Published : 7 years ago, on 09/05/2018

By Jonathan D. Blattmachr and Jonathan A. Forman

Conflicts of interest in the advisory industry, particularly with respect to fees and expenses, continue to be at the forefront of the regulatory and enforcement agenda of the U.S. Securities and Exchange Commission (“SEC”). For example, the SEC’s Division of Enforcement recently announced the Share Class Selection Disclosure Initiative to encourage advisers to self-report share class violations (as we discussed in a previous executive alert and as the Division recently updated with FAQs). More recently, the Commission proposed a rule that would require investment advisers to provide to each of their clients a relationship summary detailing the fees and costs associated with those services and specifying any conflicts of interest.{1}

In line with this continued focus, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) published on April 12, 2018 a Risk Alert identifying the most frequent advisory fee and expense compliance issues encountered during its more than 1,500 adviser examinations over the past two years. In particular, the Risk Alert noted the following fee and expense deficiencies are the most frequently observed ones during adviser examinations:

• Fee-billing based on incorrect account valuations;
• Disclosure issues involving advisory fees;
• Adviser expense misallocations;
• Billing fees in advance or with improper frequency; and
• Applying incorrect fee rates.

In addition to noting these deficiencies, OCIE warned that advisers who fail to follow the terms of their advisory agreements, Form ADV, and other client disclosures may be violating the Investment Advisers Act of 1940 (“Advisers Act”) and its rules. Given this warning and in light of certain recent enforcement actions, the first three deficiencies are discussed more fully below because they appear to be of particular interest to both OCIE and the Division of Enforcement.

Fee-Billing Based on Incorrect Account Valuations

OCIE noted that its staff frequently observed excessive fees being charged to clients due to incorrect asset valuations. These incorrect valuations resulted from advisers valuing the assets with a different metric or process than those specified in the advisory agreements. For example, some advisers were found to value assets based on their original cost rather than fair market value, while other advisers included certain assets in the fee calculation that were excluded by the advisory agreement.

The SEC has routinely pursued enforcement actions against investment advisers for such violations. For example, in March 2017, the SEC announced a settled order with Covenant Financial Services LLC (“Covenant”) and its principal Stephen Shafer for allegedly misstating the value of assets in five private funds that resulted in the overpayment of approximately $444,000 in management fees and more than $3 million in redemptions.{2} According to the no-admission order, Covenant continued to use a third-party service to value certain municipal bonds even though the third party’s valuations were not consistent with the measurement of fair value according to the Generally Accepted Accounting Principles or with the funds’ written valuation policy, representations in their private placement memoranda and limited partnership agreements, and certain of their financial statements. In particular, the valuations were materially higher than the prices at which the funds sold some of the municipal bonds. After these valuation issues were identified by the funds’ auditor, Covenant notified its clients of the corrected valuations, refunded the overpaid management fees to the funds, and paid approximately $270,000 to the funds as partial compensation for the over-redemptions. Although the SEC recognized these remedial steps, it still imposed an order requiring Covenant and Shafer to pay a civil penalty of $130,000 and prejudgment interest of nearly $15,000 for alleged violations of the Advisers Act antifraud and compliance rules.

Both the Risk Alert and the Covenant settled order emphasize the importance of advisers following their valuation policies and the disclosures they make to their clients. Any deviation should be scrutinized and addressed in real time. Advisers should ensure that their valuation policies, disclosures, and practices are consistent. The Covenant settled order illustrates that, while an adviser may use third parties to value assets, the responsibility for fair and accurate valuations remains with the adviser.

Disclosure Issues Involving Advisory Fees

Similarly, the Risk Alert noted that OCIE staff observed fee disclosures that were inconsistent with actual practices. Some advisers charged fee rates that exceeded their disclosed maximum rates, whereas others did not disclose certain additional fees, such as markups from third-party services or fee-sharing arrangements with affiliates.

Deficiencies such as these also have resulted in enforcement actions, including one against Barclays Capital Inc. (“Barclays”) that was cited in the Risk Alert. In May 2017, the SEC announced a settled order against Barclays for allegedly overcharging nearly $50 million in advisory fees.{3} According to the no-admission settled order, Barclays, among other things, charged fees for due diligence and monitoring of certain third-party managers that it represented to undertake in various disclosures, but was not actually doing. Barclays also allegedly failed to notify certain advisory clients that it had changed its advisory fee calculation methodology. These and other billing issues allegedly occurred because of inadequate policies, procedures, and controls, including the failure to integrate Barclay’s systems with those of a new clearing agent. Based on these alleged violations of the Advisers Act’s antifraud and compliance rules, Barclays agreed to make a remediation payment of more than $3.5 million to affected advisory clients and to pay a civil penalty of $30 million and disgorgement and prejudgment interest of more than $63 million.

Since publishing the Risk Alert, the SEC announced another enforcement action against an investment adviser for allegedly failing to disclose conflicts of interest relating to kickbacks it received from a third-party service provider. According to a no-admission settled order, WCAS Management Corporation (“WCAS”) entered into an agreement with a third party to get volume discounts on items used by the portfolio companies owned by the private equity funds that WCAS advised.{4} Although WCAS allegedly shared in the third party’s revenue based on the purchasing activity of the portfolio companies (in the amount of approximately $623,000), WCAS did not seek prior approval from its clients and did not otherwise disclose the arrangement. Based on these alleged violations of the Advisers Act’s antifraud rule, WCAS agreed to pay a civil penalty of $90,000 and disgorgement and prejudgment interest of approximately $688,000.

Given the Risk Alert and the Barclays and WCAS settled orders, advisers should have policies and procedures in place to verify that their fee and expenses practices are in line with their disclosures to clients. Obviously, clients should not be charged for services they are not receiving. Additionally, advisers should pay careful attention to potential blind spots in their account management and billing operations if they rely on information from, or are integrated with systems of, third-party service providers. Advisers should also be mindful of disclosures relating to services performed by affiliates or agreements with third parties relating to the sharing of fees or discounting of expenses. For example, OCIE has scrutinized in recent examinations whether private fund advisers are receiving undisclosed discounted rates on third-party services in comparison to the full rate paid by their funds for the same services. Ultimately, disclosure relating to these fee and expense arrangements should be full and accurate, taking into consideration both actual and potential conflicts of interest.

Adviser Expense Misallocations

OCIE also noted in its Risk Alert that its staff observed advisers who allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the adviser when applicable agreements or disclosures indicated the adviser should have borne those fees and expenses.

Like the other two deficiencies, the SEC has pursued enforcement actions against advisers for such misallocations. For example, in May 2017, the SEC announced a settled order against a registered investment adviser and its affiliated broker-dealer (together, “Calvert”) for allegedly causing their advisory mutual funds to pay intermediaries nearly $18 million for distribution services that were not permitted according to relevant agreements and disclosures.{5}The SEC’s no-admission settled order recognized that, upon discovery of these misallocated fees, Calvert initiated a review, enhanced its policies and procedures, and self-reported its findings to the SEC. Yet Calvert was still required to pay a civil penalty of $1 million and disgorgement and prejudgment interest of more than $21 million for its alleged violations of the Advisers Act’s antifraud rule and the Investment Company Act of 1940’s antifraud section and Rule 12b-1.

Both the Risk Alert and the Calvert settled order illustrate that advisers should have controls in place to confirm that fees and expenses are booked to the correct entity. Neither should be allocated to the fund without proper disclosure and authority, including requisite approvals by a mutual fund board where appropriate and necessary. To bolster their compliance programs, advisers should also consider implementing independent testing of billing practices and allocation procedures.

Conclusion

OCIE’s guidance in the Risk Alert is the most recent pronouncement on regulatory expectations relating to fees and expenses. In particular, OCIE concluded its Risk Alert by encouraging advisers “to assess their advisory fee and expense practices and related disclosures to ensure that they are complying with the Advisers Act, the relevant rules, and their fiduciary duty.” As both the Risk Alert and the foregoing settled orders illustrate, doing so could help advisers avoid unnecessary regulatory and enforcement attention. After all, the Risk Alert appears to indicate that some investment advisers have avoided enforcement actions altogether by proactively reimbursing clients for incorrect fees and expenses identified by enhanced policies and procedures that included periodic internal testing of billing practices.

Authorship Credit: Jonathan D. Blattmachr and Jonathan A. Forman.