The SEC has made no secret of the fact that one of its highest-priority focus areas in recent years has been ensuring that advisers are billing clients properly for services rendered.
In various recent enforcement actions and in an April 2018 risk alert issued by the Office of Compliance Inspections and Examinations, the SEC has warned that improper fee and expense billing practices can cause an adviser to violate the antifraud provisions found in the Investment Advisers Act of 1940 (the “Advisers Act”).
To help advisers identify and address any improper billing and expense practices, this article describes 15 common mistakes that are often found when reviewing advisory fee billing practices and explains how an adviser should address such mistakes.
1. Advisory fee billing arrangements outlined in client agreements are inconsistent with the disclosures made to clients in the adviser’s Form ADV.
The SEC has emphasized that the disclosures provided to clients are critical to a client’s determination as to whether to hire an adviser. Therefore, any inconsistencies in such disclosures can present a serious problem. Advisers should review their client agreements to determine if the client agreement calls for more fees and expenses to be charged to the client than are contemplated in the adviser’s Form ADV. Similarly, with respect to clients in an adviser’s wrap fee program, the disclosures as to which expenses are included or excluded from the wrap fee to be charged to the client must be consistent between the client agreement and the Form ADV. If there are inconsistencies, the adviser must either amend the client agreement or the Form ADV.
2. Advisers charge fees on assets for which the client agreement did not contemplate fee billing.
In some cases, advisers provide some limited services for certain assets for which advisory fees are not contemplated. For instance, advisers may not charge fees on assets held away from the primary custodian because the adviser may not be able to implement its recommendations. Similarly, an adviser may not charge fees on cash and cash equivalents because the adviser is not actively managing such assets or providing recommendations with respect to such assets. Similarly, an adviser may provide reporting services on certain assets for which a fee is not contemplated because the adviser is not providing management services with respect to such assets.
Where these and similar arrangements exist, an adviser must ensure that only those assets for which fee billing is contemplated should be included for billing purposes.
3. Advisers apply the incorrect fee rate when billing clients.
This might occur for a variety of reasons. Among others, if an adviser applies different fee rates depending on the type of account that is managed or the adviser applies different fee rates for different clients, this complexity might make it more challenging for the adviser to bill advisory fees properly. Coding accounts for fee billing purposes might assist an adviser in keeping things straight.
4. Advisers do not properly account for breakpoint discounts when billing clients.
Many advisers provide breakpoint discounts to clients, depending on the amount of assets a client authorizes an adviser to manage. However, calculating fees where breakpoint discounts are involved can complicate fee billing, particularly where there are additions and withdrawals from the account over time. An adviser that relies on its custodian or portfolio accounting system to calculate fees should ensure that these breakpoints are being properly calculated.
5. Advisers fail to apply fee discounts where the adviser has agreed to aggregate market values of the client’s account with those of other family members for determining the fee rate to be applied to a household.
Performing such calculations can be challenging where family members opt in or out of such an arrangement and where family members add or withdraw assets to be managed. Nonetheless, an adviser must keep track of these variables in determining the appropriate fee rate to be applied to a household for each billing period.
6. Advisers fail to apply other fee discounts and rebates to a client’s account.
Where an adviser negotiates a special fee discount or decides to apply a rebate with respect to certain clients, the adviser must ensure that such arrangements are properly reflected when it comes time to calculate advisory fees.
7. Advisers fail to properly adjust fees for additions and withdrawals of assets from a client’s account.
Some advisers prorate fees for all additions and withdrawals of assets from a client’s account. Others will only prorate fees if a specified amount of assets are added to or withdrawn from a client’s account. Whatever the arrangement, advisers must make the appropriate adjustments to ensure that clients are not overcharged, particularly with respect to any withdrawals of assets from the account.
8. Advisers fail to properly adjust fees upon the initiation of or termination of a client relationship.
Many advisers will prorate fees for the initial billing period if a client relationship is initiated in the middle of the billing period. Similarly, many advisers will prorate fees for a final billing period if the client relationship is terminated in the middle of a billing period. Some advisers choose to charge an administrative fee when an adviser terminates a client relationship. Whatever the arrangement, advisers must ensure that the appropriate fees are charged or refunded to the client when a client relationship is initiated or terminated.
Additionally, it is important for an adviser to clearly delineate when the advisory relationship is deemed to be initiated and terminated for client billing purposes.
9. Advisers bill clients at improper times and with improper frequency.
For instance, if a client agreement calls for advisory fees to be billed in arrears, the client should not be charged in advance. If the client agreement calls for a client to be billed quarterly, the client should not be billed monthly.
10. Advisers fail to use the proper metric in calculating advisory fees.
If the client agreement calls for assets to be billed based on the fair market value of the assets at the end of the billing period, the client should not be billed based on the average daily balance of the assets over the entire billing period. If the client agreement calls for assets to be billed based on the fair market value of the assets, the client should not be billed based on the cost of the asset. The latter scenario can be particularly problematic with respect to the valuation of illiquid assets where the asset has declined in value.
11. Advisers use the incorrect source for valuing assets for fee billing purposes.
If the client agreement calls for fees to be based on the fair market value of assets as valued by the custodian, the adviser should not be billing fees based on the fair market value of assets as valued by its portfolio accounting/management system. Various factors might contribute to a difference between the market values provided by a custodian and the market values provided by a portfolio accounting system, including, among other things, differences due to unsettled trades, accrued income, the pricing of securities, and the dividends earned but not received. Separately, with respect to private fund investments, if the client agreement calls for assets to be valued by the custodian, the adviser should not be using the valuation provided by the fund sponsor. An adviser that observes that its practices differ from the disclosures in the client agreement must either amend its practices or amend the client agreement to reflect its actual practice.
12. Advisers fail to properly account for the use of margin in calculating fees.
If the client agreement says that fees should be charged on assets net of margin, the client should not be charged fees on assets gross of margin. If the client agreement is silent on whether assets are charged gross or net of margin, the adviser should not charge fees based on assets gross of margin unless there are specific disclosures (including any pertinent conflicts of interest) that have been made to the client beforehand.
13. Advisers improperly charge expenses to clients.
This topic has been the source of significant scrutiny from the SEC in recent years, particularly with respect to investments in private funds where certain expenses are allocated by the fund sponsor to and expected to be paid by the fund and the underlying investors. Fund sponsors who charged expenses to the fund without providing appropriate disclosures in fund offering documents and Form ADV have received significant monetary penalties for engaging in such practices.
Although the focus has been on the allocation of expenses with respect to private fund investments, other advisers should take note as well as problems can arise in other contexts. For instance, advisers who sponsor wrap fee programs must be careful not to charge clients for expenses that are included in the wrap fee, as delineated in the client agreements.
14. Advisers improperly charge performance fees to clients who were not “qualified clients.”
Section 205(a)(1) of the Advisers Act prohibits an adviser registered or required to be registered with the SEC from charging clients performance fees unless such clients are “qualified clients” as defined in Rule 205-3 under the Advisers Act. “Qualified clients” generally include those clients: (a) who, immediately after entering into an advisory contract, have at least $1,000,000 under management with the adviser, or (b) who the adviser reasonably believes, prior to entering into the advisory contract, either have a net worth of at least $2,100,000 or are “qualified purchasers” as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940.
15. Advisers fail to properly calculate performance fees.
The calculation of performance fees can become complicated, particularly where the use of high watermarks and hurdle rates are used. Nonetheless, advisers must carefully perform such calculations so as to not disadvantage the client.
Advisers must carefully review their advisory fee billing practices to ferret out any of the above-referenced mistakes to avoid regulatory risk. This can be best done through the periodic review of client accounts to ensure that fees have been properly billed. If you would like assistance in refining your advisory billing practices, please click here.