Series 66

Client Communication and Compensation Issues - Compensation

There are few specific restrictions on fees within either the Investment Advisers Act of 1940 or the USA. The advisory fee must not be "unreasonable", which means that it should be in line with what other advisors charge. Under the USA, 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 cover all services (asset management and transactional fees) in one single annual fee
Look Out
There are a few exceptional cases in which an investment advisor can benefit from portfolio gains. Advisors can participate in capital gains (receive a performance-based fee) if the client:
  1. is an institutional investor.
  2. is a private client with a minimum net worth of $1.5 million.
  3. is a private client with a minimum of $750,000 invested with the IA.

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 $1,500,000 (Investment Adviser 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 advisor, 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. based on any of the above
The correct answer is "b": options "a" and "c" are specifically prohibited.


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