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Why the Role of Compliance Officers Is Taking on New Importance

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The Securities and Exchange Commission is counting on compliance officers, now more than ever, “to do their jobs” as more consumers seek their help, the agency’s chairman, Jay Clayton, said in mid-April at the securities regulator’s 2018 National Compliance Outreach summit, while other SEC officials detailed new rules that lie ahead.

“The importance of investment advisors and investment companies to our investors — and in particular our retail investors — has increased dramatically,” Clayton said at the agency’s 10th annual compliance summit for advisors and investment companies.

He cited a statistic showing a “shift from direct investment by our retail investors to investment through investment companies and through advisors,” stating that the “numbers are dramatic.”

This trend, Clayton continued, “only increases the importance of the compliance function at advisors’ [firms] and investment companies. We’re counting on you to do your jobs. We know your jobs are not easy.” Pete Driscoll, director of the SEC’s Office of Compliance Inspections and Examinations, noted at the event that the investment advisory industry is “growing dramatically,” with assets under management now totaling $82 trillion.

Indeed, compliance officers “tend to see issues, problems and trends before others do,” and “have a very different and valuable perspective,” stated Dalia Blass, director of the SEC’s Division of Investment Management (IM) in comments at the event. She asked compliance officers to be sure they provide input when their firms are filing comment letters or meeting with SEC personnel on proposed rules.

“Please consider if you can participate,” she asked the attendees. When an SEC proposal “is out for comment, put together a skeletal strawman — bare bones, something that would test compliance issues. These elements can go a long way to providing us with valuable information,” Blass said.

Rulemakings Ahead What’s on the agency’s plate this year in terms of rulemakings? First is the agency’s fiduciary, or standards of conduct rule, that the SEC was to discuss and vote on just days after press-time in mid-April. Blass said that the standards of conduct rulemaking, a joint effort by the IM and Trading and Markets divisions, also incorporates “tremendous input from many divisions and offices throughout the commission.”

The agency put forth a three-pronged proposal: New and amended rules and forms requiring RIAs and broker-dealers to provide a brief relationship summary — or disclosure document — to retail investors; a rule to establish a standard of conduct for broker-dealers; and an SEC “interpretation” of the standard of conduct for investment advisors. (See Washington Watch for details)

SEC Commissioner Hester Peirce has said that she supports the rule including measures to address broker and advisor titles.

Karen Barr, president and CEO of the Investment Adviser Association, asked Peirce at the group’s annual compliance conference in Washington in mid-March whether the agency should address regulating broker and advisor titles in its anticipated fiduciary rule, as varying titles have led to investor confusion.

Barr told me at press time in mid-April that the SEC “may address the titles issue in either the proposal related to the standard of conduct for brokers or in connection with the disclosure document.”

Addressing titles, Barr adds, may also not be “part of the formal [SEC] proposal but simply raised in the ‘request for comment’ section instead.” Paul Cellupica, deputy director of the IM division, stated at the compliance outreach event that “a major goal” of the standards of conduct rulemaking is “to address investor confusion and lack of clarity among investors regarding the services that they receive from investment advisors and broker-dealers.”

Compliance officers at investment advisors and broker-dealers, Cellupica said, “are in some ways best situated to understand whether what the Commission is proposing is going to get at that problem. You’re very well situated to suggest ways in which the Commission’s proposal can be improved.”

ETF Rule a Near-Term Priority ETFs, which began with an SEC exemptive order in 1992, “have been an incredible growth story for the asset management industry,” Cellupica said. Since their inception “all ETFs have had to rely on exemptive orders to get launched,” he continued, resulting in what’s now a $3.5 trillion market that’s operating under “300 or so” exemptive orders.

“It’s not ideal for such an important segment of our asset management market to operate under so many individual orders, particularly when there are variations in the terms of some of those orders,” Cellupica added.

The IM division is working on a rule recommendation that would address “inconsistencies among the exemptive orders and enable new ETFs to launch without exemptive orders,” Cellupica said.

Risk Alert on Fees, Expenses OCIE director Driscoll also announced at the summit the agency’s release the same day of a Risk Alert detailing the top compliance failures relating to fees and expenses charged by advisors that were cited most frequently in deficiency letters sent to advisors.

The alert cites the following infractions involving client’s advisory fees and expenses, which are laid out in an advisory agreement and described in an advisor’s Form ADV, as:

1. Fee-Billing Based on Incorrect Account Valuations. OCIE has observed advisors that incorrectly valued certain assets in clients’ accounts resulting in overbilled advisory fees. “Because advisors generally assess fees as a percentage of the value of assets they manage in each client’s account, an incorrect account valuation will lead to an incorrect advisory fee being assessed to that client,” OCIE states.

2. Billing Fees in Advance or with Improper Frequency. OCIE staff has observed issues with advisors’ billing practices relating to the timing and frequency for which advisory fees were billed. Staff observed, for example, advisors that billed advisory fees monthly instead of quarterly, as stated in the advisory agreement or disclosed in Form ADV Part 2.

Staff also observed advisors that billed advisory fees in advance, despite the advisory agreement specifying that clients would be billed in arrears.

3. Applying Incorrect Fee Rate. OCIE staff has observed advisors that applied an incorrect fee rate when calculating the advisory fees charged to certain clients. Advisors have applied a rate higher than what was agreed upon in the advisory agreement or double-billed a client, or charged a non-qualified client performance fees based on a percentage of their capital gains inconsistent with Section 205(a)(1) of the Advisers Act.

4. Omitting Rebates and Applying Discounts Incorrectly. Advisors failed to apply certain discounts or rebates to their clients’ advisory fees, as specified in the advisory agreements, causing the clients to be overcharged. For example, charging a client additional fees, such as brokerage fees, when such client was in the advisor’s wrap fee program and the transactions qualified for the program’s bundled fee.

5. Disclosure Issues Involving Advisory Fees. Trouble spots were seen in advisors’ disclosures of fees or billing practices, including making a disclosure in the Form ADV that was inconsistent with their actual practices; failing to disclose certain additional fees or markups in addition to advisory fees; collecting expenses from a client for third-party execution and clearing services that exceeded the actual fee charged for those services by the outside clearing broker; and earning additional compensation on certain asset purchases for client accounts or that they had fee sharing arrangements with affiliates.

6. Advisor Expense Misallocations. Advisors to private and registered funds also misallocated expenses to the funds. Advisors allocated distribution and marketing expenses, regulatory filing fees, and travel expenses to clients instead of the advisor, in contravention of the applicable advisory agreements, operating agreements or other disclosures.

Washington Bureau Chief Melanie Waddell can be reached at [email protected]