By Kelly Bird-Keith, Business Assurance Director
Advisor fees and expenses have recently come under increased scrutiny by the U.S. Securities and Exchange Commission (SEC), and it appears this will continue into the future. Areas of focus by the SEC continue to be advisor fees charged compared to the terms stated in the advisory agreements, the adequacy of disclosures and conflicts of interest, which includes using affiliated (or related-party) service providers and products.
Advisory fees charged by real estate investment firms include costs such as asset management fees, disposition fees, incentive fees, acquisition fees and financing fees. These fee arrangements are usually detailed in an advisor or management agreement and can be complex with many variables and layers to the calculations. Many times these fees are paid to an affiliated (or related-party) entity of the advisory firm and, therefore, come into even further scrutiny as related-party transactions have also recently been a hot topic and examination area by the SEC.
SEC examinations and firms under target
The SEC utilizes the Office of Compliance Inspections and Examination (OCIE) for overseeing and performing examinations of registered investment firms. In 2018, examinations of investment companies, including real estate investment firms, increased by a staggering 45 percent over the prior year, and the OCIE examinations covered 17 percent of all registered investment advisors. Due to the inherent risks around advisor fees and conflicts of interest, most OCIE examinations include the review of advisor fee and expense compliance.
The OCIE is honing in on firms with certain policies and practices that make them at greater risk for improper fee and expense disclosures. The OCIE generally focuses on firms that have never been examined as well as those that have been examined in the past but have recently grown or have significantly changed their organization’s strategy or policies.
6 Most common advisor fee examination deficiencies
Here are examples of the most prevalent issues discovered during an examination:
#1: Incorrect valuing of accounts or assets used in the fee calculation
Certain advisor fees are charged based on a percentage of the value of the accounts, assets or net assets being managed by the firm. If the value used is incorrect, the amount charged to the investor is also incorrect. Examples of these deficiencies include using the asset’s cost instead of the fair value as stipulated by the advisory agreement, including or excluding assets or liabilities from the calculation, which is not in accordance with the advisory agreement, and using the asset value at the end of the period versus an average of the value during the period as stipulated by the agreement.
#2: Incorrect timing and frequency of billing practices
An example of this is the advisor billing the investor too frequently by billing monthly when the advisory agreement states that the fee should be billed quarterly or annually.
#3: Incorrectly applying the rate
Example: The incorrect fee rate or percentage from the advisor agreement was charged to the investor or billed multiple times.
#4: Incorrectly applying discounts or rebates
For example, not reducing the fee rate when a certain threshold or breakpoint had been achieved as well as double counting fees that were already charged and included in a bundled fee.
#5: Issues involving disclosures
An example of this is disclosing practices or policies that were not consistent with the advisor agreement or omitting disclosures around certain additional fees and compensation that were in addition to the advisor fees.
#6: Misallocation of expenses
Example: Allocating travel, marketing and administrative fees to the investor instead of the advisor.
What you can do to comply and pass the exam
Here are five things you can do to ensure compliance and consequently pass the exam:
#1: Have a 3rd party perform agreed-upon procedures around the agreements, fees, expenses and the disclosures, including related-party transactions.
Since the investment firm deals with these fees, calculations and agreements regularly, a 3rd party can provide a fresh perspective by reading these agreements cold and interpreting them as the SEC would. The fees and expenses would be recalculated by the 3rd party based on their interpretation of the agreements to ensure they are accurately calculated and recorded. The underlying value of the account or assets used in the calculations would also be tested for accuracy. In addition, the disclosures, including related-party transactions, would be reviewed in detail to ensure all requirements are met and the transactions are transparent. Having agreed-upon procedures performed will proactively get the real estate investment firm in excellent shape to head off any questions or findings by the SEC and help to ensure compliance.
#2: Revise any advisor, operating and management agreements that are not clear or are not consistent with the current fees being charged to the investor.
The agreements should define all terms and inputs used in the calculations in a detailed, clear and concise manner that is not subject to interpretation. The upfront commitment it will take to revise these agreements should outweigh the hassles that will come from an SEC examination of agreements that are subjective, incorrect or missing definitions and terms.
#3: Ensure there are written policies and procedures, internal controls and periodic internal testing and checks.
There should be detailed written policies and procedures around the calculation and approval of any investment and advisor fees. In addition, internal controls should be in place to safeguard against the override of these policies and procedures. The real estate investment firm should also periodically perform internal testing and checks around these fees, expenses and disclosures.
#4: Review the agreements and fees for affiliated and related-party transactions and ensure disclosures are detailed and appropriately segregated.
The real estate investment firm should provide full transparency with respect to agreements and transactions where an affiliated entity provides services or is involved in an investment transaction. The concept of materiality does not apply to these disclosures. It is a requirement for the following to be disclosed for all related-party transactions:
- The nature of the relationship
- A description of the transaction (even if there are no amounts attributed)
- The dollar amount of the transaction
- Amounts due to or from related parties
The best practice is to disclose these advisor fees segregated by type (e.g., asset management, incentive, disposition, development) versus aggregated together. The significant terms of the agreement and fees should also be disclosed for each type of fee.
#5: Proactively reimburse any fees or expenses to investors found to be overcharged during any internal or external testing.
This will help accurately manage fees going forward and show good faith if selected for an examination.
The bottom line
The SEC is going to continue to focus and crackdown on both advisor fees and related-party disclosures. An ounce of prevention through a preemptive review by a qualified firm is well worth the investment when compared to the headache that deficiencies resulting from an SEC examination will create.
Kelly Bird-Keith, CPA, is a Director in Moore Colson’s Business Assurance Practice. Kelly specializes in the firm’s Real Estate Practice which includes fund level and property level audits of office buildings, multifamily housing, hotels and retail properties.
Steve LaMontagne, CPA, is a Partner at Moore Colson and leads the firm’s Real Estate Practice. Steve has extensive experience in all sectors of the real estate, including fund managers and advisors, registered investment advisors (RIAs), REITs, developers, institutional investment vehicles, operating properties, and syndication of private and public partnerships.