OCIE Observations from Examinations of Investment Advisers

Steve KingLegal Insights

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Authored By Financial Services Partner, Steve King

OCIE Observes Supervisory Deficiencies At Branch Offices

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On November 9, 2020, the Securities and Exchange Commission’s Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert containing observations from a series of examinations focused on SEC-registered investment advisers operating with numerous branch offices and with operations geographically dispersed from the adviser’s principal or main office.1  The exam initiative, which involved nearly 40 advisers serving mainly retail clients, was concluded in 2018.  The OCIE staff observed a number of deficiencies, in many cases involving not fully implementing the firm’s policies and procedures consistently in branch offices and in geographically dispersed operations.  Although the examinations took place before the COVID-19 pandemic, we believe that the observations made by OCIE staff also may be relevant to advisers that are currently operating remotely as a result of the pandemic.

Focus of the Examination Initiative

The examination initiative focused on certain practices of advisers relating to their compliance programs and supervision, and the process by which supervised persons of the adviser located in branch offices provided investment advice to clients.  In particular, with respect to compliance programs and supervision, the staff focused on the oversight by the main offices of an adviser of advisory services provided through branch offices, with an emphasis on compliance with the code of ethics rule (Rule 204A-1 under the Investment Advisers Act of 1940 (Advisers Act)) and the custody rule (Rule 206(4)-2 under the Advisers Act (Custody Rule)), and consistency of the adviser’s practices with its fiduciary obligations in areas such as fees, expenses and advertising.

The staff’s review of the process of providing investment advice focused on the formulation of investment recommendations and the management of client portfolios, including the oversight of investment recommendations, management and disclosure of conflicts of interest, and allocation of investment opportunities.

Observations – Deficiencies

The staff observed that certain risk factors are present in the branch office model, which are heightened when the main office and the branch offices have different practices.  The staff noted that advisers that do not monitor, review and/or test their branch office activities may not be aware that compliance controls may not be effectively implemented in branch offices or do not appropriately address certain risks and conflicts in these remote locations.  As a result, geographically dispersed personnel may develop divergent practices.

The Risk Alert notes that many firms had compliance policies and procedures that were: (i) outdated due to changes in the adviser’s organizational structure or changes in the roles and responsibilities of personnel; (ii) not applied consistently in all branch offices; (iii) inadequately implemented due to the failure to receive records called for in the policies and procedures; or (iv) not enforced. 

Many of the observed deficiencies related to the adviser’s custody practices or failure to adequately implement and oversee its fee billing practices, or both. With respect to custody practices, deficiencies included commingling the adviser’s assets with those of its clients, depositing a client’s checks with the client’s custodian, and various actions resulting in control (and therefore, custody) over a client’s assets such as acting as trustee for a client trust, general partner of a limited partnership owned by clients, or other arrangements giving the adviser broad disbursement authority over client assets.  With respect to fees and expenses, common deficiencies included charging undisclosed fees and expenses, overcharging fees by misapplying tiered fee structures or using incorrect valuations, inconsistently applying fee reimbursements, and calculating fees inconsistently with the formula set forth in the advisory agreement.


 PRACTUS NOTE: Advisers should review their practices and relationships with their clients or funds managed to ensure that they will not be deemed to have custody under the Custody Rule or, if they are deemed to have custody, they should take steps to comply with the Custody Rule.

Other compliance program-related deficiencies included:

  • Failure to disclose material information to clients, including disciplinary events of supervised persons.
  • Recommendation of mutual fund share classes that were not in the client’s best interest.
  • Failure to enforce best execution and trading policies and procedures.
  • Advertising that omitted material disclosures, contained superlatives or unsupported claims, or falsely stated the professional experience and/or credentials of supervised persons or the firm.
  • Inadequate codes of ethics or failure to comply with the provisions of the adviser’s code of ethics.

Deficiencies related to the process by which supervised persons of the adviser located in branch offices provided investment advice to clients generally related to inadequate oversight over investment decisions, disclosure of conflicts of interest, and trading allocation decisions, including the following:

  • Advisers that purchased a particular class of mutual fund shares when a lower cost share class was available.
  • Failure to adequately assess whether wrap programs were in the best interest of clients, and failure to disclose and monitor trading practices and charges to ensure that clients did not incur extra charges.
  • Implementation of rebalancing programs that caused clients to pay additional redemption fees in mutual funds in which their assets were invested.
  • Failure to disclose conflicts of interest resulting from expense allocations between proprietary and non-proprietary fund clients and financial incentives for advisers and their supervised persons to recommend specific investments.
  • Trading and allocation related issues such as failing to keep documentation to support the adviser’s review of the quality of trade executions, completing principal transactions without prior client consent, and inadequate monitoring of trading, including the improper allocation of trading losses to client accounts rather than proprietary accounts.

Observations – Helpful Compliance Practices

During the course of the examinations, OCIE staff also observed practices that advisers may find helpful in ensuring that their compliance practices meet regulatory requirements. 

In general, these practices were in three areas: (i) written compliance policies and procedures that were applicable to all office locations and all supervised persons; (ii) periodic compliance testing or reviews of key activities at all branch offices; and (iii) mandatory compliance training for branch office employees, focusing on areas identified as needing improvement based upon branch office reviews.


 PRACTUS NOTE: Generally, an adviser mitigates many of the risks of a multi-office, geographically dispersed business structure by centralizing as many functions as it can, and by periodically reviewing the practices of its remote offices.  For functions that cannot be effectively centralized, the adviser should adopt office/location-specific policies and procedures, and effectively monitor compliance with those policies and procedures.  It is also essential that personnel receive periodic training on both firm-wide and office-specific policies and procedures.

Conclusion

The Risk Alert is a good reminder to advisers operating in numerous branch offices and with geographically dispersed operations to consider the risks of operating in this manner, and to adopt policies and procedures that address these risks.  Although many of policies and procedures may be centralized in the adviser’s main office, it is important to understand any actual practices that may be different in particular locations, and to adopt procedures to ensure that the actual practices are in compliance with the firm’s policies.  Given that so many advisers are operating remotely as a result of the COVID-19 pandemic, the Risk Alert also may be instructive to advisers that do not have multiple branches and operations.

For more information, please contact Steve King or one of the Practus attorneys with whom you work.

About the Author

Steve King Practus Partner

Financial Services Partner, Steve King, has provided legal advice on SEC regulations and investment management for over 20 years. Steve specializes in a wide array of regulatory and compliance issues that arise under the federal securities and commodities laws, including assisting in regulatory examinations, advising on the use of derivatives by registered investment companies, cross-trading, trade allocation policies, trade error policies, and affiliated transactions.

Article Footnotes


  1.  OCIE Risk Alert, Observations from OCIE’s Examinations of Investment Advisers: Supervision, Compliance and Multiple Branch Offices (Nov. 9, 2020), available at here.

Practus, LLP provides this information as a service to clients and others for educational purposes only. It should not be construed or relied on as legal advice or to create an attorney-client relationship. Readers should not act upon this information without seeking advice from professional advisers.