Observations on OCIE’s Risk Alert on Examinations of Investment Advisers: Supervision, Compliance, and Multiple Branch Offices

On November 9, 2020, the U.S. Securities and Exchange Commission (SEC) Office of Compliance Inspections and Examinations (OCIE) issued a risk alert¹ (the Alert) providing an overview of the OCIE staff’s observations from examinations of SEC-registered investment advisers. The Alert focused on advisers that operate multiple branch offices that are geographically dispersed from the advisers’ principal offices (Multibranch Advisers), with a particular emphasis on assessing the compliance and supervisory practices relating to advisory personnel working at such branch offices.

The staff’s observations on Multibranch Advisers’ compliance and supervisory practices with respect to branch office advisory personnel and attendant risks generally are consistent with recurrent areas of SEC and OCIE focus as well as with longstanding SEC and Financial Industry Regulatory Authority Inc. (FINRA) focus on similar issues in the broker-dealer context.² This Alert emphasized, in particular, the need for such advisers to consider the unique risks and challenges posed by operating a geographically dispersed advisory business across numerous branch offices and to design and implement their compliance and supervisory frameworks in a manner reasonably tailored to identify and address such issues. In light of the increased prevalence of advisory personnel working from remote locations during the current pandemic, the Alert may be relevant even to advisers that historically have not considered themselves to have multibranch structures.

This Sidley Update summarizes the Alert’s observations and recommendations and offers practical tips to develop and enhance existing policies and disclosures to address risks associated with operating an advisory business across multiple branch offices, especially where geographically dispersed.

Overview

In the Alert, OCIE addresses two broad areas of focus: (1) the adequacy of compliance programs under Section 206(4) of and Rule 206(4)-7 (Compliance Program Rule) under the Investment Advisers Act of 1940 (Advisers Act), Rule 206(4)-2 (Custody Rule), Rule 204A-1 (Code of Ethics Rule), Rule 206(4)-1 (Advertising Rule), and fiduciary obligations with respect to fees and expenses billing practices, and (2) the supervision of investment advisory activities across all of a Multibranch Adviser’s offices, including with respect to the provision of investment recommendations, the disclosure of conflicts of interest and disciplinary histories of advisory personnel, and trading practices and the allocation of investment opportunities. 

The Alert reminds market participants of OCIE’s careful evaluation of the full breadth of a Multibranch Adviser’s business operations, including both its principal office and branch offices, and of the importance of maintaining a comprehensive and effective compliance program that covers the full range of its and its advisory personnel’s investment advisory activities. We expect that the familiar issues highlighted in the Alert will continue to be areas of focus in future exam inquiries and enforcement actions, especially, though not exclusively, in the context of Multibranch Advisers and, potentially, advisers without branch offices but with personnel working remotely during the ongoing pandemic.

(1) Compliance Programs

Compliance Program Rule

The Advisers Act requires that investment advisers adopt and implement written policies and procedures that are reasonably designed to prevent violation, by the adviser and its supervised persons, of the Advisers Act and all rules and regulations promulgated thereunder. The staff observed that a majority of Multibranch Advisers examined had compliance policies and procedures that were

• inaccurate because they contained outdated information (e.g., references to nonexistent entities; use of former job titles and responsibilities of advisory personnel); 
• inconsistently applied across branch offices; 
• inadequately implemented, including as a result of recordkeeping deficiencies (e.g., failure to provide the compliance department with records required under the adviser’s own policies and procedures); or
• simply not enforced.

Practical Tips/Action Items

• Written compliance policies and procedures should apply equally to all offices and advisory personnel, regardless of the status of an office (principal versus branch) or such personnel (employees versus independent contractors). Multibranch Advisers should consider adopting policies tailored to address aspects unique to individual branch offices, including specific activities performed and clients served.
• Establish clear guidelines and requirements for compliance monitoring and oversight of branch offices, including effective compliance reporting.
• Perform regular compliance testing and periodic reviews of key activities at all branch offices (conducted on site or remotely), and do not rely solely on self-reporting by advisory personnel.
• Compliance trainings should be required for advisory personnel on both an initial and ongoing basis to keep them apprised of current policies and procedures and to highlight targeted areas for improvement based on the results of compliance testing and branch office reviews.

Custody Rule

The custody of client assets and compliance with the requirements of the Custody Rule are a regular area of OCIE focus and a perennial subject of deficiencies identified in OCIE adviser examinations.³ The staff observed noncompliance with the Custody Rule by certain Multibranch Advisers as a result of inadequate policies and procedures that failed to appropriately limit the ability of advisory personnel to process withdrawals and deposits in client accounts and/or to alter clients’ addresses of record.

Practical Tip/Action Item

• Advisers should familiarize themselves with practices and arrangements that could result in custody of client assets (even where inadvertent) and take steps to avoid such status where undesired and to comply with the Custody Rule where applicable.

Code of Ethics Rule

The staff cited several Multibranch Advisers for Code of Ethics Rule deficiencies, including for failure to

1. comply with reporting requirements (e.g., by submitting transactions and holdings reports too infrequently or failing to submit at all)
2. review transactions and holdings reports
3. properly identify access persons

Practical Tip/Action Item

• Compliance trainings covering the adviser’s code of ethics should be conducted for all advisory personnel on both an initial and ongoing basis to educate them of their responsibilities thereunder and keep them informed of updates.

Advertising Rule

The staff observed deficiencies in advertising-related activities and specifically noted deficiencies with respect to materials prepared by branch office advisory personnel and by supervised persons who operate under a name different from the Multibranch Adviser, often referred to as “DBA” or “doing business as” arrangements.

Practical Tip/Action Item

• Centralize the oversight process for advertising-related activities and materials by designating a single office or team to review and approve all marketing materials.

Fees and Expenses

The staff observed that some Multibranch Advisers had inadequate policies and procedures pertaining to fees and expenses billing practices, some had none at all, and others had adequate policies and procedures that they failed to enforce.

Practical Tip/Action Item

• Instituting uniform and centralized processes to manage client fees and expenses billing practices can help standardize decision-making and limit deviations from firm policies, advisory client agreements, and disclosures.

(2) Supervision of Investment Advisory Activities

Oversight of Investment Recommendations

The staff highlighted deficiencies in the oversight of investment recommendations and the failure to disclose related conflicts of interest in the following contexts:

• Mutual Fund Share Class Selection Practices. Some Multibranch Advisers purchased share classes that charged 12b-1 fees rather than share classes of the same mutual fund with lower fees, despite equal availability to the advisory clients and without disclosing the clear conflict of interest owing to the adviser’s incentive to purchase the share classes with higher fees at the expense of such clients.
• Wrap Fee Programs. Some Multibranch Advisers did not adequately assess whether programs were in their clients’ best interests; charged improper commissions; misrepresented, or lacked appropriate disclosures regarding, their wrap fee programs (e.g., regarding applicable fees, trading away practices, and delegating responsibilities); or failed to adequately supervise trading away practices, including with respect to activities of subadvisers—in most cases resulting in additional costs borne by advisory clients. 
• Automated Rebalancing. Certain Multibranch Advisers implemented processes to automatically rebalance their advisory clients’ accounts, resulting in additional fees borne by such accounts, without considering whether such automated processes were in their clients’ best interests.

• Designate one or more individuals to be responsible for monitoring portfolio management activities.
• Adopt uniform portfolio management policies and procedures and portfolio management systems applicable to all office locations and all advisory personnel.

Disclosure of Conflicts of Interest and Disciplinary Events

The staff observed and cited Multibranch Advisers for failures to adequately disclose conflicts of interest and material information regarding the disciplinary history of certain branch office advisory personnel.

Practical Tips/Action Items

• Conduct regular compliance and supervision reviews of practices at branch offices and activities of advisory personnel to promote compliance with firm policies and procedures and with applicable laws.

• Establish and maintain policies and procedures to check for prior disciplinary events when hiring advisory personnel and to periodically confirm the accuracy of related disclosures and update accordingly. Review of advisory personnel’s disciplinary histories should be documented, and appropriate measures should be taken with respect to individuals with relevant disciplinary histories.

Trading Practices; Allocation of Investment Opportunities

The staff observed a number of deficiencies pertaining to certain trading and investment allocation practices of Multibranch Advisers, including these:

1. lack of documentation demonstrating Multibranch Advisers’ analyses regarding obtaining best execution for their clients
2. effectuation of principal transactions involving securities sold from a Multibranch Adviser’s own inventory without obtaining prior client consent
3. inadequate monitoring of trading by advisory personnel, including improper allocation of block trade losses to clients rather than to the advisory personnel

Practical Tip/Action Item

• Trading activities performed at an adviser’s branch offices should be included as part of such adviser’s overall testing practices.

¹ Available at https://www.sec.gov/files/Risk%20Alert%20-%20Multi-Branch%20Risk%20Alert.pdf.

² See, e.g., the following Sidley publications: “Observations on OCIE’s Risk Alert for COVID-19 Compliance Risks and Considerations” (August 24, 2020) (available here); “Observations From Private Fund Adviser Examinations: Practical Tips and Best Practices” (July 7, 2020) (available here); “OCIE Announces Plans to Assess Compliance With Reg BI and Form CRS as Scheduled” (April 8, 2020) (available here); “SEC and FINRA Issue 2020 Examination Priorities for Broker-Dealers and Investment Advisers” (January 17, 2020) (available here); and “Recent Risk Alerts by SEC OCIE Highlight Privacy and Cybersecurity Issues in Examinations” (June 3, 2019).

³See the May 8, 2017, Sidley Update, “SEC Publishes Important Guidance on the Custody Rule, Participating Affiliate Arrangements, Robo-Advisers, Form PF and Certain Compliance Topics,” available at https://www.sidley.com/en/insights/newsupdates/2017/05/sec-publishes-important-guidance-on-the-custody-rule, and the June 28, 2018, Sidley Update, “U.S. Securities and Exchange Commission Issues Two New Frequently Asked Questions About ‘Inadvertent Custody,’ ” available at https://www.sidley.com/en/insights/newsupdates/2018/06/us-securities-and-exchange-commission-issues-two-new-frequently-asked-questions.