Recent SEC Observations from Advisor Fee Calculation Reviews | Bryan Cave Leighton Paisner
Key points to remember:
- On November 10, 2021, the SEC issued a risk alert that provides observations from recent reviews on the calculation of advisor fees. A copy of this alert can be found HERE.
- In another grim report, the SEC said “most” of its recent reviews related to this topic have resulted in the issuance of deficiency letters.
- Violations noted included inadequate compliance programs, inaccurate fee calculations, disclosures that did not align with advisory agreements, and violations of books and records. These issues “often” resulted in financial harm to clients and violated advisers’ fiduciary duties under the Investment Advisors Act.
Below is a summary of the SEC’s observations on breaches of compliance and its suggestions on how investment advisers can improve in this area.
The SEC’s Examinations Division (the “Division”) recently concluded a national initiative (the “Initiative”) that focused on the effectiveness of advisor compliance programs regarding advisory fees and accuracy. and the adequacy of their expense calculations, disclosures, and books and records. As it becomes more and more common, the SEC noted that “most” of the reviews on this topic have resulted in findings of non-compliance and the issuance of letters of non-compliance.
The topic of advisory fees is not new, as it has appeared in the division’s review priorities every year since 2018. It was also the subject of another risk alert issued by the SEC in April 2018. , which can be found HERE. Given the continuing difficulties for compliance advisers in these areas, as evidenced by the review results below, this topic is highly unlikely to fall out of favor with the SEC anytime soon.
FEATURES COMMON TO ADVISORS
In reporting the Initiative’s results, the SEC observed some common and acceptable characteristics in the billing practices of investment advisers, including:
- advisers have standard fee schedules with tiered fees based on assets under management;
- advisory fees are assessed quarterly;
- advisory fees are taken directly from clients’ accounts;
- the advisory fee is calculated based on the value of the account on the start or end date of the billing period;
- advisors frequently use third-party software or service providers to calculate fees;
- consultancy fees are recorded through written consultancy agreements or contracts; and
- the combination of client and family account values helps reduce costs (i.e., household maintenance).
COMMON COMPLIANCE DEFICIENCIES IDENTIFIED BY THE SEC
The SEC noted frequent problems with advisor fee calculations, disclosures, written policies and procedures, and the way advisory fees were reflected in advisers’ own financial statements. Specifically, the SEC found issues with the following:
Consultancy fee calculations:
- Consulting fees were miscalculated, including:
- Fees calculated using rates incompatible with contractual agreements;
- Fees calculated using an incorrect price list; and
- Fees calculated with obsolete fee schedules, sometimes leading to inconsistencies between client companies.
- Consulting fees were double billed due to oversight or outdated systems.
- Breakpoint or milestone billing rates were calculated incorrectly, including instances where milestone rates were not applied correctly or at all.
- Customer and family accounts were not properly grouped to provide the best rates for customers.
- The assets have been included for valuation purposes and the disclosure indicated would be excluded.
- Fees were not properly prorated for accounts opened or closed mid-cycle.
- Prepaid charges on terminated accounts were only refunded at the customer’s request, or refunds were made years after the fact.
False or misleading disclosures:
The SEC noted that many failed disclosures:
- To make full and accurate disclosures on ADV Part 2 brochures, including the failure to:
- Reflect the current fees charged;
- Indicate whether the fees were negotiable (including certain disclosures incorrectly indicating that the fees were non-negotiable);
- Describe precisely how the fees were calculated and invoiced; and
- Be consistent with related customer agreements.
- Disclose the impact of cash flow, such as large deposits made in the middle of a billing cycle, on advisory fees.
- Accurately disclose the billing schedule for charges, for example indicating that charges would be calculated and billed in advance, when in reality they were calculated and billed in arrears.
- To accurately disclose account valuations used for billing purposes, such as disclosing month-end value usage, when in fact a daily average value was used.
- Accurately disclose the minimum or maximum fees that could be charged to a customer.
- Some advisors did not document the fee amounts charged to clients at all.
Omitted or inadequate policies:
- The SEC noted that many advisers have failed to design and implement policies and procedures regarding the billing of advisory fees, including calculating, billing, monitoring and testing fee calculations.
- The reviewers found that many policies and procedures were silent on how important items of billing would be calculated, including:
- Valuations of illiquid or difficult to value assets;
- Expense offsets, such as those offered for 12b-1 fees;
- Reimbursement of fees for terminated accounts;
- Pro-rata charge for cash deposited or withdrawn from accounts; and
- Aggregation of family accounts or application of breakpoints to calculate fees.
Inaccuracies in Advisors’ Own Financial Statements:
Many of the advisors we examined had inaccurate fee entries in their books and records, including:
- Failure to record prepaid advisory fees as liabilities in the financial statements.
- Failure to record all advisory fee income, administrative fee income and compensation expense in general ledgers on the financial statements. Fees were missing from the records when advisers accepted goods and services (such as IT services) instead of advisory fees, or when clients paid fees directly to representatives of investment advisers.
- In practice, advisers used cash accounting and modified cash accounting, but prepared the financial statements on an accrual basis. This discrepancy resulted in advisory fees showing up as accounts receivable in the financial statements when they were not.
SUGGESTIONS FOR IMPROVING THE SEC
- Adopt and implement written policies and procedures regarding the calculation of consulting fees and invoicing processes,
- Adopt and implement written policies and procedures for periodic testing and validation of fee calculations.
- Centralize the fee invoicing process within the company.
- Perform periodic testing and validation to ensure fees charged to clients are in accordance with compliance procedures, consulting contracts, and disclosures.
- Use checklists and other tools when testing and validating expense calculations, to ensure that all staff perform these tasks consistently.
- Correctly record all advisory fees assessed and received from clients, including those paid directly to advisory staff.
The subject of advisory fees remains a hot topic for the SEC and we expect the widespread compliance failures noted here will cause some repetition in this space until the SEC becomes more comfortable with broader compliance. As a result, all firms providing advisory services to clients would be better advised to undertake a comprehensive review of their advisory fee practices, including fee calculations, disclosures, client agreements, policies. , procedures, and books and records to ensure compliance with SEC concerns.