The US Securities and Exchange Commission's ("SEC") Office of Compliance Inspections and Examinations ("OCIE") released its 2019 examination priorities on December 20, 2018, a few weeks earlier than in past years and just in time for the holidays.1 A number of the 2019 priorities are continuations from the exam priorities for 2018, and others have been informed by OCIE Risk Alerts published during 2018. As was the case in prior years, OCIE's examination priorities cover investment advisers and registered investment companies as well as market participants such as broker-dealers and transfer agents.2 This Legal Update gives an overview of the exam priorities for investments advisers, briefly describes certain key SEC enforcement actions brought in 2018 applicable to advisers and offers certain practice points that advisers may want to consider in response to those priorities and enforcement actions.
General OCIE Examination Principles
OCIE made it clear that its announced exam priorities are not exhaustive and will not be the only issues OCIE addresses in the upcoming year. Although the priorities generally drive OCIE examinations, OCIE selects registered entities to examine, and determines the scope of its examinations, through a flexible, risk-based approach. To assess risk, OCIE considers the registrant's operations and service/product offerings and continuously evaluates market conditions, industry practices and investor behavior. OCIE stated, however, that its activities remain grounded in its four pillars: promoting compliance, preventing fraud, identifying and monitoring risk and informing policy.3
Retail Investors: Disclosure of the Costs of Investing
OCIE stated that it is critically important that investors are provided with proper disclosures of the fees and expenses they pay for products and services and that financial professionals accurately calculate and charge fees in accordance with these disclosures. Consistent with its 2018 priorities, OCIE will continue to review fees charged to advisory accounts to make sure that the fees are assessed in accordance with client agreements and firm disclosures. 4 In 2018, OCIE specifically referenced fees that are based on account value and related valuation practices.5
Also consistent with its 2018 priorities, OCIE plans to select firms with practices or business models that may create increased risks of inadequately disclosed fees, expenses or other charges. Although OCIE did not elaborate on these practices or business models this year, it did so in its 2018 priorities, explaining that such practices or models include:
- advisory personnel that receive financial incentives to recommend that investors invest, or remain invested, in particular share 2 Mayer Brown | OCIE's 2019 Examination Priorities and 2018 Enforcement Actions: Practice Points for Advisers to Consider classes of mutual funds that impose higher sales loads or distribution fees without adequate disclosure of the financial conflicts of interest;
- accounts where investment advisory representatives have departed from the firms, and the accounts have not been assigned a new representative to properly oversee them;
- advisers that changed the manner in which fees are charged from a commission on executed trades to a percentage of client assets under management; and
- private fund advisers that manage funds with a high concentration of investors investing for the benefit of retail clients, including nonprofit organizations and pension plans.6
With respect to mutual fund share classes, OCIE will continue to evaluate financial incentives paid to financial professionals that may influence their recommendations of particular share classes. It should be noted that the SEC's Division of Enforcement (the "Enforcement Division") previously launched a self-reporting share class disclosure initiative in February 2018 (the Share Class Selection Disclosure Initiative or "SCSD Initiative"), in which Enforcement agreed not to recommend financial penalties against investment advisers who self-report violations from January 2014 through the expiration of the initiative (June 12, 2018) relating to certain mutual fund share class selection issues. Under the SCSD Initiative, the Enforcement Division recommended "standardized, favorable settlement terms" to investment advisers that self-reported failures to disclose conflicts of interest associated with the receipt of 12b-1 fees by the adviser, its affiliates or its supervised persons for investing advisory clients in a 12b-1 fee paying share class when a lower-cost share class of the same mutual fund was available for the advisory clients. As part of such settlement, eligible investment advisers were required to disgorge ill-gotten gains and pay those amounts to harmed clients but did not face civil monetary penalties.7 We cover some of the 2018 enforcement settlements involving mutual fund share classes later in this Update.
In addition, echoing its 2018 exam priorities, OCIE stated that it remains focused on investment advisers participating in wrap fee programs, with particular interest in the adequacy of disclosures and brokerage practices.8
On a related note, on April 12, 2018, OCIE published a Risk Alert outlining the most frequent advisory fee and expense compliance issues identified in adviser examinations.9 In this Risk Alert, OCIE described frequently identified advisory fee-related issues cited in OCIE exam deficiency letters, which included:
- Fee Billing Based on Incorrect Account Valuations - OCIE observed that certain investment advisers incorrectly valued certain assets in clients' accounts resulting in overbilled advisory fees.
- Billing Fees in Advance or with Improper Frequency - OCIE observed issues with certain investment advisers' billing practices relating to the timing and frequency for which advisory fees were billed, such as advisers billing fees on a monthly basis instead of the disclosed quarterly basis and billing for an entire period instead of prorating for partial periods.
- Applying Incorrect Fee Rate - OCIE observed that certain investment advisers applied an incorrect fee rate when calculating the advisory fees charged to certain clients (e.g., the charged fee was higher than the fee in the client's advisory agreement).
- Omitting Rebates and Applying Discounts Incorrectly - OCIE observed that certain investment advisers failed to apply certain discounts or rebates to their clients' advisory fees, as specified in the advisory agreements, causing the clients to be overcharged (e.g., advisers did not reduce fees according to the disclosed fee breakpoint levels).
- Disclosure Issues Involving Advisory Fees - OCIE staff observed several issues with respect to certain investment advisers' disclosures of fees or billing practices, such as inconsistent maximum advisory fee practices, failure to disclose additional fees and markups from outside clearing brokers, imposition of brokerage fees in addition to wrap fees (that presumably cover cost of brokerage services in a single, bundled fee), and failures to disclose revenue sharing arrangements with affiliates.
- Adviser Expense Misallocations - OCIE observed that certain investment advisers to private and registered funds misallocated expenses to the funds. This included instances where such investments advisers improperly allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to their fund clients instead of paying such expenses directly.10
- Advisers would be wise to take note of the 2018 expense-related enforcement actions, which demonstrate, painfully, the importance of the above principles.11
- To that end, consider periodically reviewing onboarding and fee billing practices. Sample testing contractual terms against actual fee invoices, and disclosed allocation promises against actual allocation practices, should provide a good sense of potential regulatory exposure.
- Incorporate the above testing and reviews in your compliance risk assessment, as well as your annual review for purposes of the Rule 206(4)-7 under the Investment Advisers Act of 1940 ("Advisers Act").
Retail Investors: Use of Affiliated Service Providers and Products
New this year, OCIE specifically mentioned examining an adviser's use of services or products provided by affiliates in connection with their investment advisory services, with a particular focus on the impact to clients and the adequacy of conflicts of interest disclosure.12
- 2018 enforcement actions against advisers involved use of, and payments to/from, affiliated service providers.13
- Advisers should review their use of affiliated service providers in connection with their investment advisory services and should:
- Find out how affiliated service providers are used;
- Try to document and support the quality of the services provided by the affiliates as compared to those provided by unaffiliated service providers;
- Find out how affiliated service providers are paid;
- Evaluate whether the compensation paid to affiliates for those services is comparable to, less than or greater than the compensation that unaffiliated service providers would charge for comparable services; and
- Evaluate the disclosures to clients/investors regarding the adviser's use of affiliated service providers.
- The primary purpose of this review is to document a robust process of evaluating, at inception and periodically thereafter, both the quality and cost of the affiliate's services as compared to unaffiliated service providers.
- It may be that the most effective way to mitigate the risks of using affiliated service providers is for clients and investors (or LPACs/advisory committees) to affirmatively approve the use of, or continued use of, affiliated service providers after fully disclosing the conflict and disclosing how the adviser selects and pays them.
1 See OCIE, National Exam Program, Examination Priorities for 2019 (Dec. 20, 2018) [hereinafter "OCIE 2019 Exam Priorities"], available at https://www.sec.gov/files/OCIE%202019%20Priorities.pdf.
2 Id. at 1.
3 Id. at 5. OCIE noted that in Fiscal Year 2018, OCIE examined approximately 17 percent of registered investment advisers, an increase of 9 percent from 5 years prior
4 Id. at 6.
5 See OCIE, National Exam Program, Examination Priorities for 2018 (February 7, 2018) [hereinafter "OCIE 2018 Exam Priorities"], available at https://www.sec.gov/about/offices/ocie/nationalexamination-program-priorities-2018.pdf.
6 Id. at 5.
7 SEC Enforcement Division, Share Class Selection Disclosure Initiative (February 9, 2018), available at https://www.sec.gov/enforce/announcement/ scsd-initiative.
8 OCIE 2019 Exam Priorities at 6.
9 OCIE, "Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers," OCIE Risk Alert (April 12, 2018), available at https://www.sec.gov/ocie/announcement/ocie-riskalert-advisory-fee-expense-compliance.pdf.
10 Id. at 2-4.
11 See, e.g., Release No. IA-4975 (July 20, 2018), available at https://www.sec.gov/litigation/admin/2018/ia-4975.pdf (the SEC alleged that an adviser and its employees improperly withheld prepaid, unearned advisory fees totaling $131,000 from 63 departing clients that had requested termination of their advisory relationship); Release No. IA-5065 (November 19, 2018), available at https://www.sec.gov/litigation/admin/2018/ia-5065.pdf (the SEC alleged that an adviser failed to apply advisory fee discounts to certain client accounts contrary to its disclosures, representations to clients and advisory agreements); Litigation Release No. 24206 (July 18, 2018), available at https://www.sec.gov/litigation/litreleases/2018/lr24206. htm (the SEC alleged that an adviser steered clients and other investors into four risky, illiquid private offerings and concealed high commissions as well as grossly overbilled some of their advisory clients); Release No. IA4951 (June 29, 2018), available at https://www.sec.gov/litigation/admin/2018/ia-4951.pdf (the SEC alleged that an adviser failed to offset consulting fees against management fees paid by certain advised funds resulting in such funds overpaying around $780,000 in management fees); and Release No. IA-5096 (December 26, 2018) available at https://www.sec.gov/litigation/admin/2018/ia-5096.pdf (the SEC alleged that the adviser failed to properly allocate fees and expenses among co-investors and employee funds).
12 OCIE 2019 Exam Priorities at 6.
13 Release No. IA- 5002 (Sept. 7, 2018), available at https://www.sec.gov/litigation/admin/2018/ia-5002.pdf, in which the SEC alleged that an adviser failed to adequately disclose material conflicts of interest arising out of a compensation arrangement with an affiliated adviser (the adviser in question recommended to its clients that they invest in wrap fee programs sponsored by three other investment advisers, one of which was an affiliate of the adviser). See also Release No. IA-4932 (June 4, 2018), available at https://www.sec.gov/litigation/admin/2018/ia-4932.pdf, in which an adviser entered into agreements with two affiliated investment advisers ("Affiliated Advisers"), calling for the Affiliated Advisers to make payments to the adviser based upon the total amount of its clients' assets the adviser placed or maintained in funds advised by the Affiliated Advisers. The SEC alleged that the adviser failed to disclose these agreements or the payments, which were in contravention of investment management agreements with two of the adviser's clients. The SEC alleged that the adviser also lacked policies and procedures reasonably designed to detect and prevent such conflicts and failed to account on its books and records for the amounts owed and ultimately paid.
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