Compliance and Regulatory Alerts  |  12-02-21

SEC Exam Division Issues Alerts on Robo-Advisory Services and IA Fee Calculations Upon Finding Deficiencies

SEC Exam Division Issues Alerts on Robo-Advisory Services and IA Fee Calculations Upon Finding Deficiencies

This month, the SEC Division of Examinations (the “Division”) issued two alerts based on staff findings from recent examination initiatives. The first risk alert, published on November 9, 2021, concerned advisers that offer automated digital investment services to their clients. The initiative was based on increases in the number of advisers operating, recommending or sponsoring discretionary robo-investment services. The targeted examination revealed widespread disclosure and supervisory deficiencies in these services. The second risk alert, published on November 10, 2021, was a follow-up to previously issued guidance on fee-related deficiencies, compliance and disclosure issues. This new alert is based on a national exam initiative focusing on the calculation of advisory fees charged to retail clients and the adequacy of fee disclosures. Here’s a brief overview.

Risk Alert on Digital Investment Advisory Services

In the Division’s Electronic Investment Advice Initiative, staff examined advisers who: provided robo-advisory services to retail investors, (including retirement plans and their participants); “sold, licensed, or granted interactive, digital platform access to third parties,” (i.e., advisers, broker-dealers and banks); and/or provided advisory services to digital investment platforms. The alert concentrated on advisers providing general electronic investment advice and advisers offering investment advisory programs on discretionary (managed) accounts.

Of those providing electronic investment advice, examiners found that most advisers (i) had inadequate compliance programs, including a lack of written policies and procedures or policies that were “insufficient for their operations, unimplemented, or untested;” (ii) were deficient in portfolio management oversight, including failing to test whether the advice generated on the platform was satisfying a client’s stated investment objectives; (iii) were deficient in disclosing to clients conflicts of interest, advisory fees, investment practices, and ownership structure; (iv) were deficient in their marketing and advertisement related communications; (v) were deficient in protecting private data and suffered from inadequate cybersecurity; and (vi) had registration deficiencies, driven, in part, by incorrectly “claiming reliance on the internet adviser registration exemption.”

As to advisers offering electronic advisory services for discretionary accounts, examiners found (i) improper reliance on the safe-harbor provisions of rules intended to ensure clients receive individualized investment treatment; (ii) deficiencies in communicating about these programs, particularly when opening customer accounts; (iv) failures to regularly update clients regarding account changes; and (v) improper restrictions on clients’ accessibility to withdraw securities or cash.

The Division recommended that advisers offering electronic advisory services review their portfolio management practices and related disclosures; performance advertising and marketing materials; and written policies and procedures, including the implementation and testing of those policies and procedures. Staff reminded advisers that policies must be tailored to the adviser’s practices, algorithms must be tested regularly “to ensure that they are operating as expected,” and that safeguards should be instituted to prevent unauthorized algorithm changes. Further, the Division warned “advisers relying on the internet adviser exemption…to review their registration eligibility.” For those that recommend discretionary investment advisory programs, the Division recommended that advisers “assess whether clients are being provided with individualized advice, and whether sufficient policies, procedures, and practices are being employed to prevent such programs from being deemed unregistered investment companies and securities.”

Risk Alert on Investment Adviser Fee Calculations

In the Division’s observations from its Advisory Fees Initiative, staff examined for fee-related calculation deficiencies. The Division found that such deficiencies “often resulted in financial harm to clients.” The Division also examined fee-related compliance and disclosure issues, warning that such deficiencies “may violate [an adviser’s] fiduciary duties and the Advisers Act, including its antifraud provisions.”

Among the findings in staff examinations, the Division observed inaccurate calculations of advisory fees or account valuations, instances of over-billing, double billing, incorrect tiered or breakpoint fees, and the improper "householding" of accounts and failures to refund unearned fees due to clients, (e.g. prepaid fees for terminated accounts or fees that were not assessed on a pro rata basis for new clients). The Division found numerous disclosure issues including false or misleading statements on Form ADV, inaccuracies in describing how fees would be calculated or billed, and the valuation and timing of billing. Similarly, the Division found inaccuracies in financial statements with respect to advisory fees. Staff also found inadequate written policies and procedures related to advisory fee billing and the testing and monitoring of fee calculations.

The Division recommended (i) reviewing, adopting and implementing written policies and procedures on advisory fee billing processes and “validating fee calculations;” (ii) centralizing account and fee billing, and ensuring that “the fees charged to clients are consistent with compliance procedures, advisory contracts, and disclosures;” (iii) ensuring the use of tools and resources (like checklists) when reviewing fee calculations; (iv) accurate recording of expenses and fees assessed to and received from clients, including those paid directly to advisory personnel; and (v) ensuring that “clients are provided with full and fair disclosure of all fees and expenses and related material conflicts of interest.”

The examination initiatives that led to these risk alerts are examples of how the SEC (in this case, the Division of Examinations) can concentrate its resources on particular areas of emerging or continuing risk. Compliance programs must adapt accordingly — Bates can help.

How Bates Helps

Bates Compliance provides tailored solutions for financial institutions and investment advisers. Our compliance team includes senior compliance staff and former regulators, with expertise in the development of policies, procedures, supervisory and compliance processes, including in state and federal registration, supervision and oversight, recordkeeping, and disclosure.

 

Contact us today to learn how we can support your team and your clients.

Rhonda Davis, Managing Director, Bates Compliance & AML - rdavis@batesgroup.com

Rory O’Connor, Director, RIA Compliance - roconnor@batesgroup.com

Brandi Reynolds, Managing Director, MSB and Cryptocurrency Compliancebreynolds@batesgroup.com

Alex Russell, Managing Director, White Collar, Regulatory and Internal Investigations - arussell@batesgroup.com

Julie Johnstone, Managing Director, Securities Litigation and Data Analyticsjjohnstone@batesgroup.com

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