On November 10, 2021, the SEC’s Division of Examinations (Division) published a Risk Alert containing examiners’ observations regarding investment advisers’ fee calculations.
To arrive at these observations, examiners conducted approximately 130 examinations of SEC-registered advisers. Examiners uncovered fee-related deficiencies at almost every Registered Investment Adviser (RIA) that they examined. These deficiencies frequently resulted in financial harm to clients and included:
- Calculation errors, such as over-billing advisory fees, inaccurate calculating of tiered or breakpoint fees, and errors stemming from incorrect householding of accounts; and
- Not crediting certain fees owed, such as prepaid fees to be refunded when accounts were terminated or pro-rated fees when onboarding clients.
Several examined advisers either did not refund prepaid fees on terminated accounts or did not pro-rate fees on new accounts. Some RIAs provided refunds to certain clients but not others or delayed refunding the unearned fees. Certain firms required clients to request a refund in writing of unearned advisory fees.
Examiners’ observations in the Risk Alert
While RIAs have a wide range of advisory fee arrangements and use numerous calculation methodologies, examiners observed that the typical adviser:
- Utilized a standard fee schedule with tiered fee levels based upon assets under management;
- Assessed advisory fees quarterly;
- Deducted advisory fees directly from clients’ accounts;
- Calculated fees based on the account value at the beginning or end of the billing period;
- Relied upon software or third-party service providers to calculate fees;
- Documented advisory fees with client advisory agreements; and
- Combined family account values where this practice results in lower fees.
This practice is referred to as the householding of accounts.
Deficient fee-related practices uncovered by examiners
Examiners identified a number of deficient practices in the following areas:
- Calculation of advisory fees;
- False, misleading or omitted disclosures;
- Missing or inadequate policies and procedures; and
- Inaccurate financial statements.
With regard to advisory fee calculations, examiners found that several of the RIAs examined charged inaccurate fees. In some cases, the fee charged differed from contractually agreed-upon rates. Advisers sometimes used an incorrect fee schedule or failed to convert all clients to their new or updated schedule. In addition, certain RIAs input inaccurate fee percentages when they manually entered them into their portfolio management systems.
In some cases, advisory fees were double-billed. Breakpoint or tiered billing rates were not always calculated correctly or were not applied at all. In some instances, RIAs did not aggregate client or family accounts, which would have reduced the fee charged.
Examiners also found that incorrect account valuations were used in calculating fees. For example, advisers’ account valuations included assets that should have been excluded, such as legacy positions. RIAs often utilized stale account balance information and incorrect valuations. Account values were sometimes incorrect due to timing differences in cash and dividend transactions in electronic custodial feeds.
In the area of false, misleading, or omitted disclosures, several of the RIAs’ Form ADV Part 2 disclosure brochures:
- Did not reflect current fees charged or whether fees were negotiable;
- Did not accurately describe how fees would be calculated or billed; and
- Contained inconsistencies between Form ADV and the advisory agreement.
There were even RIAs examined that did not have any written agreements or documentation that specified the fee owed by the client.
As a fiduciary and also as the party that constructs advisory agreements, RIAs must recognize that ambiguities in agreements must be resolved in favor of the client. As such, ambiguous fee schedules and fee calculation and deduction language in a contract can result in SEC comment letters asking the RIA to conduct a full audit of billing practices and to refund any fees that were deducted based on ambiguous language that the SEC interprets differently than the RIA. This is especially true when an RIA includes multiple fee schedules for different types of accounts in the advisory agreement and does not accurately classify the types of accounts managed for the client.
RIAs in certain cases did not disclose:
- Cash flows and their impact on fees, such as how a client is charged for large deposits made during the billing period;
- The timing of advisory fee billing, and there were sometimes discrepancies as to whether the client would be charged in advance or arrears;
- The valuations used for fee calculations, or there were inconsistencies such as month-end versus average daily values; and
- Minimum fees, extra fees, and discounts, such as whether fees are negotiable.
With regard to missing or inadequate policies and procedures, many of the RIAs examined did not maintain written policies and procedures to address fee-related issues. Policies and procedures did not always specifically address fee calculations. Some of the RIAs examined had no policies and procedures for testing or monitoring fee calculations.
With regard to inaccurate financial statements, examiners encountered RIAs that did not record prepaid advisory fees as liabilities. Furthermore, they did not record all advisory fee income, administrative fee revenue, and compensation expenses on their general ledgers and on financial statements.
Best practices
The Risk Alert offered examples of policies, procedures, and practices that can help RIAs with compliance in this area, including:
- Adopting and implementing written policies and procedures to address advisory fee billing processes and to confirm fee calculations. As a general rule, examiners found fewer errors when RIAs implemented specific written policies and procedures governing the supervision, calculation, review, and billing of advisory fees.
- Centralizing the fee billing process and validating that the charges to clients are consistent with compliance procedures, advisory contracts, and disclosures. Examiners observed that RIAs with centralized billing had fewer clients who were billed incorrectly.
- Allocating resources and tools for reviewing fee calculations. Examiners suggested that RIAs use checklists and other resources for reconciling client fee calculations with advisory contracts. These checklists and resources are helpful tools if they are used consistently by all advisory personnel.
- Properly recording all advisory expenses and fees charged to and received from clients, including those paid directly to advisory personnel.
The Risk Alert can be found here.
Takeaways
The Risk Alert took note that each dollar that clients pay in fees and expenses is a dollar not invested for their benefit. Overcharges by RIAs can cause serious damage to a client’s nest egg over the long run.
With so many RIAs receiving bad marks on their handling of fee calculations and billing, it is relatively certain that examiners will focus on these areas during upcoming examinations, especially since clients are harmed by these errors in the short-term and the long-term. As is usually the case, the Risk Alert recommended that RIAs implement robust policies and procedures in an effort to prevent future advisory fee deficiencies.
RIAs will also benefit from reviewing an earlier Risk Alert published on April 12, 2018, which provided an overview of the most frequent advisory fee and expense compliance issues identified during RIA examinations. The Risk Alert can be found here.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – sales@ria-compliance.com
Recent Comments