Common Pitfalls in Advisory Billing Practices – A Focus on Fees and Expenses
September 23, 2020
To no one’s surprise, the topics of advisory fees, billing practices, and valuation continue to be at the forefront of Securities and Exchange Commission (“SEC”) exams this year. It’s no secret that the SEC has prioritized the review of fee billing practices for investment advisers over the past several years, even issuing a 2018 Risk Alert highlighting the most common fee-related compliance issues identified in SEC examinations. In 2019 and 2020, the SEC followed up on this Alert by identifying the review of fees and expenses as a priority in its Office of Compliance Inspections and Examinations (“OCIE”) exam program. The SEC continues to take enforcement action against firms that violate provisions of the Investment Advisers Act of 1940 (the “Advisers Act”) in fee-related matters. The enforcement actions typically fall into one of two categories (with some cases crossing into both categories): (1) fee errors where clients are incorrectly charged due to inaccurate valuations, inaccurate fee rates, billing cycle errors, or failure to apply fee discounts; and (2) failure to accurately and clearly disclose the firm’s fees, compensation and any associated conflicts of interest. Failure to mitigate conflicts of interest is frequently added to failure to disclose conflicts.
Advisers are on notice that significant focus must be given to the compliance risks and considerations related to proper billing practices and fee disclosures. Advisers should have a testing program designed to promptly identify and remediate billing errors and a compliance program designed to identify conflicts, ensuring full and accurate disclosure. The following discussion highlights the most common deficiencies found by the SEC related to fee billing errors and inadequate disclosures, as well as practice tips to avoid these problems.
Fee Billing Errors
Account Valuation Errors
The SEC commonly finds that advisers incorrectly value certain client assets resulting in the overcharging of advisory fees. Oftentimes, an asset’s valuation is determined using a different fee methodology or billing practice than what’s described in the Form ADV. For example, some advisers use an original cost basis to value an illiquid asset, instead of the fair market value of the asset as described in the adviser’s Form ADV. Other advisers use the value of an account at the end of the billing period vs. the average daily balance of the account as specified in the adviser’s advisory agreement. The SEC has found that advisers may disclose their fee-billing practices one way (balance at the end of a quarter, for example), while engaging a third-party manager or retirement plan provider that bills the adviser’s fees using a different methodology (average daily balance, for instance). This inconsistency between what’s disclosed in the adviser’s agreement and ADV vs. what a third party’s practices are becomes an inaccurate disclosure and a potential violation of the Advisers Act.
Advisers should also be careful to note discrepancies between account valuations provided by a custodian vs. a valuation as reported in portfolio management software. In some cases, accrued interest or dividends may be included on one platform and not the other, which results in minor discrepancies in account value. If an adviser’s ADV or advisory agreement states that assets will be billed on the value of an account as reported by the custodian, the adviser may need to adjust the value in portfolio management software used for billing to match the custodian’s valuation (or an adviser should adjust its ADV disclosure to remove language that specifies “as reported by the custodian”). Finally, an adviser may also inadvertently include an asset in the fee calculation when that asset was excluded from management by the client’s advisory agreement. Proper compliance controls should be implemented to review for these types of incorrect valuations. The terms of an adviser’s advisory agreement should be regularly reviewed for accuracy, and random sampling should be done to ensure fees charged match what’s disclosed in the agreement and ADV.
“As a result of this continued regulatory focus on fees and expenses, and in accordance with an adviser’s fiduciary duty to act in a client’s best interest, advisers should have robust compliance policies and procedures related to billing practices.”
Inaccurate Fee Rates
Advisers are often cited for applying incorrect fee rates when calculating advisory fees, and recent enforcement actions have been taken against advisers that routinely applied a higher fee rate than the rate disclosed to clients and agreed upon in the advisory agreement. Advisers must be particularly careful when relying on automated billing systems to ensure human oversight of the automated program. While automated billing platforms may be less prone to error than manual processes, advisers still have a fiduciary responsibility to ensure that fees are charged properly, and must ensure the automated program performs in a manner consistent with the billing disclosure made to clients. Advisers should randomly sample fee calculations on a routine basis to demonstrate this oversight. The SEC has also found that some advisers have double-billed clients, which could also be detected through an oversight review process.
Billing Cycle Errors
Advisers must be careful to bill in accordance with the terms disclosed in their Form ADV and/or advisory agreement. For example, due to efficiencies provided by advances in advisory-specific portfolio management technology, many advisers have switched to a monthly billing cycle vs. a more traditional quarterly billing methodology. However, some advisers neglect to update their advisory agreement, ADV Part 2 and/or Form CRS, which may describe a quarterly billing practice. This results in inaccurate disclosure to clients and an improper billing frequency, which may be cited as a deficiency in an SEC exam. Another common infraction is when advisers bill in advance of a billing cycle, while their ADV and agreement state that fees are billed in arrears. In the case of new clients, advisers must be careful to bill the initial fee in accordance with the disclosure made to the client – typically on a pro rata basis and not based on an entire billing cycle. Terminated clients must receive a pro rata refund of any unearned advisory fees paid in advance. Advisers should have compliance controls in place to ensure proper billing in the client on-boarding and off-boarding process.
Failure to Apply Fee Discounts
In some cases, advisers fail to apply certain fee discounts or rebates to their clients’ fees, as described in an advisory agreement. For example, advisers may fail to aggregate (or “household”) accounts for family members in order to achieve a lower fee, when such practice is stated in the ADV or advisory agreement. In other situations, fees may not be adjusted when a client’s accounts pass through breakpoint levels, which would entitle the client to a lower fee. Automated programs may eliminate some of this risk, but human oversight is still needed to ensure the accuracy of fees. Advisers should also consider whether a fee should be adjusted for asset flows into and out of an account, consistent with disclosure related to the adviser’s practices for this flow. Finally, advisers must ensure that clients do not pay additional costs and fees if such fees were not disclosed in the ADV or advisory agreement. For example, if an advisory service is described as a wrap-fee program with a bundled fee, the client should not be subject to additional trading or brokerage costs that should be included in the bundled advisory fee.
Inadequate Disclosures Related to Fees and Conflicts
Many deficiencies cited by the SEC during exams relate directly to the adviser’s disclosure of fees and billing practices or the adviser’s failure to properly disclose fee-related matters. As discussed above, advisers often fail to update disclosure in Form ADV or an advisory agreement when changes are made to a billing process. Advisers are often cited for fee billing disclosures that are inconsistent with their practices – such as charging a higher fee than the maximum fee stated in the ADV, using a different fee calculation methodology or applying a different fee billing frequency.
Advisers are also frequently cited for failing to disclose additional fees or markups to which clients are subject, in addition to the advisory fee, or additional compensation earned by an adviser for the sale of a particular product. Examples of this practice include collecting expenses from a client for execution services that were in excess of the actual trading costs (mark-ups), earning incentive compensation for recommending certain products, or earning additional compensation for certain asset purchases when the adviser had revenue sharing arrangements with another entity. This last example is of particular concern to regulators, and many enforcement cases specifically relate to firms’ failure to disclose revenue sharing.
Advisers should also be aware of any economic benefit derived from client transactions – such as additional compensation earned from money market cash sweep accounts, discounts applied to mutual funds purchased from a “no-transaction fee” list, differential compensation earned from proprietary or affiliated products, and receipt of 12b-1 fees, just to name a few. The conflicts of interest represented by these economic benefits must also be disclosed – a particular emphasis in the new Form CRS.
“In order to establish an effective testing program related to billing practices, advisers should establish protocol for randomly reviewing a healthy sample of client fees each billing cycle. Documentation should be kept to demonstrate this compliance oversight.”
The terms of a client’s advisory fees are typically described in the adviser’s Form ADV and advisory agreement. Advisers that fail to adhere to the terms of their agreements and disclosures, who fail to properly disclose, or who engage in improper fee billing practices, may be found to have violated the Advisers Act anti-fraud provisions. Such violations may subject an adviser to SEC enforcement action. In addition to fines and penalties, advisers are often required to reimburse clients for any overbilled or improperly collected advisory fees.
Practice Tips for an Effective Testing Program for Billing Practices
In order to establish an effective testing program related to billing practices, advisers should establish protocols for randomly reviewing a healthy sample of client fees each billing cycle. Documentation should be kept to demonstrate this compliance oversight. A review should include the following steps:
- Verifying the accuracy of the calculation (rate x asset valuation);
- Reviewing the client agreement to confirm the proper rate (or blended rate) was applied;
- Confirming the calculation as of last business day or average daily balance, as agreed to by the client;
- Confirming the correct billing cycle was applied (monthly vs. quarterly, in advance or in arrears) as agreed to by the client;
- Reconciling householded accounts for fee-discount purposes;
- Verifying the prorating of fees for accounts opened or closed mid-billing cycle;
- Confirming that assets marked as “unmanaged” are not included in a fee calculation;
- Accounting for cash in-flows or out-flows, as applicable and if disclosed;
- Reconciling account values provided by the custodian vs. account values billed in portfolio management software;
- Confirming transaction charges are not assessed for accounts billed under a wrap program; and
- Validating the pricing of non-marketable securities or hard-to-value assets.
As a result of this continued regulatory focus on fees and expenses, and in accordance with an adviser’s fiduciary duty to act in a client’s best interest, advisers should have robust compliance policies and procedures related to billing practices. Such procedures should not only include a regular review of fee billing practices as discussed above, but should also include cross-checks and controls on the number of employees with access to the billing systems. Advisers should evaluate the timing, householding, fee level, and method of calculation to ensure their firm’s practices match what is disclosed to clients in the ADV, advisory agreement, and policies and procedures. If an adviser utilizes an automated billing platform, the firm must ensure the accuracy of the calculations with human oversight. When a billing error is detected, an adviser should correct and remediate the error and determine what steps should be taken to prevent a similar error in the future. Importantly, advisers should keep detailed records that demonstrate this oversight process and the controls and reviews implemented to test the adviser’s billing practices.
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*Kerry Rider is a Managing Director of Foreside in the Los Angeles office and has more than 25 years of compliance experience. Ms. Rider provides compliance consulting services to registered investment advisers, working to develop effective compliance programs and solve complex regulatory issues, including serving as an Outsourced CCO. Prior to joining Foreside, she ran her own consulting firm and served as CCO for regional, retail and institutional investment advisers and broker-dealers. She earned her BA from the University of California at Los Angeles and holds FINRA Series 7 and 24 registrations. She may be reached at krider@foreside.com or 213-320-0500.
This article is for general information purposes and is not intended to be and should not be taken as legal or other advice.
