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Saturday, December 17 2016

Fee Calculations and Fee Calculation Disclosure

Fee calculations are one of the most overlooked compliance issues in the registered investment adviser community. For those who employ a simple fee structure, such as, fees are billed quarterly in arrears based upon the market value of the assets on the last day of the previous quarter, this may not be an issue. Well, as long as that is how you are calculating your fees.

So many times I have conducted a fee calculation verification using the fee disclosure in the ADV and found that the adviser’s calculations are off. I’ll address this with the adviser and inevitably I will find out they are not actually calculating fees in the manner in which it is disclosed in the ADV.

As an example, I will use the fee schedule described previously. When conducting a fee calculation review I will obtain the balance for the calculations from the quarter ending balance from the clients’ custodial statements. Then I will take the review the fee schedule on the ADV and ensure that the agreed upon fee percentage shown on the agreement fits within the schedule in the ADV. If the fee shown on the agreement is higher than the fee schedule disclosed on the ADV there is a problem. At this point a regulatory auditor is going to expand their fee review. If it is determined that a client, or clients, have been over-billed due to the adviser charging a fee higher than what is disclosed in the fee schedule, the adviser is going to face possible sanctions from the regulator, which will probably include a reprimand, a fine and most definitely a restitution order for the excess fees.

If the fee being charged is in line with the fee schedule, I will then take the statement balance and multiply it by the fee percentage and divide by four. If the adviser is waiting until the custodial statements are generated each quarter and taking the balance from the statement our calculations should be identical. If the adviser is logging on to their custodial master account on the last business day of the month and capturing a value, the balance used by the adviser may vary slightly from the statement used by the adviser, but they should be close. As a regulatory auditor I would have no problem with the fees being off by pennies because of this issue.

Let’s use the same fee schedule, but now I finish my audit and all of the fees that I have calculated are substantially different from those of the adviser’s. At this point I will address the issue with the adviser. The most common issue I run into here is because the adviser is pro-rating for deposits and withdrawals in the account during the quarter. This is obviously to the benefit to the client. However, if this is not disclosed in the ADV and agreement, the adviser is effectively in violation because they are not calculating fees according the disclosed fee schedule in the ADV and agreement. A regulatory auditor would in most cases put the adviser on notice of the issue and require them to amend the ADV and agreement to reflect the correct fee schedule.

Another issue might be that the ADV states that fees based upon the market value of the assets on the last day of the previous quarter, but the Adviser is actually using a daily average balance.  Again, in most cases this is a benefit to the client, but not properly disclosed in the ADV. Although both cases are unintentional, minor issues, please be aware that the client should be able to take the ADV, agreement and statements and verify the fees being charged to their account.

With all of this being said it is quite obvious to see how those advisers that employ more sophisticated fee schedules run a greater risk of running into issues with their fee calculations. One example is the adviser that charges a graduated/tiered fee schedule. It is OK to employ a graduated/tiered fee schedule, but it is imperative to ensure that once a client’s account balance reaches the next tier that the correct fee be charged on those assets. Even if it is an honest mistake and a client, or clients, are over-billed, the auditors will take you to task for the over-billing.

So in summary, the most common issues I see with fee calculations is that the adviser is not billing exactly as described in the ADV and agreement. As stated before, even though it may be unintentional, you will be held accountable for any over-billings. And if it is done intentionally, be prepared to find a new career.