If you’re an investment advisor, one of the quickest ways to run afoul of the Securities and Exchange Commission (SEC) is to make statements in your Form ADV that you fail to execute. When this happens in connection with investment-advisory fees, the SEC will be especially unhappy with you. To motivate advisors to not play games with their fees, the SEC recently published a Risk Alert detailing the most frequent advisory fee and expense compliance issues they encounter.
Based on a review of 1,500 examinations and resulting deficiency letters over the last two years, the SEC’s Office of Compliance Inspections and Examinations identified the most common compliance issues that arise out of sloppy or deceptive advisor billing of consumer fees and expenses. They include:
- Inflating the value of an account in order to generate higher fees. This results from practices such as using a different valuation metric than what was defined in the advisory agreement; calculating the account value at the end of a billing cycle rather than using the average daily balance; or including asset types such as cash equivalents, alternative investments, or variable annuities in the value calculation in violation of the agreement.
- Manipulating the timing and frequency of fee billing in order to benefit the firm. For example, advisors may bill advisory fees on a monthly basis instead of the required quarterly basis or bill new clients in advance for an entire cycle rather than making a pro-rata adjustment.
- Applying an incorrect fee rate. This tactic may include applying a higher rate to the calculated account value than is stated in the advisory agreement or Form ADV or charging a non-qualified client performance fees based on a share of capital gains in violation of the Advisors Act.
- Omitting rebates and applying discounts incorrectly. Here, OCIE staff said advisors sometimes fail to aggregate account values as promised for multiple family members in the same household or never reduce the fee rate when the account value reaches an agreed-upon benchmark. They also may charge clients brokerage fees when they are in the advisor’s wrap fee program.
- Making disclosures in their Form ADVs that conflicted with actual practices. For instance, advisors sometimes charge a fee rate higher than the maximum promised in their advisory agreements. Or they may bill for expenses unmentioned in their agreements (example: billing for third-party execution and clearing services that exceed actual fees charged by an outside clearing broker).
- Misallocating expenses to clients rather than to advisors. This occurs in connection with distribution and marketing expenses, regulatory filing fees, and travel expenses that advisors charge to clients rather than properly allocating to themselves.
What should you do with this information? The OCIE provides three pieces of advice:
- Assess one’s advisory fee and expense practices (and disclosures) to make sure they comply with the Advisor’s Act and related rules.
- Based on this review, change or enhance your practices and procedures to assure compliance.
- Reimburse clients for the overbilled amount of advisory fees and expenses.
This may not be what you want to hear, but it’s good advice. Full compliance with the law and if not, mitigation of any problems, including refunds paid to consumers, will always be the smartest strategy. Questions? Contact your compliance officer or attorney as soon as possible so you can avoid problems in case the SEC comes calling.
To read more on ethical business practices, visit the Ethics Center at the National Ethics Association, sponsor of EOforLess.