SEC Issues Risk Alert on Fees and Expenses

The Office of Compliance Inspections and Examinations (“OCIE”) of the Securities and Exchange Commission  (the “SEC” or the “Staff”) issued a Risk Alert discussing the most frequent advisory fee and expense compliance issues identified in examinations of investment advisers.

Duff & Phelps strongly recommends that clients perform the 12-Step Analysis described below, in an effort to demonstrate their commitment to acting in the best interest of advisory clients and to present the best support possible if contacted by the SEC's examination or enforcement programs.  

The Staff's continued focus on fees, expenses, compensation, and fiduciary duties in the investment advisory space should not be a surprise. These concerns are at the core of the fiduciary relationship that exists between an adviser and its clients. OCIE's recent fixation on adviser compensation and expenses can be traced to the May 6, 2014 "Spreading Sunshine" speech by then-OCIE Director, Andrew Bowden, when he expressed some of the same concerns in the context of private equity examinations. In the same vein, albeit in the mutual fund context, OCIE issued a Risk Alert on July 13, 2016 discussing the purchase of a more expensive share class of a fund when less expensive alternatives were available. The 2016 Share Class Risk Alert noted "[a]s a fiduciary, an adviser has an obligation to act in its client's best interest and to disclose material conflicts of interest such as the receipt of compensation...." Importantly, earlier this year, on February 14, 2018, the SEC's Division of Enforcement (the “Division”) got involved and announced the Share Class Selection Disclosure ("SCSD") Initiative. The SCSD Initiative provides a mechanism for mutual funds to avail themselves of the opportunity to self-report, remediate, and resolve--without the imposition of civil monetary penalties--situations where mutual fund investors suffered financial harm by the adviser's purchase of more expensive share classes when lower cost shares were available. It should be noted that the Division commenced the SCSD Initiative after filing at least seven enforcement actions--both before and after the 2016 Share Class Risk Alert. The Division did not make a similar 'self-report and settle option' available to individuals who are responsible for the alleged violations.  The fact that the OCIE found it necessary to issue the Risk Alert – even after filing several notable enforcement actions for non-scienter based anti-fraud violations involving fees and expenses – strongly suggests that the Staff is continuing to find instances of ongoing non-compliance.  

Recently, there is increasing evidence that the Commission is leveraging more of the deterrence tools in its arsenal to discourage misconduct and to prioritize the use of its investigative and examination resources. A pattern of utilizing 'softer' deterrence tools such as speeches, investor alerts, risk alerts, Reports of Investigations (pursuant to Section 21(a) of the Securities Exchange Act of 1934), and other forms of outreach to put the industry on notice – followed by significant enforcement activity – can be gleaned from the developments described above.  

Prudent investment advisers should view the latest Risk Alert as an early warning advisory and take the opportunity to evaluate – and promptly mitigate and remediate – any material exposure that may still exist regarding compensation received by the adviser, or inappropriate expenses charged by the adviser and its affiliates to clients. It is strongly recommended that the evaluation of the policies, procedures, disclosures, and practices on behalf of the adviser should not be conducted by those who may be perceived by a regulator as being responsible for the related errors. At a minimum, the adviser should perform a candid and credible review of:

  1. Disclosures in all communications to clients and investors, as well as in filings to the Commission concerning fees and expenses; 
  2. Systems and processes to ensure that fees and expenses charged are consistent with those disclosures; 
  3. Valuation of assets under management used as a basis to determine the advisory fees charged;
  4. Client agreements to ensure that any fee discounts to which the client is entitled, whether negotiated or otherwise, have been calculated accurately and applied consistently; and
  5. The compliance program, policies, and procedures to ensure that proper oversight and controls are being applied going forward.    
    In addition, advisers should:
  6. Examine and maintain for at least the required period supporting documentation reflecting the calculation of fees and expenses, including applicable formulas used; 
  7. Consider a five-year look back review of the disclosures, charges, calculations, and methodologies used. (This recommendation reflects the impact of the 2017 US Supreme Court holding in Kokesh v. SEC, wherein the Court applied the five-year statute of limitations to claims by the SEC for disgorgement of ill-gotten gains from violations of the federal securities laws);
  8. Promptly make any necessary reimbursements to clients, with interest;
  9. Promptly disclose to clients if the review discovered inappropriately-charged fees or expenses; 
  10. Take appropriate steps to re-train or discipline individuals who are responsible for material deviations from the advisers policies and procedures relating to compensation and expense calculations and allocations; 
  11. Review, disclose, and mitigate conflicts and compensation arrangements that cause the adviser and its affiliated persons or entities to receive total compensation and benefits resulting from the fiduciary relationship that is above and beyond what was disclosed clients; and 
  12. Evaluate whether the adviser has made accurate and complete representations regarding fees and expenses to advisory clients who are placed in wrap-fee programs, but who incur additional charges, fees and mark-ups for services provided by third parties and/or affiliates of the adviser.
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