Focus Perspective: National Exam Program Risk Alerts

On July 11, 2018, the SEC’s Office of Compliance and Examinations (“OCIE”) issued the third Risk Alert for the 2018 fiscal year, “Compliance Issues Related to Best Execution by Investment Advisers,” following “Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers” on April 12, 2018 and “Observations from Municipal Advisor Examinations” on November 7, 2017.

Observations from Municipal Advisor Examinations (November 7, 2017)

Prior to the passage of the Dodd-Frank Act, the activities of Municipal Advisors were largely unregulated and typically not required to be registered. In 2013, the SEC adopted final Municipal Advisor registration rules, effective on July 1, 2014.

Subsequently, the SEC staff conducted over 100 examinations of Municipal Advisors that, “evaluated compliance with regulatory obligations including registration, statutory fiduciary standard of care, fair dealing, recordkeeping, and supervision, among other things. Examiners most frequently observed deficiencies in the areas of registration, books and records, and supervision.” Some of the examinations resulted in referrals to the SEC’s Division of Enforcement.

See Risk Alert

Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers (April 12, 2018)

This Risk Alert reflects issues identified in deficiency letters from over 1,500 adviser examinations completed during the two prior years.

“The terms of a client’s advisory fees and expenses are typically detailed in an advisory agreement and described in an adviser’s Form ADV and other materials provided to the client. An adviser that fails to adhere to the terms of these agreements and disclosures, or otherwise engages in inappropriate fee billing and expense practices, may violate the Investment Advisers Act of 1940 (“Advisers Act”), and the rules promulgated thereunder, including the antifraud provisions.”

The most frequent deficiencies identified were:

  • Fee-Billing Based on Incorrect Account Valuations. Because advisers generally assess fees as a percentage of the value of assets they manage in each client’s account, an incorrect account valuation will lead to an incorrect advisory fee being assessed to that client.
    • Valued assets in a client’s account using a different metric than that specified in the client’s advisory agreement, such as the asset’s original cost rather than its fair market value.
    • Valued a client’s account using the market value of the account’s assets at the end of the billing cycle, instead of using the average daily balance of that account over the entire billing cycle as specified in the advisory agreement.
    • Including assets in the fee calculation that were excluded by the advisory agreement from the management fee, such as cash or cash equivalents, alternative investments, or variable annuities.
  • Billing Fees in Advance or Refusing Reimbursement.
    • Billed advisory fees in advance, despite the advisory agreement specifying that clients would be billed in arrears.
    • Did not reimburse a client a prorated portion of the advisory fees when the client terminated the advisory services mid-billing cycle, despite disclosing that they would do so in Form ADV Part 2.
  • Applying Incorrect Fee Rate.
    • Applied a rate higher than what was agreed upon in the advisory agreement or double-billed a client.
    • Charged a non-qualified client performance fees based on a percentage of their capital gains inconsistent with the Advisers Act.
  • Omitting Rebates and Applying Discounts Incorrectly.
    • Did not aggregate client account values for members of the same household for fee-billing purposes, which would have qualified them for discounted fees according to the Form ADV or advisory agreement.
    • Did not reduce a client’s fee rate when the value of that client’s account reached a prearranged breakpoint level, which entitled that client to a lower fee rate according to the Form ADV or advisory agreement.
    • Charged a client additional fees, such as brokerage fees, when such client was in the adviser’s wrap fee program and the transactions qualified for the program’s bundled fee.
  • Disclosure Issues Involving Advisory Fees.
    • Made a disclosure in the Form ADV that was inconsistent with their actual practices, such as advisers that disclosed in the Form ADV a maximum advisory fee rate, but nevertheless had an agreement with a certain client to charge a fee rate exceeding that disclosed maximum rate.
    • Did not disclose certain additional fees or markups in addition to advisory fees, such as advisers that did not disclose that they earned additional compensation on certain asset purchases for client accounts or that they had fee sharing arrangements with affiliates.
  • Adviser Expense Misallocations.
    • 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.

In response to these comments, some advisers have elected to change their practices, enhance policies and procedures, and reimburse clients by the overbilled amount of advisory fees and expenses, as well as proactively reimburse clients for incorrect fees and expenses that they identified through the implementation of periodic internal testing of billing practices.

See PDF File

Compliance Issues Related to Best Execution by Investment Advisers (July 11, 2018)

This Risk Alert reflects issues identified in deficiency letters from over 1,500 adviser examinations completed during the prior two years. Perhaps the same adviser examinations as the prior Risk Alert.

“The Advisers Act establishes a federal fiduciary standard for investment advisers. As a fiduciary, when an adviser has the responsibility to select broker-dealers and execute client trades, the adviser has an obligation to seek to obtain “best execution” of client transactions, taking into consideration the circumstances of the particular transaction. An adviser must execute securities transactions for clients in such a manner that the client’s total costs or proceeds in each transaction are the most favorable under the circumstances. In directing brokerage, an adviser should consider the full range and quality of a broker-dealer’s services including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness to the adviser. As the Commission has stated, “the determinative factor [in an adviser’s best execution analysis] is not the lowest possible commission cost but whether the transaction represents the best qualitative execution for the managed account.” Advisers should therefore periodically and systematically evaluate the execution quality of broker-dealers executing their clients’ transactions.”

Some of the most common deficiencies identified were:

  • Not performing best execution reviews or not documenting that best execution reviews were performed.
  • Not considering materially relevant factors during best execution reviews, such as the broker-dealer’s execution capability, financial responsibility, and responsiveness to the adviser.
  • Not soliciting and reviewing input from the adviser’s traders and portfolio managers.
  • Not seeking comparisons from other broker-dealers or considering the quality and costs of services available from other broker-dealers.
  • Not fully disclosing that certain types of client accounts may trade the same securities after other client accounts and the potential impact of this practice on execution prices.
  • Not reviewing trades to ensure that prices obtained fell within an acceptable range, contrary to statements in their brochures.
  • Not adequately disclosing soft dollar arrangements or that certain clients may bear more of the cost of soft dollar arrangements than other clients.
  • Not appearing to provide adequate or accurate disclosure regarding products and services acquired with soft dollars that did not qualify as eligible brokerage and research services under the Section 28(e) safe harbor.
  • Not properly administering mixed use allocations or failing to provide support of the rationale for mixed use allocations.
  • Inadequate or no policies and procedures relating to best execution.
  • Not following best execution policies and procedures.

See PDF File


Focus Perspective:

A few years back, before the SEC had a website, you had to go to conferences to find out what the SEC was looking for on an examination. Then, the only written policy required was for the prevention of the misuse of inside information and now we have a list of required policies and procedures. Now, the SEC tells us what their concerns are for the next four years, what their priorities are for the next fiscal year, and what risks to be aware of and how to address them.

More frequently now, we sit and wonder, are things getting easier in our world, or harder?

An update on the proposed Standards of Conduct for Broker-Dealers and Investment Advisers. Over 2,000 comments received so far, and almost two weeks left until the close of comments on August 7, 2018. In addition, representatives from the SEC have had almost fifty meetings with professional organizations representing Investment Advisers and Broker-Dealers, as well as several large registrants.

Comments are closed.