Advisor Advocate - News & Information

Examiners Will Be Looking at RIAs’ Contracts for Regulatory Compliance

By:  Les Abromovitz, National Compliance Services, Inc.

Many advisory firms are using contracts that were drafted years ago. Over the years, however, the business model and advisory fees of the Registered Investment Adviser (RIA) may have changed. Therefore, it is important RIAs review their advisory agreements to ensure that they are consistent with the firm’s practices, as well as applicable rules and regulations.

Fee inconsistencies

In December 2010, the Chicago Regional Office of the SEC issued a deficiency letter to an RIA. One of the compliance problems found was an inconsistency between the RIA’s investment advisory agreement and the fee charged to a client. Examiners discovered that during a particular period, the RIA was billing a client at 1.5 percent per year. However, the advisory agreement specified that an advisory fee of one percent was owed.

The examination team also observed inconsistencies between the RIA’s advisory agreements and the firm’s billing practices. The RIA’s practice was to bill advisory fees quarterly in advance. The RIA’s advisory contracts, however, stipulated that fees would be collected in arrears at the end of each quarter.

In the deficiency letter, the RIA was instructed to review its other agreements to ensure that each client was billed at the rate stipulated in the contract. The RIA was also asked to reimburse the client who was overcharged. When the SEC asks an RIA to take certain action, it should do so promptly unless the firm disputes the findings.

Hedge clauses

According to Commission Release No. 40-58 (April 18, 1951), an RIA violates the Investment Advisers Act if the firm utilizes any legend, hedge clause or other provision that leads investors to believe they have waived any cause of action they might have under federal or state securities statutes. Including a hedge clause in an advisory agreement may cause clients to assume that they have given up a legal remedy to which they are entitled. Depending upon the facts and circumstances, a hedge clause may be considered misleading, which renders the contract void.

According to a no-action letter to Heitman Capital Management LLC (publicly available February 12, 2007), there are a number of facts and circumstances that help determine if a hedge clause is misleading such as:

  • Whether the client is sophisticated regarding legal matters
  • Whether the hedge clause was highlighted by the adviser and explained in person to the client
  • Whether enhanced disclosure was provided to explain situations where a client may still have a cause of action


  • Whether the client was assisted by a sophisticated intermediary

A recent deficiency letter issued by the SEC’s Atlanta Regional Office concluded that an RIA’s advisory agreements improperly used a hedge clause. The inclusion of this hedge clause was not consistent with the RIA’s fiduciary obligations, because the firm’s clients were unsophisticated regarding legal matters. Furthermore, the RIA’s solicitors did not highlight the hedge clause nor did they explain it to clients.

Performance fees

An RIA’s advisory contract should state explicitly if performance fees may be charged to a client. Section 205(a) of the Investment Advisers Act mandates that advisory contracts shall not:

  • Provide for compensation to an RIA 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
  • Fail to provide, in substance, that no assignment of a contract shall be made by the RIA without the consent of the other party


  • Fail to provide, in substance, that the RIA, if a partnership, will notify the other party to the contract of any change in the membership of the partnership within a reasonable time after the change occurs

Compensation based on capital gains or capital appreciation is usually referred to as performance fees.

Rule 205-3 provides an exemption from the performance fee prohibition of section 205(a)(1). The provisions of section 205(a)(1) do not prohibit an RIA from entering into, performing, renewing or extending an investment advisory contract that provides for performance-based compensation if the agreement is with a qualified client.

In May 2011, the SEC announced its plan to raise certain dollar thresholds that must be met before RIAs are allowed to charge their clients performance fees. Under the SEC’s proposed rule, a qualified client would be required to have $1 million invested with the RIA or a total net worth of $2 million. Previously, a qualified client was defined as a natural person or company with at least $750,000 under management of the RIA immediately after entering into the contract or a natural person or company that the firm believes has more than $1,500,000 in assets. The SEC also proposed to exclude the value of a client’s primary residence from the new net worth standard.

Some states prohibit the use of performance fee contracts by RIAs registered in their jurisdiction, even if the agreement is with a qualified client. In addition, certain states impose restrictions on performance-fee calculation methods.

Solicitor agreements

Pursuant to Rule 206(4)-3 under the Investment Advisers Act, RIAs must meet certain conditions if they pay cash compensation to solicitors. Among other requirements, fees must be paid pursuant to a written agreement, which meets certain conditions. The agreement must also require the solicitor to provide clients with the RIA’s latest disclosure brochure and a separate written disclosure statement containing the following information:

  • The name of the solicitor
  • The name of the RIA
  • The nature of the relationship, including any affiliation, between the solicitor and the RIA
  • A statement that the RIA will be compensating the solicitor for solicitation activities
  • The terms of the compensation arrangement


  • Any extra cost charged to the client, if any, if it is attributable to the existence of the solicitation arrangement

In that same deficiency letter issued by the Atlanta Regional Office of the SEC, the RIA was criticized for entering into a number of different solicitation agreements, which did not require the solicitor to perform the necessary duties required by Rule 206(4)-3.


The North American Securities Administrators Association’s (“NASAA”) model rule, “Unethical Business Practices Of Investment Advisers, Investment Adviser Representatives, And Federal Covered Advisers,” places a number of restrictions on advisory contracts. RIAs may not enter into, extend or renew an advisory contract that is not in writing. The contract must disclose the services to be provided, the term, the advisory fee, the formula for computing the fee and the amount of prepaid fee to be returned in the event of termination or non-performance. Contracts must also state whether they grant discretionary power. No assignment of the contract may occur without the consent of the other party. NASAA’s model rule also states that an advisory contract may not force a person to waive compliance with the Investment Advisers Act or a rule prohibiting unethical business practices.

Whether an RIA is SEC or state-registered, it is imperative that advisory contracts be consistent with Form ADV Part 2 disclosure brochures, which may have changed over the years. For example, if Form ADV Part 2 states that the RIA does not vote proxies on behalf of clients, the firm’s advisory agreement should be consistent on that point.

Older advisory agreements may not address issues such as whether the client consents to electronic delivery of documents. Furthermore, for SEC-registered advisers and many state RIAs, there is no longer a requirement that new clients be given five days after the inception of the agreement to terminate the contract.

Because NCS is not engaged in the practice of law, we can only offer advice from a regulatory or compliance perspective. You should engage an attorney who is licensed in your jurisdiction to review your advisory agreement to ensure that it complies with state law. It is also important to recognize that the best person to determine whether your advisory contracts are consistent with your business model is you.

Les Abromovitz, an attorney, can be reached at NCS by calling 561-330-7645, Ext. 213, or by e-mailing him at Les is the author of GROWING WITHIN THE LINES: THE INVESTMENT ADVISER’S ADVERTISING AND MARKETING COMPLIANCE GUIDE.

Article reprinted with permission from National Compliance Services, Inc. To learn more about NCS, please visit or the Scottrade Advisor Services Resource Center.

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