Client Communication and Compensation - Investment Advisory Contracts
Contracts between IAs and Clients
While state laws require that contracts between state-registered IAs and clients be in writing, the Investment Advisers Act of 1940 does not.
However, most IAs take the initiative to put their contracts in writing to avoid misunderstandings.
SEC Rules on
SEC rules impose the following conditions on a written investment advisory contract:
- Performance-based fees are generally prohibited (we'll discuss further in the next section).
- Contract language must not lead clients to believe they have waived rights to take legal action against the adviser.
- There must be no provisions that force the client to waive compliance with any of the rights or rules within the Investment Advisers Act of 1940.
- The contract must prohibit the IA from assigning the contract without the client's consent.
Exam Tips and Tricks
Although the NASAA Model Rule on Unethical Business Practices states that written contracts are required, the questions on the exam reference oral contracts.
Uniform Securities Act Rules on Contracts
Under the Uniform Securities Act, IA contracts must do the following:
- Disclose all material information regarding the services to be provided and the fees to be charged
- Disclose conditions under which the contract may be assigned to another party
- Require client consent prior to the IA assigning the contract
- Require the IA (if a partnership) to notify the client of any change in the membership of the partnership
- Prohibit the IA from being compensated on the basis of sharing in capital gains or capital appreciation of the client's accounts (however, fees based on the total value of the account, such as an assets under management fee, are allowed)
Performance guarantees are generally considered a conflict of interest. The hallmark of an investment adviser is objectivity, so there must be no personal interest in the outcome of any specific investment recommendation. Also, guaranteeing a client's account against loss is specified as an unethical business practice under the Uniform Securities Act.
Remember that guaranteeing a client\'s account against loss is a type of performance guarantee. The Series 65 exam is not likely to test you on any distinction between these two concepts.