On November 9, 2020, the Office of Compliance Inspections and Examinations ("OCIE") of the US Securities and Exchange Commission ("SEC") published a risk alert1 ("Risk Alert") discussing its observations from a series of examinations that focused on SEC-registered investment advisers operating from numerous branch offices2 and with operations geographically dispersed from the adviser's principal or main office ("Initiative"). In this Initiative, OCIE staff assessed, among other things, the advisers' compliance and supervisory practices relating to advisory personnel working within the advisers' branch offices.
OCIE first highlighted compliance risks associated with branch offices advisers in its 2016 examination priorities, followed by an announcement of a related examination initiative later that same year.3 OCIE stated that investment advisers with multiple offices continue to be an area of interest for examinations because these advisers (1) often advise retail clients and (2) have unique risks and challenges related to the design and implementation of their compliance programs and oversight of advisory services provided through remote offices.
Although the examinations conducted under this Initiative concluded in 2018, before the COVID-19 pandemic began, OCIE's observations as outlined in the Risk Alert and in OCIE's August 2020 risk alert regarding COVID-19 compliance matters4 should still prove helpful to investment advisers in evaluating their policies, procedures and controls in the midst of the pandemic.5
The following Legal Update provides a summary of OCIE's observed deficiencies outlined in the Risk Alert, followed by a discussion of observed practices that seek to mitigate compliance risks.
General Observations About Branch Offices – OCIE believes that the branch office model may pose certain risk factors that advisers should consider in designing and implementing their compliance programs and in supervising personnel and that these risks may be heightened when the main and branch offices have different operations or controls or ways of communicating. EXAMPLE: Advisers that do not monitor, review, and/or test their branch office activities may not be aware that the compliance controls they have adopted:
- are not effectively implemented or
- do not appropriately address the risks and conflicts in or unique to these remote locations.
Compliance Program Issues – OCIE staff observed that more than one-half of the examined advisers had compliance policies and procedures that were:
- inaccurate because they included outdated information, such as references to entities no longer in existence and personnel that had changed roles and responsibilities;
- not applied consistently in all branch offices;
- inadequately implemented because, among other things, the compliance department did not receive records called for in the policies and procedures; or
- not enforced.
Compliance issues often were related to the advisers failing to recognize that they had custody of clients' assets, failing to adequately implement and oversee their fee billing practices, or both.
Custody Issues – Some advisers did not have policies and procedures that limited the ability of supervised persons to process withdrawals and deposits in client accounts, change client addresses of record, or do both. In addition, advisers, perhaps unknowingly, had custody of their clients' assets due to a variety of practices, including instances where the adviser:
- comingled its assets with those of its clients;
- was the 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 these checks with the client custodians; and/or
- had various arrangements in place that gave it broad disbursement authority over client assets.6
Fee and Expense Issues – OCIE observed that some advisers did not have policies and procedures that included identifying and remediating instances where undisclosed fees were charged to clients. In addition, OCIE observed:
- policies and procedures governing such fees, including those related to wrap fee programs, that were not enforced;
- that most fee billing issues were related to the lack of oversight over fee billing processes, and in some cases, this resulted in overcharges to clients;7
- Advisers overcharging advisory fees to clients by:
- using inaccurate fee calculations by, for example, misapplying tiered fee structures or employing incorrect valuations for the calculations;
- inconsistently applying fee reimbursements, including for advisory fee offsets for 12b-1 fees from certain mutual fund purchases and refunds for prorated fees paid in advance by clients who terminated their accounts; and
- charging fees at a rate that was different than the rates included in advisory agreements or on assets that were to be excluded from advisory fees.8
Issues with Oversight and Supervision of Personnel – OCIE observed supervision deficiencies related to:
- the failure to disclose material information, including disciplinary events of supervised persons;9
- portfolio management, such as the recommendation of mutual fund share classes that were not in the client's best interest;10 and
- trading and best execution, including enforcing policies and procedures the adviser had in place.
1 Observations from OCIE's Examinations of Investment Advisers: Supervision, Compliance and Multiple Branch Offices, SEC OCIE Risk Alert (November 19, 2020), available at https://www.sec.gov/files/Risk%20Alert%20-%20Multi-Branch%20Risk%20Alert.pdf
2 For purposes of the Initiative, a branch office is an office or "place of business" other than the adviser's "principal office and place of business" as those terms are defined in Rule 222-1 under the Investment Advisers Act of 1940 ("Advisers Act").
3 Exam Priorities for 2016, SEC OCIE (Jan. 11, 2016), available at https://www.sec.gov/about/offices/ocie/national-examinationprogram-priorities-2016.pdf and Multi-Branch Adviser Initiative, SEC OCIE National Program Risk Alert (December 12, 2016), available at https://www.sec.gov/ocie/announcement/risk-alert-multi-branch-adviser-initiative.pdf
4 Select COVID-19 Compliance Risks and Considerations for Broker-Dealers and Investment Advisers, SEC OCIE Risk Alert (August 12, 2020), available at https://www.sec.gov/files/Risk%20Alert%20-%20COVID-19%20Compliance.pdf
5 The staff in the Division of Investment Management stated that it would not recommend enforcement action if a firm does not update its Form ADV in order to list the temporary teleworking addresses of its employees (see https://www.sec.gov/divisions/investment/iard/iardfaq.shtml#item1f )
6 See, generally, Significant Deficiencies Involving Adviser Custody and Safety of Client Assets, SEC OCIE National Program Risk Alert (March 4, 2013), available at https://www.sec.gov/about/offices/ocie/custody-risk-alert.pdf
7 Advisers should maintain policies and procedures regarding the appropriate calculation of, and adherence to, advisory fees contractually agreed to in the applicable investment advisory agreement with the respective client. Miscalculation of fees, even those resulting in clients being charged less than their contractual fee rates, will likely be viewed as a compliance deficiency by OCIE examination staff.
8 See also Overview of the Most Frequent Advisory Fee and Expense Compliance Issues Identified in Examinations of Investment Advisers, SEC OCIE National Program Risk Alert (April 12, 2018), available at https://www.sec.gov/ocie/announcement/ocie-riskalert-advisory-fee-expense-compliance.pdf
9 Observations from Examinations of Investment Advisers: Compliance, Supervision, and Disclosure of Conflicts of Interest, SEC OCIE Risk Alert (July 23, 2019), available at https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Supervision%20Initiative.pdf
10 Share Class Selection Disclosure Initiative, SEC Division of Enforcement, available at https://www.sec.gov/enforce/announcement/scsd-initiative
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