On November 10th, 2021, the Securities and Exchange Commission (“SEC”) Division of Examinations released a new risk alert describing the findings from the recent Advisory Fees Initiative examinations of registered investment adviser ("RIA") firms.
Under this initiative, the agency conducted 130 examinations of SEC-registered investment advisory firms. Examiners focused on whether advisers have adopted and are following policies and procedures for fair and accurate billing practices.
Below we discuss the common compliance deficiencies highlighted in this RIA compliance risk alert, along with regulatory compliance best practices for investment advisers to consider.
This risk alert reiterates the compliance concerns previously addressed in the Advisory Fees Risk Alert published in April 2018. We'd like to stress the importance of the Chief Compliance Officer ("CCO" of all RIA firms to review both risk alerts, as advisers may face regulatory implications if they engage in inappropriate billing practices. While this risk alert is specific to SEC-registered RIA firms, many of these findings also apply to state-registered RIA firms as highlighted in the 2021 Investment Advisers Coordinated Examinations Report. SEC-registered investment advisers must engage in proper fee billing and expense practices to adhere to their fiduciary duty established in the Investment Advisers Act of 1940 ("Advisers Act").
It's also important to note that the examinations were conducted for advisers providing advice to retail clients.
Below we provide an overview of the four categories of notable compliance deficiencies highlighted in the risk alert:
- Inaccurate Advisory Fee Calculations
From the examinations, Division staff determined deficiencies related to fee calculations were due to the following: 1) inaccurate percentages used to calculate fees, 2) double-billing for advisory fees, 3) incorrect or a lack of follow-through with breakpoint or tiered fee schedules, and 4) incorrect client valuations used. The staff also noted several issues with prepaid fees, including inconsistency with refunding unearned fees and requiring clients to submit written requests for refunds of unearned fees.
- False, Misleading, or Omitted Disclosures
The variety of disclosure issues discovered were related to incomplete or misleading Form ADV Part 2 brochures and other disclosures. For instance, advisers were found to have insufficient disclosures about how cash flow changes (deposits and withdrawals) impact advisory fees. There were also many cases of incorrect or missing information related to the timing of advisory fee billing. Some examined advisers did not properly disclose accurate valuations for advisory fees, and several advisers failed to disclose other fee topics, such as wrap fee programs.
- Missing or Inadequate Policies and Procedures
A recurring issue for examined advisers, their policies and procedures often did not adequately address advisory fee billing, along with the monitoring of fee calculations and billing. Some advisers' policies and procedures omitted or had insufficient information on calculating the valuation of "difficult-to-value assets," fee offsets, fees for terminated accounts, and householding of client accounts to meet fee breakpoints.
- Inaccurate Financial Statements
The Division staff discovered issues related to financial statements with advisers in potential financial distress, failed to record pre-paid advisory fees as liabilities, and those who did not properly maintain financial statements. As an example, there were advisers failing to record all advisory fee income and compensation in general ledgers and financial statements because their gross revenue and expenses were exchanged for other business related goods or services. Additionally, some advisers incorrectly classified client advisory fees as "accounts receivable".
The Division staff offered up the following best practices for investment advisers to improve compliance with advisory fee calculation, billing, and disclosures:
- Adopt and implement policies and procedures specifically written to address supervision, calculation, review, and billing of advisory fees.
- Implement a centralized billing approach and validate that fees charged are consistent with policies and procedures, contracts, and disclosures.
- Utilize resources and tools, such as checklists, for fee calculation reconciliation with advisory agreements.
- Ensure your firm has adequate record keeping processes for all advisory expenses and fees assessed to and received from clients, including those paid directly to advisory personnel.
Once again, we highly recommend that the CCO and all advisory firm principals carefully review this latest SEC RIA compliance risk alert. Fee billing issues can present serious compliance issues and continue to be one of the most frequently discovered compliance deficiencies during state-registered RIA examinations.