OCIE Observes Supervisory Deficiencies At Branch OfficesOn 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 InitiativeThe 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 – DeficienciesThe 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.
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.
- 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.