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The Securities and Exchange Commission (the “SEC”) on June 5, 2019 released an interpretation of the standard of conduct required by the Investment Advisers Act of 1940 (the “Advisers Act”) of investment advisers as fiduciaries to their clients.   1  The Release affirmed the  SEC’s long–standing view that the scope of an adviser’s obligations must be based on overarching principles, as opposed to a laundry list of specific obligations. However, the Release does provide some useful examples of the application of an adviser’s fiduciary duty obligations to its clients, and additional information as to the SEC’s view of what constitutes full and fair disclosure by an adviser of its conflicts and informed consent to those conflicts by a client.

The Release purports not to create any new legal obligations for advisers, and thus to be only an “interpretation” and not a rulemaking. The Release does not take a position on the scope or substance of any fiduciary duty that applies to an adviser under applicable state law, nor does it address the extent to which the Advisers Act applies to impersonal investment advice.

I.      Best Interest is Combination of Care and Loyalty

According to the SEC, an investment adviser’s fiduciary obligation to act in the best interest of its client encompasses both the duty of care and duty of loyalty. The duty of care requires an investment adviser to provide investment advice and take actions that are in the best interest of the client, while the duty of loyalty requires an investment adviser to “eliminate or make full and fair disclosure of all conflicts of interest which might incline an investment adviser … consciously or unconsciously … to render advice which was not disinterested.” 2

Interestingly, in response to the proposed interpretation, one commenter questioned whether there is much support for the conclusion that a duty of care obligation actually exists.   3  Not surprisingly, the SEC disagreed, and asserted the view that the duty of care requires an investment adviser to “provide investment advice in the best interest of its client, based on the client’s objectives.” 4   (While the argument that advisers do not have a duty of care was never going to be accepted by the SEC, there is actually surprisingly little, if anything, in the way of regulatory enforcement actions as to the duty of care imposed on an adviser.  The regulatory enforcement actions are almost entirely on the duty of loyalty and failures to make adequate disclosures.)

The SEC also affirmed that an adviser’s fiduciary duty applies to all investment advice the adviser provides to clients, including advice about investment strategy, engaging a sub-adviser, and appropriate account type.” 5

II.     Contract with Client

The relationship between an investment adviser and its client may be shaped by contract, so long as there is full and fair disclosure and informed consent and subject to certain further constraints.  An investment adviser must consider whether the client is retail or institutional when negotiating its agreement with a client. An adviser’s obligations when agreeing to terms with a retail client may differ from that of an adviser to a registered investment company or private fund.

As to specific provisions that may be included in a client agreement, the Release states that an adviser’s “fiduciary duty may not be waived, though it will apply in a manner that reflects the agreed-upon scope of the relationship.” 6   The SEC also provided three specific examples of unacceptable waivers: (i) that the adviser will not act as a fiduciary, (ii) a waiver of all conflicts of interest, and (iii) a waiver of any specific obligation under the Advisers Act.  7

The SEC also clarified its view as to the use of “hedge clauses” in advisory agreements. (A hedge clause is a provision added to an investment advisory contract or agreement which typically discharges the adviser from liability unless the adviser has been grossly negligent or has engaged in reckless or willful misconduct, illegal acts, or acts outside the scope of its authority. 8   ) The SEC stated that, while a hedge clause may be appropriate for an institutional client, the Release stated that “there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with those antifraud provisions …” 9    The use of a hedge clause in an agreement with an institutional client will depend on the “particular facts and circumstances.” 10  Advisers must address any conflicts of interest created by the hedge clause as required by their duty of loyalty. Further in this regard, the SEC withdrew the Heitman Capital Management No-Action Letter. 11

III.    Reasonable Inquiry

The SEC pointed out several differences between advising a retail client versus an institutional client, particularly as it relates to the adviser’s obligation to make a reasonable inquiry into its client’s circumstances.

A retail client’s investment objectives may fluctuate due to various life events. As a result, when advising retail clients, an adviser must make an ongoing reasonable inquiry into the client’s “investment profile,” including its financial situation, level of financial sophistication, investment experience, and financial goals. The frequency with which an adviser must inquire and update a retail client’s investment profile turns on individual facts, circumstances, and events.

However, an institutional client’s investment objectives are typically fixed by the  advisory agreement or its constituent documents. Therefore, when dealing with institutional clients, “the nature and extent of the reasonable inquiry into the client’s objectives generally is shaped by the specific investment mandates from those clients.” 12  Any obligation to update the investment objective of an institutional client should be set forth in the advisory agreement.

IV.    Conflicts

The SEC’s proposed interpretation on fiduciary principles stated that an adviser must “seek to avoid” conflicts of interest with clients. 13  The Release clarifies that an adviser may satisfy the duty of loyalty by “making full and fair disclosure of conflicts of interest and obtaining the client’s informed consent.” 14  However, the requirement to obtain informed consent “does not require advisers to make an affirmative determination that a particular client understood the disclosure and that the client’s consent to the conflict of interest was informed. Rather, disclosure should be designed to put a client in a position to be able to understand and provide informed consent to the conflict of interest.” 15

V.     Full and Fair Disclosure

The SEC also pointed to potentially significant differences between the meaning of full and fair disclosure for institutional clients and retail clients. Institutional clients “generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications.” 16  On the other hand, it may be difficult to provide disclosure regarding complex or extensive conflicts that is sufficiently specific, but also understandable enough for retail clients to provide their informed consent. In these cases, disclosure alone will not be sufficient, and the adviser should “either eliminate the conflict or adequately mitigate ( i.e. , modify practices to reduce) the conflict such that full and fair disclosure and informed consent are possible.” 17

The Release stated that some conflicts “may be of a nature and extent that it would be difficult to provide disclosure to clients that adequately conveys the material facts or the nature, magnitude, and potential effect of the conflict sufficient for a client to consent to or reject it.” 18  Despite taking the view that there are some conflicts that cannot be cured through disclosure, the SEC did not define what such conflicts might be.  The Release, does  however, provide some guidance as to (i) the appropriate level of specificity required, and (ii) the considerations for disclosure regarding conflicts related to the allocation of investment opportunities among eligible clients. 19   For example, disclosing that an adviser “may” have a particular conflict, without more, is not adequate when the conflict actually exists. Similarly, the use of “may” is insufficient if it simply precedes a list of all possible or potential conflicts regardless of likelihood. With respect to allocating investment opportunities, an adviser is permitted to consider the nature and objectives of the client and the scope of the relationship. However, if a conflict exists, it would be inadequate to disclose that the adviser has “other clients” without describing how the adviser will manage conflicts between clients.

The Release also makes clear that informed consent does not have to take the form of a written advisory contract. In fact, a client’s informed consent can be either explicit or, “depending on the facts and circumstances, implicit.” 20  It further explained that “a client generally may provide its informed consent implicitly ‘by entering into or continuing the investment advisory relationship with the adviser’ after disclosure of a conflict of interest.” 21

VI.    Going Forward

Advisers should assess their policies regarding the frequency with which they inquire and update a retail client’s investment objectives. Additionally, advisers should determine whether they wish to specify the frequency of obligation to update in their advisory agreements.

Advisers should evaluate their advisory agreements to ensure they are not using waiver language that would be prohibited by the Release.

Advisers should determine whether they have made full and fair disclosure of conflicts and obtained the necessary informed consent from clients. In particular, advisers should assess the adequacy of any disclosure relating to the allocation of investment opportunities.

Taking account of the sophistication of the clients that they serve, advisers should review and confirm that any disclosures are sufficiently specific and understandable enough for their clients to make an informed decision to consent to the conflict of interest.

In relationships where a client has provided implied consent to a conflict, an adviser may want to identify evidence of such consent, or when possible, obtain explicit consent.

 1  See  Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA-5248 (June 5, 2019) (“the Release”).

     The Interpretation was one of a set of four releases relating to the standard of conduct required of broker-dealers and investment advisers. The other releases are: Regulation Best Interest: The Broker-Dealer Standard of Conduct, Release No. 34-86031 (June 5, 2019); Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles, Investment Advisers Act Release No. 5247 (June 5, 2019); Fiduciary Interpretation; Commission Interpretation Regarding the Solely Incidental Prong of the Broker-Dealer Exclusion to the Definition of Investment Adviser, Advisers Act Release No. 5249 (June 5, 2019).

2 The Release at page 6.

3  See  Comment Letter of Dechert LLP (Aug. 7, 2018) (citing the absence of a single federal case holding that the Advisers Act imposes a “duty of care” and pointing out that the cited administrative proceedings base their holdings on a failure to adequately disclose rather than a “duty of care”).

4  The Release at page 8.

5 Consistent with Reg BI, the Release clarified that account type clearly includes “advice about whether to roll over assets from one account ( e.g. , a retirement account) into a new or existing account that the adviser or an affiliate of the adviser manages; Release at page 18 (stating an adviser’s duty to monitor extends to all personalized advice it provides to the client, including an evaluation of whether a client’s account or program type continues to be in the client’s best interest).

6 The Release at page 10.

7 The Release at pages 10-11.

8 Hedge clauses are often followed by “non-waiver disclosures” which explain that the client may have certain legal rights arising under federal and state securities laws which have not been waived. The key concern is that these antifraud provisions may be violated if such a clause is likely to lead a client to believe that it has waived non-waivable rights of action against the adviser that are provided by federal or state law.

9 Release at page 11, footnote 31.

11  Release at page 11, footnote 31;  See   also  Heitman Capital Mgmt., LLC, SEC No-Action Letter, (Fed. 12, 2007). (On Feb. 12, 2007, the SEC issued a No-Action Letter which indicated that the use of a hedge clause, accompanied by non-waiver disclosure, would not  per se  violate Sections 206(1) and (2) of the Advisers Act. Instead, in the context of a retail client, the staff would consider numerous factors including, but not limited to, whether: (i) the hedge clause was written in plain English; (ii) the adviser highlighted and explained the hedge clause during an in-person meeting with the client; and (iii) the adviser provided enhanced disclosure to explain the instances in which such client may still have a right of action against the adviser).

12  Release at page 14.

13  Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Release No. IA-4889 (April 18, 2018) (“Proposed Release”).

14  Release at page 23, footnote 57.

15  Release at page 27.

16  Release at page 26.

17  Release at page 28 (emphasis in original).

18  Release at page 28.

19  Release at page 24.

20  Release at page 27.

21  Release at page 27, footnote 68.

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August 17, 2022 07:07 am 1 Comment CATEGORY: Regulation & Compliance

Executive Summary

Registered Investment Advisers (RIAs) are generally required to enter into an advisory agreement with their clients prior to being hired for advisory services. And while there is no standard ‘template’ language applicable to all advisory agreements, there are a number of best practices that RIAs can follow in drafting and reviewing their agreements to ensure they can pass legal and regulatory muster.

In this guest post, Chris Stanley, investment management attorney and Founding Principal of Beach Street Legal, lays out the statutory requirements for RIA advisory agreements and some of the essential elements for advisory agreements to include when describing the RIA’s services and fees.

Advisory agreements for SEC-registered RIAs are governed by Section 205 of the Investment Advisers Act of 1940. In terms of specific advisory agreement language, the Advisers Act focuses essentially on three items:

• First, the law restricts RIAs from charging performance-based fees unless the client is a “qualified client” (in most cases, a client with at least $1.1 million under the management of the adviser, or with a total net worth of at least $2.2 million);
• Second, advisory agreements are required to give clients the opportunity to consent to their advisory agreement being ‘assigned’ to another adviser (including when an RIA changes ownership by merging with or being acquired by another firm); and
• Third, advisory agreements of RIAs organized as partnerships are simply required to contain a clause informing the client of any change in the membership of that partnership “within a reasonable time after such change”.

But even though the specific requirements of the Advisers Act are relatively narrow in scope, a well-crafted advisory agreement will contain additional elements, including descriptions of the RIA’s services and fees.

When describing the RIA’s services, advisory agreements should lay out the specific services – such as discretionary or nondiscretionary asset management, and the scope and duration of any financial planning services – to be included in the arrangement.

When it comes to fees charged to clients, advisory agreements should include – at minimum – the exact amount of the fee (either as a dollar amount or percentage of assets under management), when the fee will be charged, how the fee will be prorated at the beginning and end of the agreement, how the client can pay the fee, and which of the client’s accounts may be billed. For AUM-based fees, agreements should also include breakpoints for multi-tiered fee schedules (and whether breakpoints are applied on a ‘cliff’ or ‘blended’ basis) and how AUM is calculated (and whether it is based on assets at a single point in time or averaged over a specific period, and if it includes cash and/or margin balances). Any fees for third-party advisers or subadvisers should also be described in the agreement. While these constitute only two core elements of advisory agreements, there are numerous other essential components for RIAs to include (so many, in fact, that covering them all will require another separate article!).

The key point, however, is that a good advisory agreement requires a solid grasp of the Federal and state statutory requirements, and clearly lays out the RIA’s services and fees. For established firms, understanding these points more deeply will allow RIA owners to review their existing agreements – to ensure not only that they comply with existing regulations, but that they also include the elements constituting a valid agreement between RIA and client!

Author: Chris Stanley

Chris Stanley is the Founder of Beach Street Legal LLC, a law firm and compliance consultancy that focuses exclusively on legal, regulatory compliance, and M&A matters for registered investment advisers and financial planners. He strives to provide simple, practical counsel to those in the fiduciary community, and to keep that community ahead of the regulatory curve. When he’s not poring over the latest SEC release or trying to meet the minimum word count for a Nerd’s Eye View guest post, you’ll find Chris enjoying the outdoors away from civilization. To learn more about Chris or Beach Street Legal, head over to  beachstreetlegal.com .

Read more of Chris’ articles  here .

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.

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.

Editor’s Note: Because of the sheer volume of information related to advisory agreement requirements, this article has been divided into 2 parts. Part 1 will focus only on the statutory requirements of Section 205 of the Advisers Act, as well as the ‘core’ elements of any advisory agreement: a description of the adviser’s services and fees. Part 2 will address the additional considerations that should be made in any advisory agreement. Each part is intended to be read in conjunction with the other, so as to provide a holistic view of a robust and complete advisory agreement.

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.

Client Consent To Assignment

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.
• 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).
• 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).

The 2% asset-based fee threshold traces its roots back to various no-action letters from the 1970s, like Equitable Communications Co., SEC Staff No-Action Letter, 1975 WL 11422 (pub. avail. Feb. 26, 1975) ; Consultant Publications, Inc., SEC Staff No-Action Letter, 1975 WL 12078 (pub. avail. Jan. 29, 1975) ; Financial Counseling Corporation, SEC Staff No-Action Letter (Dec. 7, 1974) ; and John G. Kinnard & Co., Inc., SEC Staff No-Action Letter (Nov. 30, 1973) .

In these letters, the SEC’s Division of Investment Management took the position that an asset-based fee greater than 2% of a client’s assets under the adviser’s management is excessive and would violate Section 206 of the Advisers Act (Prohibited Transactions By Investment Advisers) unless the adviser discloses that its fee is higher than that normally charged in the industry.

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.

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Understanding the Provisions Required for Registered Investment Adviser Client Contracts

May 16, 2013, reading time : 4 minutes.

Under Section 205 of the Investment Advisers Act of 1940 (“Investment Advisers Act”), an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”)  shall not “enter into, extend, or renew any  investment advisory contract, or in any way to perform any investment advisory contract entered into, extended, or renewed…” unless the investment advisory contract meets certain requirements specified under Section 205.  Section 205(d) of the Investment Advisers Act defines an investment advisory contract as “any contract or agreement whereby a person agrees to act as an investment adviser to or to manage an investment or trading account of another person….”

Although the Investment Advisers Act does not expressly require that agreements or advisory contracts be in writing, it is generally considered best practice to have a written agreement between the investment adviser and the client and certain provisions of the Investment Advisers Act, such as Section 205, and SEC Rule 204-2, the books and records rule, is based on the existence of written agreements or advisory contracts.  For example, Rule 204-2(a)(9) under the Investment Advisers Act requires SEC registered investment advisers to maintain, “[a]ll powers of attorney and other evidence of the granting of any discretionary authority by any client to the investment adviser, or copies thereof.” Similarly, Rule 204-2(a)(10) requires SEC registered investment advisers to maintain, “[a]ll written agreements (or copies thereof) entered into by the investment adviser with any client or otherwise relating to the business of such investment adviser as such.” If a dispute or a regulatory inquiry or investigation occurs, a written investment advisory agreement will serve to provide evidence of the registered investment adviser’s authority to act on the client’s behalf as well as the level of authority the investment adviser has been given by the client.

When entering into an investment advisory contract with a client, an SEC registered investment adviser must make sure that at a minimum the investment advisory contract meets the following requirements.

• No assignments without client consent – Section 205(a)(2) : The investment advisory contract must provide that the investment adviser cannot assign the contract without the client’s consent; therefore, the investment advisory contract must convey that the investment advisory services provided by the SEC registered investment advisory may not be assigned by the investment adviser to any other person(s) without prior consent from the client.
• Disclosures of general partnership changes – Section 205(a)(3) : If the registered investment adviser is a partnership, the investment advisory contract must provide that the investment adviser will notify the client to changes in membership of the partnership within a reasonable time period after any change.
• Restrictions on Performance Fees – Section 205(a)(1) : Investment advisory contracts generally shall not provide for compensation to the registered investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds of a client (“performance fees”). However, Section 205(b) of the Investment Advisers Act provides certain circumstances when Section 205(a)(1) will not apply and Rule 205-3 under the Investment Advisers Act provides certain exemptions from the compensation prohibition under Section 205(a)(1) and allows investment advisers to receive performance fees in certain limited circumstances.
• Prohibition of Waiver of Compliance – Section 215 (a) & (b) :  Section 215(a) states that “Any condition, stipulation, or provision binding any person to waive compliance with any provision of this title or with any rule, regulation, or order thereunder shall be void.”  The SEC believes that any clauses or provisions that are likely to lead clients to believe that they have waived their rights of legal action under federal securities laws or common law may violate the anti-fraud provisions of the Investment Advisers Act.  Therefore, hedge clause provisions generally may not be included in investment advisory contracts.

The securities laws of many states actually require written investment advisory agreements and require the investment advisory contracts to meet at a minimum the same requirements previously stated.  Additionally, many state securities regulators require certain basic terms and disclosures such as, services to be provided, the term of the contract, the advisory fee or formula for computing the fee, and the manner for pro-rating pre-paid fees at termination.

For more information on investment advisory contracts, attorney, Bryan Hill, will share his insights about key provisions and disclosures that should be included in an investment advisory agreement during a webinar sponsored by RIA Compliance Consultants on June 6, 2013, at 12:00 CDT, titled: “Key Elements that Should be Included in an Investment Advisory Client Contract – Presented by Bryan Hill Law.” During this webinar Mr. Hill will review state and federal regulatory requirements, common mistakes and best practices for an investment adviser to consider when preparing its client agreement. (Please note RIA Compliance Consultants is not a law firm.) For more information and to register for this event, please click here .

Posted by Bryan Hill Labels: Books Records , Client Contracts , Compliance Program , Investment Advisory Client Contracts , Webinar

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17 CFR § 275.204-2 - Books and records to be maintained by investment advisers.

• Table of Popular Names

(a) Every investment adviser registered or required to be registered under section 203 of the Act ( 15 U.S.C. 80b–3 ) shall make and keep true, accurate and current the following books and records relating to its investment advisory business;

(1) A journal or journals, including cash receipts and disbursements, records, and any other records of original entry forming the basis of entries in any ledger.

(2) General and auxiliary ledgers (or other comparable records) reflecting asset, liability, reserve, capital, income and expense accounts.

(3) A memorandum of each order given by the investment adviser for the purchase or sale of any security, of any instruction received by the investment adviser concerning the purchase, sale, receipt or delivery of a particular security, and of any modification or cancellation of any such order or instruction. Such memoranda shall show the terms and conditions of the order, instruction, modification or cancellation; shall identify the person connected with the investment adviser who recommended the transaction to the client and the person who placed such order; and shall show the account for which entered, the date of entry, and the bank, broker or dealer by or through whom executed where appropriate. Orders entered pursuant to the exercise of discretionary power shall be so designated.

(4) All check books, bank statements, cancelled checks and cash reconciliations of the investment adviser.

(5) All bills or statements (or copies thereof), paid or unpaid, relating to the business of the investment adviser as such.

(6) All trial balances, financial statements, and internal audit working papers relating to the business of such investment adviser.

(7) Originals of all written communications received and copies of all written communications sent by such investment adviser relating to:

(i) Any recommendation made or proposed to be made and any advice given or proposed to be given;

(ii) Any receipt, disbursement or delivery of funds or securities;

(iii) The placing or execution of any order to purchase or sell any security; and, for any transaction that is subject to the requirements of § 240.15c6 –2(a) of this chapter, each confirmation received, and any allocation and each affirmation sent or received, with a date and time stamp for each allocation and affirmation that indicates when the allocation and affirmation was sent or received;

(iv) Predecessor performance (as defined in § 275.206(4) –1(e)(12) of this chapter) and the performance or rate of return of any or all managed accounts, portfolios (as defined in § 275.206(4) –1(e)(11) of this chapter), or securities recommendations; Provided, however:

(A) That the investment adviser shall not be required to keep any unsolicited market letters and other similar communications of general public distribution not prepared by or for the investment adviser; and

(B) That if the investment adviser sends any notice, circular, or other advertisement (as defined in § 275.206(4) –1(e)(1) of this chapter) offering any report, analysis, publication or other investment advisory service to more than ten persons, the investment adviser shall not be required to keep a record of the names and addresses of the persons to whom it was sent; except that if such notice, circular, or advertisement is distributed to persons named on any list, the investment adviser shall retain with the copy of such notice, circular, or advertisement a memorandum describing the list and the source thereof; and

(v) Any notice required pursuant to § 275.211(h)(2) –3 as well as a record of each addressee and the corresponding date(s) sent.

(8) A list or other record of all accounts in which the investment adviser is vested with any discretionary power with respect to the funds, securities or transactions of any client.

(9) All powers of attorney and other evidences of the granting of any discretionary authority by any client to the investment adviser, or copies thereof.

(10) All written agreements (or copies thereof) entered into by the investment adviser with any client or otherwise relating to the business of such investment adviser as such.

(i) A copy of each

(A) Advertisement (as defined in § 275.206(4) –1(e)(1) of this chapter) that the investment adviser disseminates, directly or indirectly, except:

(1) For oral advertisements, the adviser may instead retain a copy of any written or recorded materials used by the adviser in connection with the oral advertisement; and

(2) For compensated oral testimonials and endorsements (as defined in § 275.206(4)–1(e)(17) and (5) of this chapter), the adviser may instead make and keep a record of the disclosures provided to clients or investors pursuant to § 275.206(4)–1(b)(1) of this chapter; and

(B) Notice, circular, newspaper article, investment letter, bulletin, or other communication that the investment adviser disseminates, directly or indirectly, to ten or more persons (other than persons associated with such investment adviser); and

(C) If such notice, circular, advertisement, newspaper article, investment letter, bulletin, or other communication recommends the purchase or sale of a specific security and does not state the reasons for such recommendation, a memorandum of the investment adviser indicating the reasons therefor; and

(ii) A copy of any questionnaire or survey used in the preparation of a third-party rating included or appearing in any advertisement in the event the adviser obtains a copy of the questionnaire or survey.

(i) A copy of the investment adviser's code of ethics adopted and implemented pursuant to § 275.204A –1 that is in effect, or at any time within the past five years was in effect;

(ii) A record of any violation of the code of ethics, and of any action taken as a result of the violation; and

(iii) A record of all written acknowledgments as required by § 275.204A –1(a)(5) for each person who is currently, or within the past five years was, a supervised person of the investment adviser.

(i) A record of each report made by an access person as required by § 275.204A –1(b), including any information provided under paragraph (b)(3)(iii) of that section in lieu of such reports;

(ii) A record of the names of persons who are currently, or within the past five years were, access persons of the investment adviser; and

(iii) A record of any decision, and the reasons supporting the decision, to approve the acquisition of securities by access persons under § 275.204A –1(c), for at least five years after the end of the fiscal year in which the approval is granted.

(i) A copy of each brochure, brochure supplement and Form CRS, and each amendment or revision to the brochure, brochure supplement and Form CRS, that satisfies the requirements of Part 2 or Part 3 of Form ADV, as applicable [ 17 CFR 279.1 ]; any summary of material changes that satisfies the requirements of Part 2 of Form ADV but is not contained in the brochure; and a record of the dates that each brochure, brochure supplement and Form CRS, each amendment or revision thereto, and each summary of material changes not contained in a brochure given to any client or to any prospective client who subsequently becomes a client.

(ii) Documentation describing the method used to compute managed assets for purposes of Item 4.E of Part 2A of Form ADV, if the method differs from the method used to compute regulatory assets under management in Item 5.F of Part 1A of Form ADV.

(iii) A memorandum describing any legal or disciplinary event listed in Item 9 of Part 2A or Item 3 of Part 2B (Disciplinary Information) and presumed to be material , if the event involved the investment adviser or any of its supervised persons and is not disclosed in the brochure or brochure supplement described in paragraph (a)(14)(i) of this section. The memorandum must explain the investment adviser's determination that the presumption of materiality is overcome, and must discuss the factors described in Item 9 of Part 2A of Form ADV or Item 3 of Part 2B of Form ADV.

(i) If not included in the advertisement, a record of the disclosures provided to clients or investors pursuant to § 275.206(4) –1(b)(1)(ii) and (iii) of this chapter;

(ii) Documentation substantiating the adviser's reasonable basis for believing that a testimonial or endorsement (as defined in § 275.206(4) –1(e)(17) and (5) of this chapter) complies with § 275.206(4) –1 and that the third-party rating (as defined in § 275.206(4) –1(e)(18) of this chapter) complies with § 275.206(4) –1(c)(1) of this chapter; and

(iii) A record of the names of all persons who are an investment adviser's partners, officers, directors, or employees , or a person that controls , is controlled by, or is under common control with the investment adviser, or is a partner, officer, director or employee of such a person pursuant to § 275.206(4) –1(b)(4)(ii) of this chapter.

(16) All accounts, books, internal working papers, and any other records or documents that are necessary to form the basis for or demonstrate the calculation of any performance or rate of return of any or all managed accounts, portfolios (as defined in § 275.206(4) –1(e)(11) of this chapter), or securities recommendations presented in any notice, circular, advertisement (as defined in § 275.206(4) –1(e)(1) of this chapter), newspaper article, investment letter, bulletin, or other communication that the investment adviser disseminates, directly or indirectly, to any person (other than persons associated with such investment adviser), including copies of all information provided or offered pursuant to § 275.206(4) –1(d)(6) of this chapter; provided, however , that, with respect to the performance of managed accounts, the retention of all account statements, if they reflect all debits, credits, and other transactions in a client's or investor's account for the period of the statement, and all worksheets necessary to demonstrate the calculation of the performance or rate of return of all managed accounts shall be deemed to satisfy the requirements of this paragraph.

(i) A copy of the investment adviser's policies and procedures formulated pursuant to § 275.206(4) –7(a) of this chapter that are in effect, or at any time within the past five years were in effect;

(ii) Any records documenting the investment adviser's annual review of those policies and procedures conducted pursuant to § 275.206(4) –7(b) of this chapter;

(iii) A copy of any internal control report obtained or received pursuant to § 275.206(4) –2(a)(6)(ii).

(i) Books and records that pertain to § 275.206(4) –5 containing a list or other record of:

(A) The names, titles and business and residence addresses of all covered associates of the investment adviser;

(B) All government entities to which the investment adviser provides or has provided investment advisory services, or which are or were investors in any covered investment pool to which the investment adviser provides or has provided investment advisory services, as applicable, in the past five years, but not prior to September 13, 2010;

(C) All direct or indirect contributions made by the investment adviser or any of its covered associates to an official of a government entity, or direct or indirect payments to a political party of a State or political subdivision thereof, or to a political action committee; and

(D) The name and business address of each regulated person to whom the investment adviser provides or agrees to provide, directly or indirectly, payment to solicit a government entity for investment advisory services on its behalf, in accordance with § 275.206(4) –5(a)(2).

(ii) Records relating to the contributions and payments referred to in paragraph (a)(18)(i)(C) of this section must be listed in chronological order and indicate:

(A) The name and title of each contributor;

(B) The name and title (including any city/county/State or other political subdivision) of each recipient of a contribution or payment;

(C) The amount and date of each contribution or payment; and

(D) Whether any such contribution was the subject of the exception for certain returned contributions pursuant to § 275.206(4) –5(b)(2).

(iii) An investment adviser is only required to make and keep current the records referred to in paragraphs (a)(18)(i)(A) and (C) of this section if it provides investment advisory services to a government entity or a government entity is an investor in any covered investment pool to which the investment adviser provides investment advisory services.

(iv) For purposes of this section, the terms “contribution,” “covered associate,” “covered investment pool,” “government entity,” “official,” “payment,” “regulated person,” and “solicit” have the same meanings as set forth in § 275.206(4) –5.

(19) A record of who the “intended audience” is pursuant to § 275.206(4) –1(d)(6) and(e)(10)(ii)(B) of this chapter.

(i) A copy of any quarterly statement distributed pursuant to § 275.211(h)(1) –2, along with a record of each addressee and the corresponding date(s) sent; and

(ii) All records evidencing the calculation method for all expenses, payments, allocations, rebates, offsets, waivers, and performance listed on any statement delivered pursuant to § 275.211(h)(1) –2.

(21) For each private fund client:

(i) A copy of any audited financial statements prepared and distributed pursuant to § 275.206(4) –10, along with a record of each addressee and the corresponding date(s) sent; or

(ii) A record documenting steps taken by the adviser to cause a private fund client that the adviser does not control , is not controlled by, and with which it is not under common control to undergo a financial statement audit pursuant to § 275.206(4) –10.

(22) Documentation substantiating the adviser's determination that a private fund client is a liquid fund or an illiquid fund pursuant to § 275.211(h)(1) –2.

(23) A copy of any fairness opinion or valuation opinion and material business relationship summary distributed pursuant to § 275.211(h)(2) –2, along with a record of each addressee and the corresponding date(s) sent.

(24) A copy of any notification, consent or other document distributed or received pursuant to § 275.211(h)(2) –1, along with a record of each addressee and the corresponding date(s) sent for each such document distributed by the adviser.

(b) If an investment adviser subject to paragraph (a) of this section has custody or possession of securities or funds of any client, the records required to be made and kept under paragraph (a) of this section shall include:

(1) A journal or other record showing all purchases, sales, receipts and deliveries of securities (including certificate numbers) for such accounts and all other debits and credits to such accounts.

(2) A separate ledger account for each such client showing all purchases, sales, receipts and deliveries of securities, the date and price of each purchase and sale, and all debits and credits.

(3) Copies of confirmations of all transactions effected by or for the account of any such client.

(4) A record for each security in which any such client has a position, which record shall show the name of each such client having any interest in such security, the amount or interest of each such client, and the location of each such security.

(5) A memorandum describing the basis upon which you have determined that the presumption that any related person is not operationally independent under § 275.206(4) –2(d)(5) has been overcome.

(1) Every investment adviser subject to paragraph (a) of this section who renders any investment supervisory or management service to any client shall, with respect to the portfolio being supervised or managed and to the extent that the information is reasonably available to or obtainable by the investment adviser, make and keep true, accurate and current:

(i) Records showing separately for each such client the securities purchased and sold, and the date, amount and price of each such purchase and sale.

(ii) For each security in which any such client has a current position, information from which the investment adviser can promptly furnish the name of each such client, and the current amount or interest of such client.

(2) Every investment adviser subject to paragraph (a) of this section that exercises voting authority with respect to client securities shall, with respect to those clients, make and retain the following:

(i) Copies of all policies and procedures required by § 275.206(4) –6.

(ii) A copy of each proxy statement that the investment adviser receives regarding client securities. An investment adviser may satisfy this requirement by relying on a third party to make and retain, on the investment adviser's behalf, a copy of a proxy statement (provided that the adviser has obtained an undertaking from the third party to provide a copy of the proxy statement promptly upon request) or may rely on obtaining a copy of a proxy statement from the Commission's Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system.

(iii) A record of each vote cast by the investment adviser on behalf of a client. An investment adviser may satisfy this requirement by relying on a third party to make and retain, on the investment adviser's behalf, a record of the vote cast (provided that the adviser has obtained an undertaking from the third party to provide a copy of the record promptly upon request).

(iv) A copy of any document created by the adviser that was material to making a decision how to vote proxies on behalf of a client or that memorializes the basis for that decision.

(v) A copy of each written client request for information on how the adviser voted proxies on behalf of the client, and a copy of any written response by the investment adviser to any (written or oral) client request for information on how the adviser voted proxies on behalf of the requesting client.

(d) Any books or records required by this section may be maintained by the investment adviser in such manner that the identity of any client to whom such investment adviser renders investment supervisory services is indicated by numerical or alphabetical code or some similar designation.

(1) All books and records required to be made under the provisions of paragraphs (a) to (c)(1)(i), inclusive, and (c)(2) of this section (except for books and records required to be made under the provisions of paragraphs (a)(11), (a)(12)(i), (a)(12)(iii), (a)(13)(ii), (a)(13)(iii), (a)(16), and (a)(17)(i) of this section), shall be maintained and preserved in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record, the first two years in an appropriate office of the investment adviser.

(2) Partnership articles and any amendments thereto, articles of incorporation, charters, minute books, and stock certificate books of the investment adviser and of any predecessor, shall be maintained in the principal office of the investment adviser and preserved until at least three years after termination of the enterprise.

(i) Books and records required to be made under the provisions of paragraphs (a)(11) and (a)(16) of this rule shall be maintained and preserved in an easily accessible place for a period of not less than five years, the first two years in an appropriate office of the investment adviser, from the end of the fiscal year during which the investment adviser last published or otherwise disseminated, directly or indirectly, the notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication.

(ii) Transition rule. If you are an investment adviser that was, prior to July 21, 2011, exempt from registration under section 203(b)(3) of the Act ( 15 U.S.C. 80b–3(b)(3) ), as in effect on July 20, 2011, paragraph (e)(3)(i) of this section does not require you to maintain or preserve books and records that would otherwise be required to be maintained or preserved under the provisions of paragraph (a)(16) of this section to the extent those books and records pertain to the performance or rate of return of such private fund (as defined in section 202(a)(29) of the Act ( 15 U.S.C. 80b–2(a)(29) ), or other account you advise for any period ended prior to your registration, provided that you continue to preserve any books and records in your possession that pertain to the performance or rate of return of such private fund or other account for such period.

(f) An investment adviser subject to paragraph (a) of this section, before ceasing to conduct or discontinuing business as an investment adviser shall arrange for and be responsible for the preservation of the books and records required to be maintained and preserved under this section for the remainder of the period specified in this section, and shall notify the Commission in writing, at its principal office, Washington, D.C. 20549, of the exact address where such books and records will be maintained during such period.

(g) Micrographic and electronic storage permitted —(1) General. The records required to be maintained and preserved pursuant to this part may be maintained and preserved for the required time by an investment adviser on:

(i) Micrographic media, including microfilm, microfiche, or any similar medium; or

(ii) Electronic storage media, including any digital storage medium or system that meets the terms of this section.

(2) General requirements. The investment adviser must:

(i) Arrange and index the records in a way that permits easy location, access, and retrieval of any particular record;

(ii) Provide promptly any of the following that the Commission (by its examiners or other representatives) may request:

(A) A legible, true, and complete copy of the record in the medium and format in which it is stored;

(B) A legible, true, and complete printout of the record; and

(C) Means to access, view, and print the records; and

(iii) Separately store, for the time required for preservation of the original record, a duplicate copy of the record on any medium allowed by this section.

(3) Special requirements for electronic storage media. In the case of records on electronic storage media, the investment adviser must establish and maintain procedures:

(i) To maintain and preserve the records, so as to reasonably safeguard them from loss, alteration, or destruction;

(ii) To limit access to the records to properly authorized personnel and the Commission (including its examiners and other representatives); and

(iii) To reasonably ensure that any reproduction of a non-electronic original record on electronic storage media is complete, true, and legible when retrieved.

(1) Any book or other record made, kept, maintained and preserved in compliance with §§ 240.17a –3 and 240.17a–4 of this chapter under the Securities Exchange Act of 1934 , or with rules adopted by the Municipal Securities Rulemaking Board, which is substantially the same as the book or other record required to be made, kept, maintained and preserved under this section, shall be deemed to be made, kept, maintained and preserved in compliance with this section.

(2) A record made and kept pursuant to any provision of paragraph (a) of this section, which contains all the information required under any other provision of paragraph (a) of this section, need not be maintained in duplicate in order to meet the requirements of the other provision of paragraph (a) of this section.

(i) As used in this section the term “discretionary power” shall not include discretion as to the price at which or the time when a transaction is or is to be effected, if, before the order is given by the investment adviser, the client has directed or approved the purchase or sale of a definite amount of the particular security.

(1) Except as provided in paragraph (j)(3) of this section, each non-resident investment adviser registered or applying for registration pursuant to section 203 of the Act shall keep, maintain and preserve, at a place within the United States designated in a notice from him as provided in paragraph (j)(2) of this section true, correct, complete and current copies of books and records which he is required to make, keep current, maintain or preserve pursuant to any provisions of any rule or regulation of the Commission adopted under the Act.

(2) Except as provided in paragraph (j)(3) of this section, each nonresident investment adviser subject to this paragraph (j) shall furnish to the Commission a written notice specifying the address of the place within the United States where the copies of the books and records required to be kept and preserved by him pursuant to paragraph (j)(1) of this section are located. Each non-resident investment adviser registered or applying for registration when this paragraph becomes effective shall file such notice within 30 days after such rule becomes effective. Each non-resident investment adviser who files an application for registration after this paragraph becomes effective shall file such notice with such application for registration.

(3) Notwithstanding the provisions of paragraphs (j)(1) and (2) of this section, a non-resident investment adviser need not keep or preserve within the United States copies of the books and records referred to in said paragraphs (j)(1) and (2), if:

(i) Such non-resident investment adviser files with the Commission, at the time or within the period provided by paragraph (j)(2) of this section, a written undertaking, in form acceptable to the Commission and signed by a duly authorized person, to furnish to the Commission, upon demand, at its principal office in Washington, DC, or at any Regional Office of the Commission designated in such demand, true, correct, complete and current copies of any or all of the books and records which he is required to make, keep current, maintain or preserve pursuant to any provision of any rule or regulation of the Commission adopted under the Act, or any part of such books and records which may be specified in such demand. Such undertaking shall be in substantially the following form:

The undersigned hereby undertakes to furnish at its own expense to the Securities and Exchange Commission at its principal office in Washington, DC or at any Regional Office of said Commission specified in a demand for copies of books and records made by or on behalf of said Commission, true, correct, complete and current copies of any or all, or any part, of the books and records which the undersigned is required to make, keep current or preserve pursuant to any provision of any rule or regulation of the Securities and Exchange Commission under the Investment Advisers Act of 1940 . This undertaking shall be suspended during any period when the undersigned is making, keeping current, and preserving copies of all of said books and records at a place within the United States in compliance with Rule 204–2(j) under the Investment Advisers Act of 1940 . This undertaking shall be binding upon the undersigned and the heirs, successors and assigns of the undersigned, and the written irrevocable consents and powers of attorney of the undersigned, its general partners and managing agents filed with the Securities and Exchange Commission shall extend to and cover any action to enforce same.

(ii) Such non-resident investment adviser furnishes to the Commission, at his own expense 14 days after written demand therefor forwarded to him by registered mail at his last address of record filed with the Commission and signed by the Secretary of the Commission or such person as the Commission may authorize to act in its behalf, true, correct, complete and current copies of any or all books and records which such investment adviser is required to make, keep current or preserve pursuant to any provision of any rule or regulation of the Commission adopted under the Act, or any part of such books and records which may be specified in said written demand. Such copies shall be furnished to the Commission at its principal office in Washington, DC, or at any Regional Office of the Commission which may be specified in said written demand.

(4) For purposes of this rule the term non-resident investment adviser shall have the meaning set out in § 275.0 –2(d)(3) under the Act.

(k) Every investment adviser that registers under section 203 of the Act ( 15 U.S.C. 80b–3 ) after July 8, 1997 shall be required to preserve in accordance with this section the books and records the investment adviser had been required to maintain by the State in which the investment adviser had its principal office and place of business prior to registering with the Commission.

• Securities Exchange Act of 1934
• Investment Advisers Act of 1940

Adviser Changes of Control: An Elusive Definition

In some form or another, nearly every registered investment adviser will at some point be involved in a merger, acquisition, sale, or restructuring. Whether it’s a simple equity ownership stake by a new financier, the addition of a new partner, a union of two practices, the death of a major shareholder or the full-blown execution of a succession plan, RIAs will inevitably need to navigate SEC “change of control” rules and guidance.

Such rules and guidance are rooted in the requirement that investment advisory contracts may not be assigned without client consent. I discussed the interplay of positive and negative consent a few years back in this article , but left open the question of what actually constitutes an “assignment” that would necessitate client consent. Said another way, what types of mergers, acquisitions, sales, or restructurings are considered an assignment of an advisory contract and therefore require client consent?

For starters, the SEC attempts to define “assignment” in the very first definition of the Investment Advisers Act, Section 202(a)(1): “Assignment includes 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, but we’ll address that later. The general concept of the “assignment” definition is that there are essentially two situations in which an assignment is deemed to have occurred: (1) when advisory contracts are transferred to another RIA or pledged as collateral, or (2) The equity ownership structure of an RIA changes such that a “controlling block” of the RIA’s outstanding voting securities changes hands.

Both situations would trigger the need for client consent.

With respect to #2, the logical next question is: what constitutes a “controlling block?” What percentage of voting equity interest needs to change hands for the SEC to care? Unfortunately the SEC does not define “controlling block”, but we can cobble together an understanding from a few different guideposts.

The first is Section 202(a)(12) of the Advisers Act, which defines “control” as “the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company”. This is only moderately helpful since “controlling influence” is still left undefined, but at least we can discern that such control should be in relation to management of the RIA or its policies. And just because somebody employed by an RIA has a fancy title doesn’t mean he or she automatically has control over the RIA.

The second is the instructions to Form ADV Part 1, the glossary to which presumes that RIA equity owners with the right to vote 25% or more of the securities of that RIA “control” that RIA. Under this framework, the following persons would be deemed to control an RIA:

• A corporate stockholder that owns 25% of its voting stock
• A LLC member that owns 25% of its voting membership units, has contributed 25% of the capital, or has a right to receive 25% of the capital upon dissolution
• A partner that has contributed 25% of the partnership’s capital, or has the right to receive 25% of the capital upon dissolution

The third is actually the section that defines “control” in the Investment Company Act (applicable to mutual funds), not the Advisers Act. In Section 2(a)(9), the SEC establishes a rebuttable presumption that “any person who owns beneficially, either directly or through one or more controlled companies, more than 25% of the voting securities of a company shall be presumed to control such company”. Though technically not applicable to RIA change of control scenarios, many have looked to this percentage as a helpful guidepost regardless.

The fourth is SEC Rule 202(a)(1)-1, which states that “a transaction which does not result in a change of actual control or management of an investment adviser is not an assignment for purposes of section 205(a)(2) of the [Investment Advisers] Act”. This mainly applies to reorganizations, and the SEC cites a scenario in which an RIA changes its state of incorporation as one example of a transaction that would not constitute a change of control.

The fifth and final guidepost is several no-action letters that, though fact-specific to the complex transactions described therein, generally stand for the proposition that the SEC is ultimately concerned with the “trafficking” in investment advisory contracts to the detriment of investors. So long as there is no actual change in control or management of an RIA, the trafficking concern is moot.

Side bar about RIAs organized as partnerships: minority partners that are admitted to the partnership, die, or otherwise withdraw from the partnership do not trigger an advisory contract assignment. That said, any change in the membership of the partnership triggers a client notification obligation within a reasonable time.

This is all a tortuous way of saying that determining whether or not an advisory contract assignment or change in control has occurred may not be as straightforward as it seems. Complete lift-outs or cash-for-stock transactions are likely a no-brainer, but private equity infusions, partial buyouts and certain mergers likely require a more nuanced analysis.

The 25% voting security threshold is by analogy only, and higher or lower thresholds may very well be justified given the right facts.

When in doubt, simply send clients a negative consent to borderline control changes (assuming your advisory contracts permit negative consent) and let them decide whether or not to continue the advisory relationship.

This article originally appeared on October 28, 2016 in ThinkAdvisor .