Advisory Agreement Requirements & Best Practices

Part 1: Statutory Requirements

As unbelievable as it may be, the Investment Advisers Act of 1940 and the rules thereunder don’t require client advisory agreements to be in writing.

Seriously.

Technically speaking, an oral understanding that is never memorialized to a written instrument may be deemed a valid means by which a client can retain an SEC-registered investment adviser to render advice and other services in exchange for compensation. My son’s T-ball league requires that I sign a written agreement waiving every conceivable right I have (and some I didn’t know I had) before he even steps out onto the diamond, yet the fiduciary act of managing someone’s life savings is not deemed statutorily worthy of the same written memorialization.

I cannot emphasize the following enough, though: I do not advocate or endorse oral agreements in lieu of written agreements. This is partially due to my personal marital experience of never remembering what I agreed to do with or for my wife during casual conversations (don’t worry, she remembers everything), but also because it invites revisionist history of what was actually agreed to between client and adviser, and a resultant battle of he-said, she-said, that never ends well.

In addition, from a practical perspective, professional malpractice insurance carriers, custodians, potential succession partners, and most clients would likely shy away from an adviser that isn’t prepared to sign on the dotted line. It also should be noted that most, if not all, state securities regulators require that client advisory agreements be in writing, so state-registered advisers can simply ignore everything written above.

Whether oral or written, though, Section 205 of the Advisers Act imposes specific requirements and restrictions upon client advisory agreements, most of which are dedicated to the logistics of charging performance fees. Still, in order to comply with Section 205, there are many contractual best practices and drafting techniques that advisers (even those not charging performance fees) can use in the course of updating or replacing their existing advisory agreement(s).

Importantly, state securities regulators often impose different or additional requirements and restrictions with respect to advisory agreements used with their respective state’s constituents. Any state-registered adviser that has the misfortune of enduring multiple different state registrations has likely experienced this first-hand during the registration approval process. While each state’s whims will not be reviewed in this article, sections in which state rules and regulations will likely vary will be flagged.

Lastly, the contractual best practices and drafting techniques offered here are topics squarely within an attorney’s bailiwick. While they are meant to help advisers better understand and comply with advisory agreement requirements, they should not be construed as legal advice.

Section 205 Of The Advisers Act On Investment Advisory Agreements

Relative to the Advisers Act as a whole, Section 205 is fairly short and is the sole section dedicated to “investment advisory contracts”. It focuses on essentially three items:

charging performance-based fees;
client consent to the assignment of the agreement; and
partnership change notifications.

Section 205(f) is also the section of the Advisers Act that reserves the SEC’s authority to restrict an adviser’s use of mandatory pre-dispute arbitration clauses (i.e., that require clients to agree to settle disputes through arbitration before any disputes even arise) – an authority that has yet to be exercised.

CHARGING PERFORMANCE-BASED FEES

The primary takeaway from Section 205 regarding performance-based fees is that an advisory agreement cannot include a performance-based fee schedule unless the client signing the agreement is a “qualified client”, as such term is defined in Rule 205-3(d)(1).

A qualified client includes a natural person or company that:

Has at least $1.1 million under the management of the adviser immediately after entering into the advisory agreement;
Has a net worth of at least $2.2 million immediately prior to entering into the advisory agreement; or
Is a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the client enters into the advisory agreement.

Qualified clients also include executive officers, directors, trustees, general partners, or those serving in a similar capacity to the adviser, as well as certain employees of the adviser.

Notably, the Dodd-Frank Act requires the SEC to adjust the dollar amount thresholds in the rules set forth by Section 205 every 5 years. The SEC’s most recent inflationary adjustment to these dollar thresholds was released in June 2021.

For a more fulsome explanation of the restrictions imposed on advisers that charge fees “on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client” (i.e., performance-based fees), refer to this article and the rulemaking history described therein.

The dollar thresholds triggering “qualified client” status may differ in certain states, as the automatic inflationary adjustments made by the SEC do not automatically apply to the states. In other words, state securities rules may include a different definition of what constitutes a qualified client, and/or still be using ‘prior’ thresholds not in line with more recent SEC adjustments. This poses a potentially awkward scenario in that a particular client may be charged a performance fee while an adviser is state registered, but not if the adviser later transitions to SEC registration.

Section 205(a)(2) prohibits advisers from entering into an investment advisory agreement with a client that “fails to provide, in substance, that no assignment of such contract shall be made by the investment adviser without the consent of the other party to the contract.” In other words, an advisory agreement must, without exception, afford the client the opportunity to consent to his or her advisory agreement being “assigned” to another adviser.

An “assignment” of an agreement occurs when one party transfers its rights and obligations under the agreement to a third party not previously a signatory to the agreement. The new third-party assignee essentially stands in the shoes of the assigning party to the agreement going forward, and the assigning party is no longer considered a party to the agreement. In the context of an adviser-client relationship, an adviser that assigns its rights and obligations to another adviser is no longer the client’s adviser… such that Section 205(a)(2) requires the client to acquiesce to such a change.

Notably, an assignment to a new “adviser” in this context is in reference to the investment adviser (as a firm), not necessarily to a new investment adviser representative within the firm. Still, though, Section 202(a)(1) broadly defines an assignment to include “any direct or indirect transfer or hypothecation of an investment advisory contract by the assignor or of a controlling block of the assignor’s outstanding voting securities by a security holder of the assignor […]”. There are a few more sentences specific to partnerships in the definition, but the general concept of the “assignment” definition is that there are essentially two situations in which an assignment is deemed to have occurred:

When advisory agreements are transferred to another adviser or pledged as collateral; or
The equity ownership structure of an adviser changes such that a “controlling block” of the adviser’s outstanding voting securities changes hands.

Both scenarios described above would trigger the need for client consent.

Transferring Advisory Agreements To Another Adviser

A transfer of an advisory agreement from one adviser to another most commonly arises in the context of a sale, merger, or acquisition of one adviser by another (which is also often the case upon the execution of a succession plan).

If Adviser X (the ‘buyer’) is to purchase substantially all of the assets of Adviser Y (the ‘seller’) – including the contractual right to become the investment adviser to the seller’s clients going forward – the seller’s clients must either sign a new advisory agreement with the buyer, or otherwise consent (either affirmatively or passively) to the assignment of their existing advisory agreement with the seller to the buyer.

Controlling Block Of Outstanding Voting Securities

With respect to the second scenario contemplated by the Section 202(a)(1) definition of assignment, the logical next question is: what constitutes a “controlling block?” Unfortunately, the Advisers Act does not define what a “controlling block” is, but based on various sources, including the Adviser Act itself, Form ADV, SEC rulings and no-action letters, and the Investment Company Act of 1940 (a law applicable to mutual funds and separate from the Investment Advisers Act of 1940), we can reasonably conclude that such control is having at least 25% ownership or otherwise being able to control management of the company.

Thus, the logistics of client consent to assignment need to be considered both in adviser sale/merger/acquisition scenarios and in adviser change-of-control scenarios. To come full circle, the existing advisory agreement signed by the client must provide that the adviser can’t assign the advisory agreement without the consent of the client.

Importantly, Section 205(a)(2) does not contain the word “written” before the word “consent,” and does not define what constitutes consent. Must the client affirmatively take some sort of action to provide consent to an assignment, or is the client’s failure to object to an assignment within a reasonable period of time sufficient?

If the existing advisory agreement does require the client’s written consent to an assignment, the assignment cannot occur until the client physically signs something granting his or her approval (i.e., “positive” consent). If the existing advisory agreement does not require written consent, an assignment may automatically occur if the client fails to object within the stated period of time after being notified (i.e., “negative” or “passive” consent). If the existing advisory agreement does not address the assignment consent issue, though, it does not meet the requirements of the Advisers Act.

The important takeaway for SEC-registered advisers, however, is that negative/passive consent is generally permissible in the context of an assignment, so long as the advisory agreement is drafted appropriately. The SEC affirmed this view through a series of no-action letters from the 1980s, which were later reaffirmed in further no-action letters from the 1990s (see, e.g., American Century Co., Inc. / J.P. Morgan and Co. (Dec. 23, 1997).

Many states prohibit negative/passive consent assignment clauses and require clients to affirmatively consent to any assignment. Texas Board Rule 116.12(c), for example, states that “The advisory contract must contain a provision that prohibits the assignment of the contract by the adviser without the written consent of the client.”

Negative/passive ‘consent to assignment’ clauses should afford the client a reasonable amount of time to object after receiving written notice of the assignment (which ideally would be delivered at least 30 days in advance of the planned assignment). The clause should also make it clear to the client that a failure to object to an assignment within X number of days will be treated as de facto consent to the assignment.

PARTNERSHIP CHANGE NOTIFICATIONS

The third Section 205 provision with respect to advisory agreements is specific to advisers organized as partnerships and simply requires that advisory agreements contain a clause requiring the adviser to notify the client of any change in the membership of such partnership “within a reasonable time after such change.”

Disclosing Services And Fees In Advisory Agreements

With an understanding of the requirements set forth by Section 205 of the Investment Advisers Act, advisers can now supplement those requirements with additional best practices and techniques when creating or reviewing advisory agreements. Two key considerations include providing a good description of the firm’s services and fees. (Established advisory firms may wish to pull out a copy of their own advisory agreement and read through the sections of their own agreement as they explore the sections discussed below.)

DESCRIBING THE FIRM’S SERVICES

The first keystone component of an advisory agreement (or any agreement) is a complete and accurate description of the services to be provided by the adviser in exchange for the fee paid by the client. The exact nature of services will naturally vary on an adviser-by-adviser basis, but good advisory agreements should account for at least the following services:

If rendering asset management services:

For discretionary management services, include a specific limited power of attorney granting the adviser the discretionary authority to buy, sell, or otherwise transact in securities or other investment products in one or more of the client’s designated account(s) without necessarily consulting the client in advance or seeking the client’s pre-approval for each transaction. For non-discretionary management services, state that the adviser must obtain the client’s pre-approval before affecting any transactions in the client’s account(s).

Clarify whether the adviser’s discretionary authority extends to the retention and termination of third-party advisers or subadvisers on behalf of the client.

Consider provisions that discourage or restrict the client’s unilateral self-direction of transactions if they will interfere or contradict with the implementation of the adviser’s strategy (e.g., that the client shall refrain from executing any transactions or otherwise self-directing any accounts designated to be under the management of the adviser due to the conflicts that may arise).

Consider identifying the account(s) subject to the adviser’s management by owner, title, and account number (if available) in a table or exhibit, noting that the client may later add or remove accounts subject to the adviser’s management so long as such additions and removals are made in writing (or pursuant to a separate custodial LPOA form). This is particularly important if some accounts are to be managed on a discretionary basis and others are to be managed on a non-discretionary basis (or if some of the client’s accounts will be unmanaged).

Identify any client-imposed restrictions that the adviser has agreed to (e.g., not investing in certain companies or industries).

If rendering financial planning services:

Describe whether the rendering of financial planning services is for a fixed/limited duration (e.g., if the adviser is simply engaged to prepare a one-time financial plan, after which the agreement will terminate) or whether the financial planning relationship will continue indefinitely until terminated. For ongoing financial planning service engagements, either describe what financial planning services will be rendered on an ongoing basis or consider preparing a separate financial planning services calendar. Advisers can either limit financial planning topics to an identifiable list (if the adviser and/or client want to be very prescriptive in the scope of the relationship) or generally describe that the adviser will render advice with respect to financial planning topics as the client may direct from time to time (if the adviser and/or client want to keep the scope of potential financial planning topics open-ended).

Clarify that the adviser is not responsible for the actual implementation of the adviser’s financial planning recommendations and that the client may independently elect to act or not act on the adviser’s recommendations at their sole and absolute discretion. Even though the adviser may assume responsibility for discretionary management of a client’s investment portfolio, the client remains ultimately responsible for actually implementing any separate financial planning recommendations that the adviser cannot implement on behalf of the client.

Just as important as a description of the services to be provided by the adviser is a description of the services not to be provided by the adviser. While it is impossible to identify by exclusion everything the adviser won’t be doing, it is best practice to clarify that the adviser is not responsible for the following activities if not separately agreed to:

Rendering legal, accounting, or tax advice (unless the adviser is also a CPA, EA, or has otherwise specifically agreed to render accounting and/or tax advice).

Advising on or voting proxies for securities owned by the client (unless the adviser has adopted proxy voting policies and procedures and will vote such proxies on the client’s behalf).

Advising on or making elections related to legal proceedings, such as class actions, in which the client may be eligible to participate.

To the extent that the client is a retirement plan (such as a 401(k) plan), it will be important to distinguish what plan-specific services will be provided and whether the adviser is acting as a non-discretionary investment adviser (under Section 3(21)(A)(ii) of ERISA) or a discretionary investment manager (under Section 3(38) of ERISA), and what specific plan and/or participant related services are being provided by the adviser.

The nuances of ERISA-specific plan agreements are beyond the scope of this article, but suffice to say that plan agreements should generally be relegated to a separate agreement and should not be combined with a natural-person business owner’s standard advisory agreement, as discussed above.

ADVISORY FEES

The second keystone component of an advisory agreement, and the one most likely to be scrutinized by SEC exam staff, is the description of the adviser’s fees to be charged to the client. Advisory fees have justifiably received a lot of regulatory attention recently, and advisers should consider reviewing the November 2021 SEC Risk Alert which describes how advisers continue to drop the ball in this respect, from miscalculating fees to failing to include accurate (or sometimes any) disclosures, to lapses in fee-billing policies and procedures and reporting.

At a minimum, an advisory agreement should describe the following with respect to an adviser’s fees:

The exact fee amount itself (e.g., an asset-based fee equal to X%, a flat fee equal to $X, and/or an hourly rate equal to $X per hour).
The frequency with which the fee is charged to the client (e.g., quarterly or monthly).
Whether the fee is charged in advance or in arrears of the applicable billing period (e.g., monthly in advance or quarterly in arrears).
How the fee will be prorated for partial billing periods, both upon the inception and termination of the advisory relationship.
How the fee will be payable by the client (e.g., via automatic deduction from the client’s investment account(s) upon the adviser’s instruction to the qualified custodian, or via check, ACH, credit card, etc., upon presentation of an invoice to the client).
If all fees are to be charged to a specific account and not prorated across all accounts under the adviser’s management, the identity of the account(s) that are the ‘bill to’ accounts. Fees can only be payable from a qualified account(s) specifically for services rendered to such qualified account(s) (e.g., fees associated with a client’s taxable brokerage account should not be payable by the client’s IRA).

Asset-Based Fees

Specifically, with respect to asset-based fees, advisory agreements should include the following:

Whether fees apply to all client assets designated to be under the adviser’s management and whether the client will be entitled to specific asset breakpoints above which the fee will (typically) decrease.
For multi-tiered asset-based fee schedules, whether the asset breakpoints are applied on a ‘cliff’ basis or a ‘blended’ (also referred to as ‘tiered’) basis.
- If the fee starts at 1.00% per annum but then decreases to 0.70% per annum if the client maintains a threshold amount of assets under the adviser’s management, clarify whether the 0.70% fee amount applies to all client assets back to dollar zero (i.e., a cliff schedule), or only to the band of assets above a certain threshold, with assets below that certain threshold charged at 1.00% (i.e., a blended or tiered schedule).
Whether fees are calculated upon assets measured at a single point in time (such as the last business day of the calendar quarter) or calculated upon assets averaged over a specific period of time (such as the average daily balance during the prior calendar quarter).
- If fees are calculated upon assets measured at a single point in time, identify whether fees will be prorated at all for any intra-billing period deposits or withdrawals made by the client.

For example, if fees are payable quarterly in advance based on the value of the client’s assets under the adviser’s management as of the last business day in the prior calendar quarter, will the client be issued any prorated fee refund if the client withdraws the vast majority of his or her assets on the first day of the new quarter? In other words, if the billable account value is $1 million on day one of the billing period but the client immediately withdraws $900,000 on day two of the billing period (such that the adviser is only managing $100,000, not $1 million, during 99% of the billing period), is the client afforded any prorated refund?

Conversely, if fees are payable quarterly in arrears based on the value of the client’s assets under the adviser’s management as of the last business day of the quarter, will the client be charged any prorated fee if the client withdraws the vast majority of his or her assets on the day before the adviser bills? In other words, if the adviser manages $1 million of client assets for 99% of the billing period but the client withdraws $900,000 on the last day before the billable value calculation date (such that the billable value is only $100,000 and not $1 million), is the adviser afforded any prorated fee?

Charging asset-based fees calculated from an average daily balance in arrears can help to avoid either of the potentially awkward scenarios described above and the need/desire to calculate prorated refunds or fees.
Whether cash and/or outstanding margin balances are included in the assets upon which the fee calculation is applied.

Flat Or Subscription Fees

To the extent an adviser charges for investment management services on a flat-fee basis, be aware that both certain states and the SEC may consider the asset-based fee equivalent of the actual flat fee being charged for purposes of determining whether the fee is reasonable or not.

For example, if an adviser manages a client’s $50,000 account and charges an annual flat fee of $5,000 for a combination of financial planning and investment management, a regulator may take the position that the adviser is charging the equivalent of a 10% per annum asset-based fee, which, if viewed in isolation, is well beyond what is informally considered to be unreasonable (generally, an asset-based fee in excess of 2% per annum).

Setting aside the dubious reasoning underlying the citation of advisory fee practices from nearly a half-century prior, one potential way to combat such logic is to charge separate flat fees purely for investment management (with the asset-based equivalent remaining under 2% of a client’s assets under management), and separate flat fees for financial planning (while adhering to a financial planning service calendar).

Fees Involving Third-Party Advisers Or Subadvisers

To the extent the adviser may retain a third-party adviser or subadviser to manage all or a portion of a client’s assets, and the client will not separately sign an agreement directly with such third-party adviser or subadviser that discloses the additional fees to be charged to the client, it is prudent to include such third-party adviser or subadviser’s fees in the adviser’s agreement.

Advisory agreements should also generally describe the other fees the client is likely to incur from third parties in the course of the advisory relationship (e.g., product fees and expenses like internal expense ratios, brokerage commissions, or transaction charges for non-wrap program clients, custodial/platform fees, etc.).

Several states take a rather ‘creative’ position with respect to what constitutes an ‘unreasonable’ fee and may either explicitly or implicitly prohibit certain types of fee arrangements, especially with respect to flat or hourly fees for financial planning. At least two states have even been known to cap the hourly rate an adviser may charge.

Many states require that advisers present clients with an itemized invoice or statement at the same time they send fee deduction instructions to the qualified custodian. Such itemization, to use California as an example, is expected to include the formula used to calculate the fee, the value of the assets under management on which the fee is based, and the time period covered by the fee.

Ultimately, the foundation of a good advisory agreement consists of many components, including a complete and accurate description of the firm’s services and advisory fees. While these are only two essential components, there are also many other equally important elements to include and best practices to follow that should be accounted for in any advisory agreement, which will be addressed in Part 2 of this article.

* * * * *

Part 2: Drafting Best Practices

Welcome to the ‘back nine’ of our 2-part discussion addressing the ins and outs of advisory agreement requirements and best practices. Readers who stayed on course during Part 1 of this article will have a firm grip on the statutory foundation laid by Section 205 of the Advisers Act as well as the core elements to be contained in an advisory agreement’s description of services and fees. Readers who instead only took a swing or two before directing their carts to the clubhouse bar are highly encouraged to go back to the tee box and wade through the front nine of Part 1 before making the transition to this one. If you’re not familiar with golf colloquialisms, I promise not to take any more shots at the pin for the rest of this article.

Before diving into some of the key points and best practices concerning advisory agreement requirements, there are two important reminders to bear in mind:

First, state securities regulators often impose different or additional requirements and restrictions with respect to advisory agreements used with their state’s constituents. Any state-registered adviser that has the misfortune of enduring multiple different state registrations has likely experienced this first-hand during the registration approval process. This article should certainly not be construed as encompassing each state’s whims in this regard, but I will endeavor to flag sections in which state rules and regulations will likely vary.

Second, even though this discussion offers contractual best practices and drafting techniques, these are topics squarely within an attorney’s bailiwick and should not be construed as legal advice.

Advisory Agreement Basics

While understanding the requirements set forth by Section 205 of the Investment Advisers Act along with the guidelines around describing the firm’s fees and services is important for understanding how to develop a well-crafted advisory agreement, there are additional factors for advisers to consider when creating or reviewing their firms’ advisory agreements as discussed below. (Established advisory firms may wish to pull out a copy of their own advisory agreement and read through the sections of their own agreement as they explore the sections discussed below.)

IDENTIFY THE CLIENT

This may seem obvious, but it is crucial to specifically identify who the client is. Are they a single natural person? A joint agreement between two spouses? A separate business organization like a corporation or a limited liability company? A retirement plan?

If there are to be multiple natural person clients (such as joint account holders, spouses, or domestic partners), consider adding language that clarifies that the adviser will be rendering advice and/or managing accounts based on the joint and collective goals of such multiple individuals.

Also, consider describing whether the adviser can act on account-related instructions provided by just one of the joint clients or if both joint clients must jointly instruct the adviser. As a fiduciary, an adviser cannot favor one joint client to the detriment of the other joint client, so this language can be particularly helpful in the event that joint clients later separate or divorce or otherwise become adversarial.

To the extent that a retirement plan itself is the client (such as a multi-participant 401(k) plan), the advisory relationship should not be swept under the same advisory agreement that the adviser has utilized for the natural person owner(s) of the business sponsoring such retirement plan. In other words, a retirement plan should not be a joint client of a natural person and should be recognized as a distinct legal organization separate and apart from its natural person owners (even if the adviser is working with both the business owner as a client and their employer retirement plan).

In addition, the specific legal and fiduciary nuances inherent in the Employee Retirement Income Security Act of 1974 (ERISA) would necessitate untenable gerrymandering in the advisory-agreement-drafting process as to when ERISA would and would not apply. In short, advisers should relegate multi-participant ERISA plan relationships to a separate, ERISA-specific advisory agreement.

IDENTIFY THE EFFECTIVE DATE

The effective date of an agreement is the date that the agreement first becomes legally binding on its parties. In the context of an advisory agreement, the effective date generally reflects the official inception of the advisory relationship, the date from which fees can be calculated, and the date that a prospect converts to a client.

The effective date can either be hard-coded (i.e., write the actual date in the opening paragraph of the agreement itself) or be referred to as the date the advisory agreement is signed by the adviser (assuming the client signs the agreement first and the adviser’s final signature is the last in the sequence that consummates the contract).

Adviser And Client Disclosure Responsibilities Alongside Advisory Agreements

DISCLOSURE DOCUMENT DELIVERY

All advisers (hopefully) know that they are required to deliver their Form ADV Part 2A, Form ADV Part 2B, Privacy Notice, and Form CRS (to retail investors) before or at the time the adviser enters into an advisory agreement with that client. While it is important to maintain a record that demonstrates when such disclosure documents have been delivered to clients, the advisory agreement itself should also contain a short representation or acknowledgment by the client that the client has received all such disclosure documents in a timely manner.

Specifically, requiring the client to initial and date such acknowledgment of receipt may be beneficial in situations where such disclosure documents are hand-delivered or when there is no other record to prove that documents were actually delivered. Using a modern digital signature service (e.g., HelloSign) can be an alternative option to asking clients to initial and date acknowledgment of receipt of disclosure documents, as they will generally provide a time-stamped audit trail to prove document receipt.

However, bear in mind that the advisory agreement should also explicitly include the client’s consent to electronic delivery of disclosure documents, as such electronic delivery consent is still technically required under hilariously old SEC guidance dating back to 1996. Similarly, it’s not a bad idea to include a section that specifically authorizes the use of electronic signature services and the permissibility of a digital signature in lieu of an actual ‘wet’ signature.

CLIENT RESPONSIBILITIES

An advisory relationship is a two-way street, and the adviser’s advice is often wholly contingent upon the client’s full and fair disclosure of various documents and information upon which the adviser will rely. The advisory agreement should therefore set clear expectations for and require certain representations from the client. For example, such expectations and representations could include the following:

Providing the adviser with complete, current, and accurate information in a timely manner, with the understanding that the adviser will be relying on such information without independent verification.
Reviewing the adviser’s disclosure documents provided by the adviser, the qualified custodian, and applicable product sponsors.
Informing the adviser in a timely manner of any changes to the client’s financial situation that may affect the advice that the adviser renders or the way in which the adviser manages the client’s account(s).
Informing the adviser of any restrictions to be imposed with respect to the securities or other investment products to be held in the client’s account(s) (e.g., not investing in certain industries, securities, countries, etc.).

The bottom line here is that investment advice is not rendered in a vacuum, and it should be incumbent on the client to provide the adviser with the information it needs to act in the client’s best interest.

FINANCIAL EXPLOITATION REPORTING

Notwithstanding the fact that financial exploitation reporting requirements can vary from state to state (some states require advisers to report reasonably-suspected financial exploitation of certain vulnerable adults, e.g.), advisers should consider including a contractual provision that expressly permits the adviser to report any incidences of such reasonably-suspected financial exploitation for the client’s benefit (for example, to a state securities regulator and/or state adult protective services agency). Such a provision can also grant the adviser the authority to temporarily delay disbursements from the client’s account(s) if such disbursements are reasonably believed to be in furtherance of such financial exploitation. Again, state law will vary on this particular nuance.

To take the protection of potentially vulnerable clients one step further, an adviser might also consider adding an optional “Trusted Contact Form” to the end of its advisory agreement that lists a confidant or advocate that the adviser is authorized to communicate with about the client in the event the adviser has concerns about financial exploitation, diminished capacity, or other erratic financial behavior.

DISCLOSURE OF RISKS

Though an adviser need not cut and paste the risk disclosures from Item 8 of its Form ADV Part 2A (which requires advisers to provide a narrative description of their Methods of Analysis, Investment Strategies, and Risk of Loss) into its advisory agreement, there should be at least some disclosure that all investment and financial planning recommendations involve risks that the client should be prepared to bear, and that the adviser cannot and does not guarantee any future performance.

This can also be a place for the adviser to disclaim the risks associated with a client self-directing trades in their account(s), as such rogue trading can conflict with the adviser’s investment approach or otherwise jeopardize the adviser’s ability to achieve the asset allocation, risk profile, or other portfolio objectives.

When Things Go Wrong – Preventing, Mitigating, And Managing Adviser Liability

LIMITATION OF LIABILITY

While it should be fairly noncontroversial for an adviser to contractually limit its liability for the acts of certain third parties (e.g., a custodial broker-dealer’s trade error) and the client’s own actions (e.g., the client’s self-directed trading), the extent to which an adviser can limit liability for its own actions (via what’s known as a ‘hedge clause’) has recently started to garner more SEC attention.

A hedge clause is a contractual provision that purports to limit one party’s potential liability to the other party. Historically, liability limitation provisions have commonly been included as part of advisers’ standard advisory agreements (typically in a section entitled “Limitation of Liability” or something along those lines). For example, an adviser’s existing advisory agreement may contain language purporting to limit the adviser’s liability to “gross negligence” or “willful disregard,” perhaps followed by a statement that the client is not waiving any rights that the client may have under state and/or Federal securities laws.

The SEC’s extreme skepticism with respect to hedge clauses is beginning to come to light. The use of an improper hedge clause was cited as part of a recent settlement involving Comprehensive Capital Management in January 2022, and the SEC’s Division of Exams even cited “potentially misleading” hedge clauses that “may not align with [advisers’] fiduciary duty” in the January 2022 Private Fund Risk Alert and the November 2021 Electronic Investment Advice Risk Alert.

SEC Exam staff have also apparently been scrutinizing hedge clauses in the course of recent routine adviser exams. Though the roots of the SEC’s renewed skepticism can be traced back to the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers, more of the iceberg now appears visible above the surface.

While the above-referenced January 2022 settlement should not necessarily be viewed as an indication that all limitation of liability clauses will result in an enforcement proceeding in isolation (there were other alleged ADV misstatements, books and records failures, and compliance failures cited in the settlement), when viewed in combination with the recent Risk Alert, Standard of Conduct Interpretation, and general word on the street, it seems clear that advisers should reconsider any language in their advisory agreements that may be viewed as an impermissible hedge clause.

Regardless of how an adviser may want to contractually thread this needle, it would still be prudent to include language making it clear that state and Federal securities laws impose liabilities under certain circumstances on persons who act in good faith, and that nothing in the advisory agreement shall in any way constitute a waiver or limitation of any rights, which a client may have under any state or Federal securities laws.

Certain states construe any attempt by an adviser to limit its liability as an unethical business practice and ban such contractual attempts outright.

DISPUTE RESOLUTION & CHOICE OF LAW

If a client relationship breaks down and one of the parties desires to seek recovery from the other for an alleged loss, the advisory agreement should describe in reasonable detail how and where such disputes are to be resolved and pursuant to which state’s laws.

The parties can theoretically agree to any number of combinations in this regard (e.g., arbitration in St. Louis, Superior Court in Los Angeles County, Bob’s E-Z Mediation in Kissimmee, etc.), but generally, the venue, forum, and choice of law should have some nexus to the parties to the agreement.

The dispute resolution clause can also be structured as a ‘waterfall’, such that the parties first try to resolve the dispute in good faith among themselves. If that doesn’t work, the parties can next try to resolve the dispute through mediation (which is voluntary). If mediation doesn’t result in a settlement, the last stop can be either binding arbitration or court.

Regardless of how disputes are to be resolved, a good dispute resolution clause should at least address the following:

The city or county where the dispute is to physically be resolved (e.g., Dade County);
The forum in which the dispute is to be resolved (e.g., arbitration or court);
If mediation is an option, who pays for the mediation (e.g., split 50/50); and
Which state’s laws will apply (e.g., Arkansas).

To be even more granular with respect to arbitration, the dispute resolution clause can even specify the arbitration organization (e.g., JAMS or the American Arbitration Association), how many arbitrators are to oversee the arbitration (e.g., a single arbitrator or multiple arbitrators), and how arbitrators are to be selected (e.g., jointly via nomination or mutual agreement).

Many states impose various restrictions with respect to dispute resolution clauses and may require that the choice of law be based on the client’s state of residence and the venue be a location most convenient for the client. Some even outright ban mandatory arbitration. For state-registered advisers who are registered in multiple states, this is the primary reason why multiple versions of an advisory agreement may be necessary.

Changing And Terminating The Agreement

AMENDMENT & MODIFICATION

Generally speaking, an agreement may not be amended or modified without the mutual consent of parties to such agreement. An advisory agreement is no exception.

However, much like the earlier section regarding consent to the assignment of an advisory agreement, the question again becomes how such consent to an amendment or modification must be obtained. The agreement should specify whether any amendment or modification may only be effective upon the express written consent of the parties or, alternatively, whether the adviser may amend or modify the agreement via passive/negative consent upon advance written notice to the client.

Many states prohibit negative/passive client consent to an advisory agreement’s amendment or modification and instead require the client’s express written consent before any changes to the agreement can be made.

TERMINATION

The termination provision in an advisory agreement has two primary objectives:

Describing how a party can terminate the agreement and with how much advance notice (if any); and
Describing how fees will be prorated through the date of termination.

As a general rule, requiring a terminating party to provide the non-terminating party with notice of termination a certain number of days in advance of its effectiveness (e.g., 30 days advance written notice) is not advisable. If a client or an adviser wants to exit a toxic advisory relationship, he or she should be able to do so immediately, without requiring a potentially awkward number of days to elapse between when notice of termination is provided and when the termination is actually effective.

Regardless of whether any advance notice of termination is required, such notice should be in writing and should include a specific effective date (e.g., “termination will be effective as of the date a party’s notification of termination is provided in writing”) to avoid ambiguities of when the adviser’s obligation to manage accounts or render advice has ceased, and through what date fees should be prorated.

If the client has paid fees in advance in consideration of any period after the termination date, the portion of the fees attributable to the period of time after the termination date should be promptly refunded to the client.

If the adviser charges in arrears and, at the time of termination, hasn’t yet charged the client fees for the period of time before the termination date, the adviser may charge the client the prorated amount of such fees. However, the advisory agreement should clearly describe how fees are prorated at termination to avoid any ambiguity.

Miscellaneous Details

An advisory agreement (like any good agreement) should contain standardized boilerplate language that addresses the miscellaneous contractual formalities that are otherwise not captured in the prior sections. This boilerplate should address the following, if not otherwise addressed earlier in the advisory agreement:

The manner in which the parties are to provide each other ‘notice’ of the exercise of certain contractual rights (e.g., termination of the agreement, initiation of adversarial proceedings, etc.). This clause typically includes the full mailing and email addresses of the parties and describes whether notice must be provided by certified mail, email with a confirmation of delivery, etc.
A savings/reformation clause that ‘saves’ the agreement from being terminated in its entirety if only certain provisions of the agreement are deemed to be invalid, illegal, or unenforceable. This clause can also allow for the agreement to be ‘reformed’ (i.e., modified) to the extent necessary to make the agreement not invalid, illegal, or unenforceable.
A statement that the advisory agreement is the sole and entire agreement between the parties and that it supersedes any prior agreements, oral discussions, etc.

SIGNATURES

Both the adviser and the client should sign the agreement. Signatures may be obtained the old-fashioned way with a pen and ink, but electronic signature services are generally fine as well. The Federal Electronic Signatures In Global and National Commerce Act (ESIGN) of 2000 affords legal enforceability to electronic signatures, but it’s not a bad idea to include a provision in the advisory agreement that makes it clear that electronic signatures will have the same legal effect as a wet signature.

FORMATTING TIPS

If you really want to be persnickety (like me), consider adhering to the following formatting guidelines (which are generally applicable to any legal agreement):

Include the page number and the total number of pages in the agreement on all pages (e.g., “Page 6 of 7”). This makes it easier to reference certain provisions and to identify whether any pages are missing.

For similar reasons as the above, enumerate each section and subsection (e.g., Section 1, Section 2, paragraph (a), paragraph (b), etc.).

If you don’t otherwise have a version control system built into your document management system, include a version date so it is readily apparent when the agreement was last updated.

The signatures for all parties should fit onto a single page and not be broken up into separate pages unless such pages are specifically identified as signature pages.

If the body text of the agreement ends midway through a page such that a large white space remains below it, include a statement along the lines of “The remainder of this page has intentionally been left blank.” If the signature page follows on the next page, state that fact. (This helps to clarify that nothing from the agreement was removed after the fact to create that empty white space.)

Be very careful with pronouns and informal references to the parties. Ideally, each party would be identified in the opening paragraph and assigned its own shorthand definition. For example, “XYZ Wealth Management and Financial Planning Services LLC” could be abbreviated to “XYZ” or “Adviser,” and that shorthand abbreviation can be used in the rest of the agreement instead of the laborious recitation of the entire legal name. Similarly, the client’s name can be ascribed the shorthand “Client”. If the agreement uses terms like “you”, “your”, “we”, “us”, or “our”, be sure to clarify the identity to whom such terms should be ascribed.

One of the most common questions I’m asked by advisers as it relates to advisory agreements goes something like this: “My advisory agreement seems really long and I don’t want to intimidate my clients. Can you shorten it to just a page or two but still make sure I’m protected?”

I generally respond by very politely explaining in some form or another that you can’t have your cake and eat it too. While an agreement’s length is certainly not directly proportional to its validity or effectiveness, there is a ‘Goldilocks sweet spot’ that strikes the right balance between unnecessarily long, complex, and verbose on the one hand, and impractically short, informal, and incomplete on the other.

The ultimate goal of an advisory agreement (or any agreement, for that matter) is to script the desired outcomes of the parties with reasonable certainty that, regardless of whether everything goes according to plan or not, the parties need to part ways (either amicably or not).

One way to crack the Goldilocks paradox with respect to an advisory agreement could be, for example, to include the services, fees, and signature lines front and center on the first page with some marketing flourish, and then to include the other terms and conditions on the pages that follow as an exhibit of sorts.

Ultimately, an agreement is part art and part science. By better understanding the key components of an advisory agreement and some of the best practices used, advisers will be able to find the happy medium between the two that works most effectively for them.

* * * * *

Both parts of this article originally appeared in Michael Kitces’ Nerd’s Eye View on August 17, 2022 and August 24, 2022, respectively.