registration,...

617.526.9655