On November 9, 2020, the Securities and Exchange Commission (“SEC”) released its observations from the Office of Compliance Inspections and Examinations (“OCIE”) related to the supervision and compliance of registered investment advisers with multiple branch offices.

OCIE conducted a series of examinations that focused on SEC-registered investment advisers operating from numerous branch offices and with operations geographically dispersed from the advisers’ primary or main office.  The reviews emphasized the SEC’s assessment of the compliance and supervisory practices relating to advisory personnel working within the advisers’ branch offices.

The SEC Risk Alert provides observations resulting from the examination process for the subject firms that concluded in 2018.  While time has passed since these reviews were concluded, the objective of the Risk Alert is to educate advisers regarding OCIE’s examination results and to assist advisers in continuing to be vigilant in the implementation of their respective compliance programs. 

By way of background, the subject examinations included approximately 40 adviser main offices combined with one or more examinations of each adviser’s branch offices.  Collectively, the advisers managed approximately $110 billion in assets for 185,000 clients, the vast majority of which were retail investors.   As a general matter, the firms selected for examination operate their advisory businesses out of 10 or more branch offices.  This would suggest the subject firms were typically medium sized advisers.

Broadly, the examinations had two key focal points:

  • Compliance Programs and Supervision
  • Investment Advice 

Compliance Programs and Supervision

The SEC focused its review on certain practices of advisers to determine whether the adviser had adopted and implemented reasonably designed written policies and procedures under Advisers Act Rule 206(4)-7), also known as the “Compliance Rule.”  OCIE staff focused its review on advisers’ compliance programs in both their main and branch offices, as well as oversight by the main offices of advisory services provided through branch offices.  Particular emphasis included compliance with certain rules, such as Advisers Act Rule 204A-1 (“Code of Ethics Rule”) and Advisers Act Rule 206(4)-2 (“Custody Rule”) and consistency with fiduciary obligations, such as those related to fees, expenses and advertising. 

During the course of the reviews, the SEC staff identified the following deficiencies:

Compliance Programs

  • More than one half of the advisers reviewed had compliance policies and procedures that were inaccurate due to outdated information;
  • More than one half of the advisers reviewed had compliance policies and procedures that were inaccurate due to outdated information;
  • More than one half of the advisers reviewed had compliance policies and procedures that were inaccurate due to outdated information;
  • More than one half of the advisers reviewed had compliance policies and procedures that were inaccurate due to outdated information;

Custody of Client Assets

  • Policies and procedures were not designed to limit the ability of supervised persons to process withdrawals and deposits in client accounts, change client addresses of record, or both;
  • Advisers unknowingly had custody of client assets and were required to follow the provisions of the Custody Rule in that:
    • Advisers had commingled its assets with those of its clients;
    • Advisers were trustee for client accounts, or its supervised persons were trustees;
    • Was the general partner to an advised limited partnership;
    • Received client checks in branch offices and deposited said checks with the client’s custodians; and
    • Had various arrangements in place that gave it broad disbursement authority over client assets.

Fees and Expenses

  • Policies and procedures did not include identifying and remediating instances where undisclosed fees were charged to clients;
  • Policies and procedures governing fees, including wrap fee programs, were not enforced;
  • Fee billing issues involved lack of oversight over the adviser’s fee billing processes and in certain instances clients were overcharged;
  • Clients were overcharged in many instances; such as when the adviser:
  • Used inaccurate fee calculations;
    • Misapplied tiered fee structures;
    • Employed incorrect valuations;
    • Inconsistently applied fee reimbursements, including advisory fee offsets for 12b-1 fees;
    • Inconsistently applied refunds for prorated fees paid in advance by clients who terminated their accounts; and
    • Fees were charged differently than the rates stated in their investment management agreements.

Oversight and supervision of supervised persons

  • Recommendations of mutual fund shares classes that were not in the client’s best interest;
  • Supervisory deficiencies related to failure to disclosure material information; and
  • Trading and best execution practices.

Advertising

  • Performance presentations that omitted material disclosures;
  • Prodigious or unsubstantiated claims;
  • Falsely stated professional experience or credentials of the supervised persons or advisory firms; and
  • Third party rankings or awards that omitted material facts regarding those accolades.

Code of Ethics

  • Failure to comply with personal holding reporting requirements;
  • Failure to review of transactions and holding reports;
  • Failure to properly identify access persons; or
  • Failure to include all required provisions of the code of ethics.

Investment Advice

The SEC evaluated the processes by which each firm’s supervised persons located in branch offices provided investment advice to advisory clients, including the formulation of investment recommendations and the management of client portfolios.  OCIE staff focused its review on oversight of investment recommendations, both within specific branch offices and across all of the adviser’s branch offices; management and disclosure of conflicts of interest, and the allocation of investment opportunities.

During the course of the associated reviews, the SEC staff identified the following deficiencies:

Portfolio Management

More than half of the firms examined were cited for deficiencies related to their portfolio management practices.  Generally, this was related to oversight of investment decisions, disclosure of conflicts of interest and trading allocation decisions.   Further observations identified were:

  • Oversight of, or reasonable belief for, investment recommendations including:
  • Mutual fund share class selections and disclosure fees in that advisers purchased share classes of mutual funds that charged 12b-1 fees instead of lower cost shares that were available;
    • Wrap fee program issues wherein the advisers failed to adequately assess whether the programs were in the best interests of the clients;
  • Erroneously charged commissions;
  • Misrepresented or failed to have meaningful disclosures regarding their wrap fee programs;
  • Failure to implement appropriate and consistent oversight of trading away practices; and
  • Rebalancing issues that resulted in short-term redemption fees that may not have been in the client’s best interest.
  • Conflicts of Interest disclosures: Several advisers were cited for issues that were not fully and fairly disclosed such as expense allocations that benefited proprietary fund clients over non-proprietary fund clients;
  • Several advisers also did not fully and fairly disclose financial incentives related to the recommendation of specific products; and
  • Trading and allocation of investment opportunities in that advisers were cited for lack of documentation demonstrating best execution.

Staff Observations Regarding Compliance Practices

While the SEC staff’s examinations identified deficiencies and weaknesses in certain compliance programs, there were also observations of sound compliance program oversight.  The SEC did identify the following practices that may assist advisers in designing and implementing policies and procedures under the Compliance Rule:

  • Advisers implemented uniform written compliance policies and procedures that were applicable to all office locations;
  • Uniform policies and procedures regarding main office oversight for monitoring and approving advertising;
  • Centralized, uniform processes to manage client fee billing;
  • Centralized processes for monitoring and approving personal trading activities for all supervised persons; and
  • Uniform portfolio management policies and procedures, systems or both across all locations.

Compliance Program Testing

Compliance program testing occurred with structured frequency.  Many of the advisers conducted reviews no less than annually and, in some cases, more frequent testing was performed.  Oversight and testing at the branch levels included:

  • Designation of individuals within branch offices to provide portfolio management monitoring;
  • Validation that branch offices undertook compliance or supervision of their portfolio management decisions;
  • Trading activities occurring at the branch level were incorporated into the firms overall testing practices;
  • Performance of compliance reviews that did not solely rely upon self-reporting by firm personnel;
  • Advisers established sound onboarding practices of supervised persons and periodically confirmed the accuracy of disclosure related information; and
  • Compliance training for branch office employees, including targeted training sessions.

Asgard Observations

The OCIE Risk Alert is a helpful tool related to the ongoing development and implementation of an adviser’s compliance program.  We often see deficiencies related to inadequate policies and procedures; lack of policies and procedures; lacking oversight by supervisory personnel; not adhering to the code of ethics; and inconsistent fee billing application.

The Compliance Rule is the lifeblood of an adviser’s compliance program. Developing and implementing fundamentally sound compliance policies and procedures as well as ongoing testing of the effectiveness of those policies and procedures is critical to fostering a culture of compliance.  The OCIE staff’s Risk Alert should be used by advisory firms to ensure consistent implementation of written policies and procedures across each office location.  Ongoing monitoring and testing will go a long way to avoid potential regulatory gaps.