Client Communication and Compensation - Compensation

Restrictions on Fees
There are few specific restrictions on fees within either the Investment Advisers Act of 1940 or the Uniform Securities Act. The advisory fee must not be "unreasonable," which means that it generally should be in line with what other advisers charge. Under the Uniform Securities Act, the following types of fee arrangements are permitted:

  • Fees based on a percentage of assets under management
  • Flat annual dollar amount for services agreed upon
  • Brokerage fees on trades made for clients
  • Wrap fees that combine all services (asset management and transaction fees) into a single annual fee

As mentioned above, performance-based fees are generally prohibited. Only two types of clients may be charged such a fee:

  • Registered investment companies (mutual funds)
  • An individual with an account value in excess of $1 million (Uniform Securities Act), or
  • An individual with an account value in excess of $750,000 AND a net worth of at least $1.5 million (Investment Advisers Act)

In these cases, a performance-based fee (known as a "fulcrum fee") is permitted. A fulcrum fee provides for a base fee to be paid to the adviser, with additional fees permitted for performance above a specific benchmark. However, this is allowed only if the base fee would be reduced equally for inferior performance beneath the benchmark.


Look Out!
Don\'t confuse performance-based fees with performance guarantees - read the exam questions carefully. Remember that performance guarantees are always prohibited, while performance-based fees are generally prohibited, with the exceptions discussed above.



Exam Tips and Tricks
Here is a question you might encounter on the exam:

IAs may enter into advisory contracts that allow compensation:

  1. Based on the level of trading activity
  2. Based on a percentage of the value of all assets under management
  3. Based on a percentage of capital gains or losses in the account
  4. Any of the above

The correct answer is "b". The other two options are specifically prohibited.

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