The U.S. Securities and Exchange Commission's (SEC) Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert on November 9, 2020 that focused on SEC-registered investment advisers operating from numerous branch offices and with operations geographically dispersed from the adviser’s principal or main office. Advisers with multiple branch offices continue to be an area of OCIE interest because, according to OCIE, this operating model has unique risks and challenges related to the design and implementation of compliance programs and oversight of advisory services provided through remote offices. The staff explained in the risk alert that while many of the issues identified are not unique to advisers that use the multiple branch office model, such a model may be more susceptible to these issues because geographically dispersed personnel may develop different practices or disparate ways of communicating.
The alert is a culmination of approximately 40 OCIE examinations of advisers that collectively managed approximately $110 billion in assets for about 185,000 clients, the majority of whom were retail investors, and most registrants selected for examination conducted their advisory business out of 10 or more branch offices. Although the OCIE examinations were concluded in 2018, the risk alert included a reminder on the Division of Investment Management’s Form ADV and IARD Frequently Asked Questions: Form ADV Item 1.F guidance regarding listing temporary teleworking addresses.
The OCIE initiative focused on certain compliance program functions such as written policies and procedures, oversight by the main offices of advisory services provided through branch offices, compliance with the code of ethics and custody rules, and consistency with fiduciary obligations such as those related to fees, expenses, and advertising. OCIE examinations also focused on the investment advice to advisory clients (both within specific branch offices and across all the advisers’ branch offices), management and disclosure of conflicts of interest, and allocation of investment opportunities.
Issues and Deficiencies Identified by OCIE
Compliance Program Written Policies and Procedures: Citing the compliance rule, OCIE staff observed registrants 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- Inaccurate because they included outdated information, such as references to entities no longer in existence and personnel that had changed roles and responsibilities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
- Not enforced
Custody Policies and Procedures: Registrants frequently lacked policies and procedures that limited the ability of supervised persons to process withdrawals and deposits in client accounts, change client addresses, or do both.
Fees and Expenses: OCIE staff observed a lack in policies and procedures to identify and remediate undisclosed fees, including inadequate governance of wrap fee programs. Firms also lacked oversight of fee billing processes which resulted in overcharging clients in various ways, such as:
- 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
- Charging fees different than the rates included in advisory agreements or on assets that were to be excluded from advisory fees
Oversight and Supervision of Supervised Persons: Supervision deficiencies were observed related to disclosures, best execution, and recommendations related mutual fund share classes that were not in the client’s best interest. The risk alert noted these deficiencies were particularly prevalent when the advisers oversaw branch office personnel with higher-risk profiles, which included instances related to the identification and documentation of disciplinary events.
Advertising: OCIE identified deficiencies that included performance presentations that omitted material disclosures; superlatives or unsupported claims; professional experience and/or credentials of supervised persons or an advisory firm that were falsely stated; and third-party rankings or awards that omitted material facts regarding these accolades. Offenders included supervised persons of the adviser and supervised persons operating under a name different than the primary name of the adviser (also known as “doing business as” or “DBAs”).
Code of Ethics: Deficiencies cited by OCIE staff included the timeliness and review of transaction and holdings reports, identification of access persons, or registrant’s codes of ethics lacking certain provisions such as pre-approval for limited or private offerings and submissions of initial and annual holdings reports.
Portfolio Management: Deficiencies related to oversight of investment decisions, including the oversight of investment decisions occurring within branch offices, disclosure of conflicts of interest, and trading allocation decisions. For example:
- Inadequate oversight of, or reasonable basis for, investment recommendations (e.g., mutual fund share class selection practices and wrap fee program governance)
- Failure to adequately assess whether programs were in the best interests of clients (e.g., erroneously charged commissions, misrepresented or failed to have appropriate disclosures regarding their wrap fee program)
- Rebalancing issues such as advisers implemented automated rebalancing of accounts that caused clients to incur short-term redemption fees from mutual funds which caused clients to pay additional fees
Conflicts of Interest Disclosures: Some advisers did not disclose expense allocations that appeared to benefit proprietary fund clients over non-proprietary fund clients or describe financial incentives for the advisers and/or their supervised persons to recommend specific investments.
Trading and Allocation of Investment Opportunities: Advisers were cited for their lack of documentation demonstrating the advisers’ analysis of best execution, completing principal transactions involving securities sold from the firms’ inventory without prior client consent and inadequate monitoring of supervised persons’ trading, including the improper allocation of block trade losses to clients rather than to the supervised persons.
Staff Observations to Assist Investment Advisers
This risk alert also included a list of practices with respect to branch office activities that OCIE suggested firms may find helpful in their compliance oversight efforts. Some of these practices are referenced below:
- Written policies and procedures that apply to all office locations and all supervised persons – regardless of whether these individuals are independent contractors or employees of the adviser. The risk alert stated some compliance policies and procedures specifically address monitoring and branch oversight practices, such as:
- Uniform policies and procedures regarding main office oversight for monitoring and approving advertising
- Centralized and uniform processes to manage client fee billing
- Centralized processes for monitoring and approving personal trading activities for all supervised persons located in all office locations
- Uniform portfolio management policies and procedures, portfolio management systems, or both, across all office locations (e.g., trade orders were also centralized through the main office)
- Advisers performed compliance testing or periodic reviews of key activities at all branch offices at least annually, with some firms conducting reviews more frequently. Examples include:
- Validating that branch offices undertake compliance or supervision reviews of their portfolio management decisions, both initially and on an on-going basis
- Designating individuals within branch offices to provide portfolio management monitoring, primarily to assess whether investment recommendations were consistent with clients’ investment objectives or recommendations
- Consolidating the trading activities occurring within branch offices into the advisers’ overall testing practices
- Conducting compliance reviews that do not solely rely on self-reporting by personnel
- Advisers established compliance policies and procedures to check for prior disciplinary events when hiring supervised persons and periodically confirming the accuracy of disclosure regarding such information
- Advisers required compliance training for branch office employees, preferably semi-annually or at least annually
In keeping with the framework of some of OCIE’s more recent risk alerts, this risk alert included a “Staff Observations Regarding Compliance Practices” section which might be of particular interest for multiple branch office advisers since OCIE staff specifically suggested advisers may find these observations helpful in their compliance oversight efforts.
By our count, this is OCIE’s eighth risk alert during 2020, an unprecedented level of examination transparency relative to past years. This openness and staff guidance often compels compliance officers to carefully ensure they have adequate processes and procedures to address the associated risks. We also note that if past risk alerts are a leading indicator, the highlighted risks could be a part of the exam staff’s focus for the foreseeable future.
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