Common Mistakes Investment Advisers Make with Client Agreements

June 13, 2013

Although the Investment Advisers Act of 1940 (“Investment Advisers Act”) does not explicitly require investment advisory contracts to be written, Section 205 of the Investment Advisers Act requires all advisory contracts to include certain provisions and prohibits investment advisory contracts from including other provisions.  Most state securities regulations require written agreements between the investment adviser and each client.  Regardless of whether a written contract is required by the investment adviser’s primary regulator, the use of a written agreement with each client is generally considered best practice and in the best interest of the investment adviser and the investment advisory client.  A properly drafted investment advisory agreement can help limit an investment adviser’s professional liability. During an investment adviser examination, the U.S. Securities and Exchange Commission (“SEC”) or state securities regulator will likely review an investment adviser’s written client contracts and the following are some of the common deficiencies that an investment adviser may encounter:

  • Outdated Advisory Agreements: If an investment adviser’s business model changes, the investment adviser must ensure that any clients affected by the change enter into new advisory agreements or an addendum to the advisory agreement. Regulatory changes may also require an investment adviser to update or change the terms of the advisory agreements in place. Additionally, changes made on an investment adviser’s Form ADV may result in the need for an investment adviser to revise its investment advisory agreements. Investment advisers should periodically review advisory client agreements, especially if updates are made to the investment adviser’s other regulatory documents, to ensure that advisory agreements are current, accurate, compliant with regulatory requirements, and consistent with the investment adviser’s practices and fee structures disclosed in other advisory documents.  Investment advisers should maintain copies of all advisory agreements currently used and agreements previously used in order to comply with the investment adviser’s books and records requirements.

    In 2011 the North American Securities Administrators Association(“NASAA”) issued the 2011 Coordinated Investment Adviser Exams report identifying common deficiencies among state regulated investment advisers.  The leading unethical business practice deficiencies involved investment advisory client contracts.  The report indicated 371 of 504 unethical business practice deficiencies were related to advisory contracts. The highest percentage of contractual issues included “conflict with ADV” and contracts found to be “not updated.” 40.7% of the contractual deficiencies resulted from lack of updated information. In the report’s best practices for investment advisers, NASAA includes reviewing and updating all contracts.

  • Inconsistent Fee Schedules: Investment advisory agreements should address fee schedules, how fees are charged (e.g., whether fees are charged advance or arrears, how often fees are paid, whether fees are negotiable, whether fees are withdrawn from the clients account or billed directly) and other compensation factors. This information must be consistent with the terms outlined in an investment  adviser’s Form ADV. Investment advisers should carefully review their Form ADV disclosures to ensure there is accuracy and consistency across documents.

    Information posted on the Texas State Securities Board website indicates that one of the most common errors seen in investment adviser applications is inconsistencies between Form ADV Part 1, ADV Part 2, and the investment advisory agreement. The Texas State Securities Board advocates that in efforts to avoid these common deficiencies the investment adviser must compare information disclosed in Form ADV Part 1 and Part 2 for consistency with the information disclosed in the advisory contract. An investment adviser’s fee schedule must match the fee schedule discussed in ADV Part 2 and the compensation method(s) described in the contract must match what was described in Item 5 of ADV Part 2.A and the form(s) of compensation marked in Item 5.E. of Part 1.

  • Failure to properly clarify authorities: The investment advisory agreement should clearly define what level of authority, if any, the investment advisor will have in relation to the client’s assets in any accounts managed or supervised by the investment adviser (e.g., trading authorization, discretionary authority, proxy voting).

It is in the investment adviser’s best interest to have a written agreement in place with each client that clearly defines the terms of the relationship between the investment adviser and the client.  An investment adviser must keep its written agreement(s) current and accurate and ensure that there is consistency between the advisory agreements and the investment adviser’s other advisory documents.  Investment advisers should maintain copies of all written client agreements as part of the investment adviser’s books and records requirements.

RIA Compliance Consultants recently sponsored a webinar, “Key Elements that Should Be Included in an Investment Advisor Contract,” that was presented by our affiliated law firm Bryan Hill Law.  (RIA Compliance Consultants is not a law firm.) If you were unable to attend this webinar but would like to view a recording  click here to purchase.

Posted by Bryan Hill
Labels: Client Contracts, Compliance Training, Webinar