It had been one of those cloudy, gloomy days. The petrichor filled my nostrils from the earlier downpour, briefly drowning out the typically dominant grainy smells of cereal grains being pulverized into ready-to-eat foodstuffs at one of the several local agricultural processing factories. It was the same rich aromas that wafted through the air that day a few months ago when I took an unusual case.
She was from a SMA asset management adviser who had received several inquiries from clients about the investment advisory fees they had been billed. Specifically, the clients felt the fees they were billed were too much. Not really the sort of case that I took because clients say things like that all the time. I had a hunch—call it my detective’s instincts—that something wasn’t turning out quite right on their books and they needed someone from the outside to put a fresh set of eyes on them.
“Is there a particular client you need me to watch?” I asked. Stakeout work wasn’t my favorite, but I needed to nail down whether this was specific to certain clients or if it was a systemic issue.
“No, none in particular,” she said. It knocked the wind out of me hearing that her firm’s entire fee billing record might need to be examined.
“I know we have a lot of clients, so just pick a sample of clients to examine,” she continued.
That was music to my ears. All I needed to examine were a large enough sample to be meaningful. Typically, if I were doing this each quarter, it would add up to enough clients in a year to give a full picture. Thoughts of confidence intervals and standard deviations—the weapons of determining a representative sample size in a formal statistics setting—filled my mind. But I don’t think she was in the mood for that kind of math today. Under the circumstances, I don’t blame her. From the standpoint of a regulator, that’s more of a “nice to have” than it is a hard requirement.
“I will need to visit the scene of the crime to look for clues,” I answered.
“Of course. What kinds of clues are you looking for?”
“Not sure right now, but to help me look, I will need a few things:
- your firm’s fee billing records from the previous quarter
- Investment Advisory Agreements for the clients I select
- Form ADV Part 2A
- and a list of clients who terminated in the previous quarter.”
“Done!” she answered. “The ADV Part 2A is available on the IAPD website; you can pull it from there.”
Next step: Going to her firm.
Her firm’s offices were located in a beautiful modern glass mid-rise building in a swanky neighborhood on the edge of downtown. It was nestled among several immaculately maintained and preserved historical buildings that strangely blended in with the trappings of modernity around them. I stepped inside the building to what looked like the stereotypical fancy office building lobby you see in movies. But I had a case to investigate, so instead of admiring vague furniture and post-modern artwork whose contortions and abominations of shape and color always seem to speak to the horrors contemporary American life where common men live better than royalty of antiquity, I took the elevator to the top floor.
Upon arrival, I was quickly ushered into a conference room with a spectacular view of downtown. All the materials I requested were waiting on the table, so I got to work.
The first step was to verify the consistency of disclosures between documentation:
- Are the terms outlined between Form ADV Part 2A and the Investment Advisory Agreement in alignment?
- Do the fee schedule percentages or other terms of fee billing match
- Do the stated fee billing frequency and periods match?
- Monthly? Quarterly? In advance? In arrears? As of a certain date? Average Daily Balance?
- Do they agree as to whether fees are negotiable?
- Do the Form ADV Part 2A and the Investment Advisory Agreement reference householding or aggregation of accounts of multiple clients to charge a lower fee across all aggregated/householded accounts?
- Does the Investment Advisory Agreement show indication of a negotiated fee?
All of this information is important to know as they form the basis of the firm’s fee calculations and different methods calculate differently and yield different results.
I paused to refresh my memory of how each fee billing regime worked:
- Annual Fee Billed Quarterly “As Of”: this takes the account balance as of a certain date, multiplies it by the advisory fee percentage, then divides that by four.
- Annual Fee Billed Quarterly Pro Rata “As Of”: this takes the account balance as of a certain date, multiplies it by the advisory fee percentage, then divides by 365, then multiplies by the number of days in the quarter.
- Annual Fee Billed Quarterly on Average Daily Balance: this totals up the ending balances of each day in the quarter, divides that by the number of days in the quarter, then multiplies by the advisory fee percentage, then divides by four.
- Annual Fee Billed Quarterly on Average Daily Balance Pro Rata: this totals up the ending balances of each day in the quarter, divides that by the number of days in the quarter, multiplies it by the advisory fee percentage, then divides by 365, then multiplies by the number of days in the quarter.
And that’s to say nothing about monthly billing cycles, which are less common, but still out there in the industry. Needless to say, with all that could go wrong because of different fee billing methods, firms need to be very careful about how their disclosure align with actual practice.
So, I sat down and began the process of sorting through the furnished documents. They passed the first test quickly as I validated that several client accounts were billed according to Part 2A and the Investment Advisory Agreement, whose terms all matched. This firm was a quarterly pro rata “as of” shop.
But then came the tricky task of validating householded accounts. The Firm disclosed that they household accounts for fee billing purposes and have a tiered annual fee schedule that is 1% up to the first $5 million and then 0.75% for the next $5 million. The client in front of me had five householded accounts worth a total of $10 million. The five accounts had values of $1 million, $2 million, $4 million, $1.5 million, and $1.5 million. Good thing I brought a laptop along; Excel to the rescue!
Visualized, my situation looked like this:
$10 million Fees: 1% up to $5 million, 0.75% up to the next $5 million
- $1 million (10% of the total)
- $2 million (20% of the total)
- $4 million (40% of the total)
- $1.5 million (15% of the total)
- $1.5 million (15% of the total)
Validating the fees began with calculating the total fee for the total amount of $10 million, illustrated:
(($5M x 0.01) divided by 365 days in the year)x 92 days in the quarter=$12,602.74
(($5M x 0.0075)divided by 365 days in the year)x 92 days in the quarter=$9,452.05
Total overall fee: $22,054.79
But then I needed to make sure that the total fee was apportioned to each account correctly, so I recalculated what the fees should have been. Illustrated:
($12,602.74 x 0.10) + ($9,452.05 x 0.10) = $2,205.48
($12,602.74 x 0.20) + ($9,452.05 x 0.20) = $4,410.96
($12,602.74 x 0.40) + ($9,452.05 x 0.40) = $8,821.92
($12,602.74 x 0.15)+($9,452.05 x 0.15) = $3,308.21
($12,602.74 x 0.15)+($9,452.05 x 0.15) = $3,308.21
Total of account fees: $22,054.78
And there was the problem. When I recalculated the actual fees charged to client accounts, I discovered that the fee break at the next tier was, for some reason, never activated. It appeared that the firm’s fee billing system charged all of the accounts individually. Since none of the accounts on their own broke the $5 million threshold, all of these clients’ accounts were being charged 1% on the entire balance instead of receiving 0.75% on a portion of their account balances. With this lead, I tracked down as many clients as I could who had householded accounts that exceeded the breakpoint, but with individual accounts under $5 million and recalculated them to see if I could replicate the results I got with the first set of accounts I examined. To my surprise, I saw the same process repeat itself with these as I had seen with the accounts I originally examined.
I wrote up my conclusion and took them to my contact with the Firm. She briefly read the memo and looked up at me.
“You found what we were looking for, well done! But I saw your recommendation that we double check the programming of our fee billing system, recalculate the fees for affected clients, and reimburse those clients for the overbilling. How should we refund the overbilling? Write the clients a check? Refund the fees directly to their accounts? Waive fees for a quarter?”
“That will have to be a business decision that you make as a firm. Be aware, though, that refunding fees directly to client accounts could count as a contribution if the account is an IRA. If clients being refunded this way have maxed out their IRAs, these refunds could cause a lot more issues that just having to refund fees.”
“What would you do if it was your decision to make?”
“Due to the length of time involved, there will be an expectation that clients be refunded the overbilled amount plus interest over the time period in question.”
“How much interest?”
“There is no set amount, but whatever interest calculation you used it must be considered ‘reasonable’ and pursuant to a consistent methodology, consistent over time and across clients.”
“Would reducing client fees be an option?”
“Potentially. Using that method could work if the total refund amount is less than or equal to the amount of fees the client would pay in the upcoming quarter.”
“Very good, thank you for your help. We will be in touch!”
Conclusion
In recent years, the SEC has strongly emphasized fee billing accuracy as part and parcel of an investment adviser’s fiduciary duty, and fee billing accuracy has been repeatedly featured in the SEC’s annual exam priorities, Risk Alerts, and administrative actions.
It is important to understand not only how your firm assesses fees against client accounts but also to verify that fees were billed correctly. This includes having a strong reconciliation process in place that is performed during each billing cycle and periodically testing the fee billing methodology through recalculations. Firms should also perform back-end reviews to verify that refunds were paid to terminated clients.
The Core Compliance consulting team can assist you with implementing strong fee billing testing and review processes.. We also offer compliance technology solutions, which play a crucial role in maintaining a strong compliance program. For more information, please contact us at info@corecls.com, at (619) 278- 0020 or visit us at www.corecls.com.
Author: Matt Rothchild, Sr. Compliance Consultant; Editor: Tina Mitchell, Managing Director, Consultant Services, Core Compliance & Legal Services (“Core Compliance”). Core Compliance works extensively with investment advisers, broker-dealers, investment companies, and private fund managers on regulatory compliance issues.
This article is for information purposes and does not contain or convey legal or tax advice. The information herein should not be relied upon regarding any particular facts or circumstances without first consulting with a lawyer and/or tax professional.
