Key Notes:

  • OCIE recently published a list of the most common advisory fee and expense compliance violations identified in deficiency letters over the past two years.
  • The goal of OCIE’s publication is to prevent advisers from overbilling clients.
  • Deviations from the terms of the advisory agreement, Form ADV or other fee disclosure documents may violate the Investment Advisers Act of 1940, including the antifraud provisions.
  • OCIE recommends that advisers adopt and implement written policies and procedures reasonably designed to prevent such violations.

The SEC’s Office of Compliance Inspections and Examinations (OCIE) recently published a Risk Alert detailing the most common advisory fee and expense compliance violations identified in deficiency letters from approximately 1,500 adviser examinations over the past two years. Below are the six compliance issues OCIE most frequently identified.

Fee-Billing Based on Incorrect Account Valuations

Advisers generally calculate fees based on a percentage of the value of assets that they manage in a client’s account; therefore, incorrect account valuations lead to incorrect client fees. Additionally, advisers must calculate asset-based fees as specified in the advisory agreement and other disclosure documents. Common compliance violations observed by OCIE include:

  • Calculating advisory fees using a different metric from that specified in the client agreement. For example, billing illiquid investments at cost rather than fair market value.
  • Deviating from the calculation process specified in the client agreement. For example, calculating fees at the end of the billing cycle rather than using the average daily balance, or including in the fee calculation assets (e.g., cash) that are excluded by the advisory agreement.

Billing Fees in Advance or with Improper Frequency

OCIE observed compliance violations related to the timing and frequency of advisory fee billing. Common examples include:

  • Billing monthly when the advisory agreement specifies quarterly or another frequency.
  • Billing in advance rather than in arrears as specified in the advisory agreement.
  • Failing to prorate fees for services when a client engages the adviser mid-billing cycle.
  • Failing to reimburse a prorated portion of fees upon a mid-billing cycle termination of the advisory agreement despite reimbursement language in the advisory agreement or other disclosure documents.

Applying Incorrect Fee Rate

Another type of compliance violation noted by OCIE involves advisers applying an incorrect fee rate in calculating the advisory fees. Advisers often applied an incorrect rate or even double-billed clients by failing to maintain adequate billing records. Other times, they erroneously charged non-qualified clients with performance fees. The Advisers Act prohibits non-qualified clients from paying compensation based on capital gains or capital appreciation.

Omitting Rebates and Applying Discounts Incorrectly

OCIE also cited compliance violations related to advisers omitting rebates or failing to properly apply disclosed discounts. Advisers commonly charge clients using tiered fees based on asset level breakpoints. When an adviser fails to apply a disclosed rebate or discount after a client crosses a breakpoint level, or when family assets are not aggregated for billing purposes, the client is overcharged and the adviser is in violation of the Advisers Act.

Disclosure Issues Involving Advisory Fees

Yet another common violation reported is inaccurate or misleading fee disclosures. Examples include charging fees above the stated maximum fee rates, failing to disclose fees charged and collecting additional compensation through undisclosed fee arrangements with affiliates.

Adviser Expense Misallocation

In instances where advisers managed assets through registered and private funds, OCIE observed billing practices where the adviser to the funds misallocated expenses. For example, contrary to expense allocation disclosures in the advisory agreements or fund documents, advisers allocated expenses, such as marketing and travel expenses, to the funds.

Compliance Is Key

OCIE’s goal in publishing this Risk Alert is to protect clients from overpaying for investment advisory services by encouraging advisers to adopt appropriate written policies and procedures and regularly assess their effectiveness to ensure compliance with the Advisers Act and their fiduciary duty. Adhering to practices designed to prevent fee and expense violations not only results in accurate client billing, but also reduces the likelihood of advisers receiving deficiency letters or becoming targets of enforcement actions.