Reading Between the Lines – Is Your Advisory Agreement Compliant?

The SEC recently fined two affiliated investment advisers more than $150,000 for
multiple infractions, including the use of “hedge clauses” in their advisory agreements.

While there were numerous versions of the advisory agreement, as they had been
modified over time, the hedge clause language in question all indicated that the adviser
would not be liable to the client “for any act, omission, or determination made in
connections with this Agreement except for [the Adviser’s] willful misconduct or gross
negligence…”

Broadly limiting an adviser’s liability is inconsistent with an adviser’s fiduciary duty
because it may mislead clients into not exercising non-waivable rights. This is
considered a violation of the Advisers Act.

This case is a stark reminder to advisers to assess the terms of their contracts and
ensure they are up to regulatory standards. Even when their advisory agreements have
been drafted by legal professionals, unless that professional practices in the securities
industry, it is possible that requirements were missed or prohibited language was
included.

Below is a list of what must be in your advisory agreements, what must not be in your
advisory agreements, and some best practice suggestions.

• Written Agreements - believe it or not, the Advisers Act does not require
  advisers to have written agreements with their clients. However, there are
  numerous other areas of the advisory relationship that must be in writing, such as
  the client granting discretionary authority to the adviser. Such authority is almost
  always found in the advisory agreement. In addition, state-registrants should
  know that most states DO require written advisory agreements.

• Discretionary Authority – as just mentioned above, advisers who act with
  discretion in the management of client assets must have written authorization
  from the client to do so. This includes written authorization to hire/fire third-party
  managers or sub-advisers, when applicable.

• Proxy Voting Authority – if the adviser will not vote proxies for a client, this
  must be explicitly stated

• Fees – Ensure the agreed-upon fee to be charged to the client is clearly stated in
  the agreement between the adviser and the client, and if the adviser’s fee is
  directly deducted from the client’s account by the custodian, ensure the client
  has authorized this in writing. To the extent relevant, each of the following should
  be addressed:

  • How the fee is calculated and which accounts will be included in the
    calculation

  • The value upon which the advisory fee is based (e.g. value of the account
    at the end of the billing period, average value of the account during the
    billing period, other)

  • When the fee will be charged

  • Whether the fee is assessed in advance or arrears

  • Proration of fees at the beginning and ending of the advisory relationship

  • How refunds will be determined and paid (most common when an
    advisory relationship ends and advisory fees were charged in advance)

  • If the adviser has a tiered fee schedule with breakpoints for reduced fees,
    indicate whether multiple accounts for a client or family may be
    aggregated to reduce fees payable to the adviser

  • Identify the account(s) from which the advisory fee will be deducted

  • State-registered advisers should note that many states require the adviser
    to send invoices to the client if the adviser deducts its fees from the client’s
    account

• Assignment – advisory agreements must explicitly state that the agreement
  cannot be assigned by the adviser without the consent of the client. While the 
  Advisers Act does not require that client consent be in writing, this is usually a
  best practice.

• Acknowledgement of Disclosures – since regulations require the adviser to
  deliver certain disclosure documents (Firm Brochure, Brochure Supplements,
  Form CRS, Privacy Notice) to clients at the time of, or before, entering into an
  advisory relationship with the client, a client’s written acknowledgement of receipt
  of such documents is usually found in the advisory agreement or an exhibit
  thereto.

• Consent to Electronic Delivery – in order for an investment adviser to deliver
  required disclosures to the client via email or some other form of electronic
  delivery, the Advisers Act requires the client to consent to electronic receipt of
  such disclosures. There are specific requirements that must be contained in this
  consent, including, but not limited to, identifying the documents covered by the
  consent as well as permitting the client to rescind the consent at any time.

• Duration – this is especially important for financial planning contracts and other
  agreements that are non-recurring. Clearly identify if the agreement terminates
  with the delivery of the service, or whether the client has the right to receive
  additional services under the contract, and whether a fee will be assessed for
  those services.

• Partnerships – if the adviser is organized as a partnership, the advisory
  agreement must state that the adviser will notify the client of any change in the
  membership of the partnership with a reasonable time after such change.

• Hedge Clause Prohibition – finally, we get to what CANNOT be in an advisory
  contract. As demonstrated from the case cited above, advisers are prohibited
  from broadly limiting their liability. This prohibition applies to SEC-registered
  firms; however, most states have similar restrictions. The state of PA, for
  example, prohibits an investment adviser from indicating “any condition,
  stipulation or provision binding any person to waive compliance with any
  provision” of PA advisory regulations.

In addition to reviewing their advisory agreements, advisers should ensure their
agreements are consistent with their adopted policies and actual business practices to
avoid regulatory scrutiny and mitigate potential compliance risks.