Office of Compliance Inspections and Examinations alert on advisory fee and expense compliance issues

On April 12, 2018, the US Securities and Exchange Commission (SEC) Office of Compliance Inspections and Examinations (“OCIE”) released an alert highlighting the most frequent fee and expense compliance issues identified during investment adviser examinations.1 While these identified deficiencies do not necessarily constitute violations of law or regulation, they reflect breakdowns of operating controls that could lead to inadvertent breaches of fiduciary duty. The alert, coupled with other recent SEC actions, provides critical insight into regulatory focus areas and expectations regarding advisory programs. As discussed in Deloitte’s2 recent white paper, The Rewards and Risks of Managed Account Programs, advisory accounts are an ever-increasing area of focus for regulators as growth continues to accelerate across the industry, surpassing $6T in total assets in Investment Advisory solutions at the end of 2017.3 Firms should carefully consider the OCIE alert and explore the tools and services available to support advisory program compliance while prioritizing, planning, and executing their risk management efforts.

Summary

Failure to adhere to the terms of client agreements and representations, including the disclosures provided in Form ADV, can often lead to violations of the Investment Advisers Act of 1940 (“Advisers Act”).4 In the alert, the SEC listed six compliance issues relating to fees and expenses charged to clients that were the most frequently identified in deficiency letters sent to advisers:

1. Fee-Billing based on incorrect account valuations

  • Using an asset’s original cost, rather than its fair market cost, to value an illiquid asset
  • Using the market value of assets at the end of a billing cycle rather than the average daily balance of that account over the entire billing cycle (as outlined in the advisory agreement)
  • Including assets in fee calculation that were not included in the advisory agreement

2. Billing fees in advance or with improper frequency

  • Billing advisory fees on a monthly basis, instead of on a quarterly basis (as stated in the advisory agreement)
  • Billing advisory fees for a new client in advance for an entire billing cycle rather than pro-rating such charges

3. Applying incorrect fee rate

  • Applying a higher rate than that specified in the advisory agreement
  • Double-billing a client
  • Charging non-qualified client performance fees inconsistent with the Advisers Act

4. Omitting rebates and applying discounts incorrectly

  • Failing to aggregate client account values for members of the same household when fee-billing, which would have resulted in discounted fees based on the advisory agreement
  • Failing to reduce a client’s fee rate when the value of the account reached an agreed upon breakpoint level (as specified in the advisory agreement
  • Charging a client additional fees when the client had qualified for a bundled fee

5. Disclosure issues involving advisory fees

  • Making a disclosure in the Form ADV that was not in line with actual practices
  • Failing to disclose certain additional fees or markups

 6. Adviser expense misallocations

  • Misallocating expenses to private and registered funds
  • Allocating distribution and marketing expenses, regulatory filing fees, and travel expenses to a client (contradicting the advisory agreement)

Recent SEC actions highlight the potentially severe financial implications that can arise from compliance issues stemming from the examples laid out above. During their fiscal years 2016 and 2017, the SEC imposed over $400 million in penalties at least partially attributable to advisory program activities; among those penalties was over $100 million directly related to fee and expense compliance failures.5

What can advisers do?

The six compliance issues laid out in the SEC alert, map closely to certain risk areas and associated risk mitigation steps previously laid out in The Rewards and Risks of Managed Account Programs white paper:

Say what you do and do what you say

  • Review marketing materials, disclosure forms, and client contracts to make sure advisory program details are accurately reflected
  • Review policies and procedures to make sure they accurately reflect the materials cited above
  • Review systems to make sure they accurately reflect both fee and expense policies/procedures and source materials
  • Establish a periodic review process to make sure that all areas stay in alignment

Measure twice and bill once

  • Conduct a comprehensive review of client contracts to ensure that the fees outlined in the contract align with what is set up in systems. (This is of potential concern for accounts such as ERISA Accounts, that may have special billing treatment such as fee rebating)
  • Regularly test billing systems to ensure fees are coded correctly and are billed as intended. These tests should be conducted periodically as part of a supervision program and should receive attention anytime a program or fee structure is changed or updated
  • Adopt and execute initial and ongoing regular and rigorous testing protocols for all technology systems to achieve appropriate functionality

Conclusion

Deloitte believes that advisory program assets will likely surpass $9.6T by 20206, serving as a core engine for growth at wealth management firms and providing a powerful antidote to the disruption facing the industry. However, firms will likely only be able to fully realize the advisory program opportunity if they rigorously manage the many risks these programs present.

As a trusted advisor to the wealth and investment management industry, Deloitte provides tailored solutions to enable the critical area of risk management associated with advisory programs, including specific solutions designed to mitigate risks associated with account billing, including:

  • Automated fee schedule and methodology validation
  • Fee value validation
  • Asset Pricing Validation including hard-to-value assets

For further information, please contact one of our wealth management practice professionals listed below:

Contacts

Karl Ehrsam
Principal
Deloitte & Touche LLP

Maria Gattuso
Principal
Deloitte & Touche LLP

George Hanley
Managing Director
Deloitte & Touche LLP

Gabriela Huaman
Managing Director
Deloitte & Touche LLP

Garrett O’Brien
Principal
Deloitte & Touche LLP

Christopher Stevenson
Managing Director
Deloitte & Touche LLP

Bruce Treff
Managing Director
Deloitte & Touche LLP

Robert Zakem
Managing Director
Deloitte & Touche LLP

Joshua Uhl
Senior Manager
Deloitte & Touche LLP

James Ullrich
Senior Manager
Deloitte & Touche LLP

Steve Allelujka
Senior Consultant
Deloitte & Touche LLP

Alex Lerangis
Consultant
Deloitte & Touche LLP

Endnotes

1US Securities and Exchange Commission National Exam Program, Office of Compliance Inspections and Examinations, Risk Alert Volume VII Issue 2, https://www.sec.gov/ocie/announcement/ocie-risk-alert-advisory-fee-expense-compliance.pdf
2As used in this document, “Deloitte” means Deloitte & Touche LLP, a subsidiary of Deloitte LLP. Please see http://www.deloitte.com/us/about for a detailed description of our legal structure. Certain services may not be available to attest clients under the rules and regulations of public accounting
3MMI Central – 4Q2017, Money Management Institute
4Investment Advisors Act of 1940, 15 U.S.C. §§ 80b-1-80b-21 (2018).
5Based on Deloitte review of publicly announced U.S. Securities and Exchange Commission Fiscal Year 2016 and 2017 actions
6Based on Deloitte industry insight and research into growth trends at the top 10 wealth management firms by total managed account assets according to Money Management Institute investment advisory solutions historical data

This publication contains general information only and Deloitte is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible for any loss sustained by any person who relies on this publication.

About Deloitte

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. In the United States, Deloitte refers to one or more of the US member firms of DTTL, their related entities that operate using the “Deloitte” name in the United States and their respective affiliates. Certain services may not be available to attest clients under the rules and regulations of public accounting. Please see http://www.deloitte.com/about to learn more about our global network of member firms.

Copyright © 2018 Deloitte Development LLC. All rights reserved.

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