We attended the DFI’s 2019/2020 Investment Adviser Seminar in Seattle on February 12. It was a great help to hear from Joanne Jones, Kristen Standifer, and Mark Kissler about rule changes and the types of violations they continue to see during their examination and enforcement processes.
We’re not going to regurgitate the regulations. They’re long and detailed. But we do want you to pay attention to this:
Based on what we heard from the DFI, and our own experience with how confusing some of the changes can be, there is a very strong possibility that you are not in compliance with current DFI regulations concerning at least some aspect of the compliance topics below.
What that means is that you should have a quick call with us to go over these if you have any questions at all about what the requirements are or if you’re meeting them We can help you resolve any issues quickly and effectively.
Topic 1 – Fee Billing/Invoices
A year ago, the DFI made significant changes to what must be included in your invoices. You can read the rule here for advisers who directly deduct fee, or here for advisers who don’t. The requirements are virtually the same, but you might as well read the applicable rule.
What you’re probably not doing is including both “the formula used to calculate the fee,” and “the fee calculation itself.” Here’s what those look like. First, an easy example. If I’m an adviser who charges 1% annually on the first $1 million; .75% on the next $2 million, and .50% on all other assets over $3 million, here’s what I need to show for an account with $750,000 under management on December 31, 2019:
Formula used to calculate the fee:
(Assets up to $1 million)*.01/4 = Quarterly Advisory Fee
Fee calculation itself:
($750,000*.01)/4 = $1,875
Do your invoices include the above information?
Note the fee calculation itself is unique to this client and this invoice.
And here’s a harder example, when the assets under management are $3,500,000.
First the formula used:
[(Assets up to $1M)*.01 ] + [(Assets from $1M to $3M)*.0075] + [(Assets over $3M)*.005]/4 = Quarterly Fee
And now the fee calculation itself:
[($1,000,000*.01) + (2,000,000*.0075) + (500,000*.005)]/4 = $6875
Do your invoices include this kind of information? If not, the DFI says they need to.
Also note that in addition to what’s in the rule, the DFI wants you to include on the invoice the name(s) of the custodian(s) holding the assets and your full legal name (including the “LLC” or “Inc,” etc.)
Topic #2 – Advisory Agreements
Unless you’ve updated your contract in the last 9 months and specifically compared it against DFI requirements, now is the time to ensure compliance with the new DFI rules. You can scope out WAC 460-24A-130 or you can send us a copy of your existing agreement and we’ll go through the issues with you.
Topic #3 – Financial Responsibility & Compliance with Net Worth
Lots of advisers have a bond and think they’ve met the minimum net worth requirements. It often turns out, though, they’re wrong simply because they’re not keeping their books on an accrual basis. If you don’t know what “accrual basis” means or how it applies to your own accounting, just give us a call!
The basics are:
If you have a bond for $5,000 and you take a member distribution at year-end, that leaves your balance sheet showing negative net worth of $7,000, and you’ve violated the DFI rules. The bond will bring you up to negative $2,000 in this example, but that’s not positive net worth.
Beyond the use of the bond, many advisers we talk with do not understand accrual accounting or don’t realize they are required to use it. We’ve heard many advisers (and their bookkeepers or accountants) say, “But I pay my taxes on a cash basis – I don’t keep my books on an accrual basis.” Unfortunately, the regulations mandate accrual accounting. You can still pay your taxes on a cash basis, though, and it’s a relatively simple translation for your accountant.
The fact is, you incur liabilities all the time--you use cable services in February and you don’t get the bill till March. You have a consultant work on your annual updating amendment in March, but you don’t get the bill till April. Accrual accounting requires that you reflect the expense based on when you used or obtained the service—in February for cable, in March for consulting—not based on when you receive the bill or when you pay it.
For advisers who charge fees in advance, this can create a serious issue. You’re required to treat the pre-paid advisory fees as a liability (unearned income) and then amortize that liability (write it off against an expense account) after you’ve earned the fees. If you bill quarterly, you’ll amortize a third of the quarterly fees each month. It’s not a problem UNLESS you pay yourself a big check when the fees come in. You need to change your practice so that you only pay out up to a third of the fees. t’s only recently we’ve seen regulators thinking this was a problem. Given the prevalence of prepaid fees, though, it’s potentially a very big deal, especially for smaller firms
This can be very confusing and we’ve helped many firms work through the practical implications. Don’t hesitate to reach out for help.