The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issued a Risk Alert to provide observations from its initiative to examine SEC-registered investment advisers operating from multiple branch offices that are geographically dispersed from the adviser’s principal office (“Branch Office Advisers”). The Risk Alert discusses common examination deficiencies identified by the OCIE staff (“Staff”) in their examination of Branch Office Advisers and examples of practices implemented by some Branch Office Advisers that were aimed to improve compliance and supervisory practices. More broadly, the Staff mentioned that it will continue to monitor industry trends and practices, including teleworking from dispersed remote locations. Registered investment advisers with personnel who are temporarily conducting investment advisory business from a location other than the adviser’s main office due to the COVID-19 pandemic (which is most advisers) should take note of the deficiencies and best practices identified in the Risk Alert.1
A. Deficiencies Related to Compliance and Supervision
Compliance Programs. The vast majority of Branch Office Advisers examined were cited for at least one deficiency related to Rule 206(4)-7 of the Investment Advisers Act (commonly referred to as the “Compliance Rule”).
More than half of the Branch Office Advisers examined had compliance policies and procedures that were inaccurate (i.e., contained outdated information); not applied consistently in all branch offices; inadequately implemented (e.g., the compliance department did not receive records required by policies and procedures); or not enforced. Two common compliance program-related deficiencies related to the custody of client assets and fee billing practices.
- Custody of Client Assets. The Staff observed that Branch Office Advisers often failed to recognize when they had custody of client assets. Additionally, Branch Office Advisers lacked policies and procedures that limited the ability of supervised persons to process withdrawals and deposits in client accounts or change client addresses of record.
- Fee and Expenses. The Staff observed that Branch Office Advisers did not have policies and procedures to identify and remediate instances where undisclosed fees were charged to clients. Most of the observed fee billing issues were related to lack of oversight over fee billing processes. Branch Office Advisers overcharged advisory fees to clients in a variety of ways, including through misapplied tiered fee structures or incorrect valuations for fee calculations, inconsistently applied fee reimbursements, and by charging fees that differed from the disclosed rates.
Oversight and Supervision of Supervised Persons. The Staff observed deficiencies related to the inadequate oversight and supervision of supervised persons, including failure to disclose material information, such as disciplinary events of supervised persons; portfolio management, such as the recommendation of mutual fund share classes that were not in the client’s best interest; and trading and best execution.
Advertising. The Staff frequently observed advertising-related deficiencies, specifically in materials prepared by branch office personnel. Problematic advertisements included performance presentations that omitted material disclosures, used superlatives or unsupported claims, falsely stated professional experience and/or credentials, and included third-party rankings or award without material facts on these accolades.
Code of Ethics. Several of the examined Branch Office Advisers were found to have code of ethics deficiencies, including failure to comply with reporting requirements, failure to review transactions and holdings reports, improper identification of access persons, and codes of ethics that did not include all required provisions.
B. Deficiencies Related to Investment Advice
Portfolio Management. More than half of the examined Branch Office Advisers were cited for deficiencies related to portfolio management practices. These often related to:
- Oversight of, or Reasonable Basis for, Investment Recommendations, including the purchase of mutual fund share classes that charged 12b-1 fees instead of lower-cost share classes, the failure to oversee and disclose certain wrap fee program practices and fees, and issues related to automated rebalancing of accounts that caused clients to incur short-term mutual fund redemption fees;
- Conflicts of Interest Disclosures, including the failure to fully and fairly disclose conflicts of interests related to expense allocations that benefited proprietary fund clients over non-proprietary fund clients, or financial incentives for the adviser and/or their supervised persons to recommend specific investments; and
- Trading and Allocation of Investment Opportunities, including inadequate documentation of the Branch Office Adviser’s best execution analysis, failure to obtain client consent for principal transactions, and failure to monitor supervised persons’ trading (e.g., improper allocation of block trade losses to clients rather than to supervised persons).
C. Staff Observations Regarding Compliance Practices
In addition to these commonly observed deficiencies, the Risk Alert provided compliance practices that the Staff observed with respect to branch office activities that may be helpful to Branch Office Advisers.
Policies and Procedures. The Staff observed that Branch Office Advisers adopted and implemented policies and procedures that applied to all office locations (i.e., main and branch offices) and all supervised persons; were tailored to specific branch offices activities; and addressed compliance monitoring and oversight of branch offices. For example, some Branch Office Advisers adopted (i) main office oversight, monitoring and approval of advertising; (ii) centralized uniform client fee billing processes; (iii) centralized monitoring of personal trading, including automated centralized review and approval of personal trading requests and transactions; and (iv) uniform portfolio management policies and procedures and portfolio management systems across all offices.
Compliance Testing or Periodic Reviews of Key Activities at All Branch Offices. Examples of testing included: (i) validating that branch offices conducted compliance or supervisory reviews of their portfolio management decisions; (ii) designating individuals within branch offices to provide portfolio management monitoring (e.g., for consistency with client investment objectives or recommendations); (iii) consolidating branch office trading activities into the Branch Office Adviser’s overall testing practices; and (iv) conducting compliance reviews that did not rely on individual self-reporting.
Policies and Procedures to Check for Prior Disciplinary Events when Hiring Supervised Persons for Branch Office Employees. In addition to initial screening, some Branch Office Advisers adopted policies and procedures to periodically review branch office employees’ disciplinary histories and increase supervision of individuals with disciplinary histories.
Required Compliance Training for Branch Office Employees. Most of the examined Branch Office Advisers required branch office employees to complete compliance-related training, focusing on weaknesses identified in the Branch Office Adviser’s review of branch offices.
The Staff encouraged Branch Office Advisers to consider the unique risks and challenges presented by a business model that includes geographically dispersed branch offices when designing and implementing their compliance and supervision program. As mentioned above, investment advisers that have personnel working remotely due to COVID-19 should also consider the Staff’s observations identified in the Risk Alert.
Seward & Kissel LLP, and our compliance consulting service SKRC (Seward & Kissel Regulatory Compliance), are available to assist advisers in the design, implementation and review of written policies and procedures to address the issues identified in the Risk Alert.