April 18, 2013

The AdvisorAssist CCO Series: Advisory Agreements

All of your business development efforts come down to the point when a prospect reads and signs your advisory agreement. It is at this point where the wheels start turning: fiduciary duties, service delivery and, of course, revenue.

As both a legal contract and a regulatory requirement, you obviously depend on your agreements to mitigate or eliminate regulatory risk and professional liability. Yet advisory agreements serve many purposes beyond this utilitarian role. They codify your fiduciary duty, communicate your client’s rights and responsibilities, and they define the mutual understanding that underpin your relationship going forward.

Advisory Agreements In a Nutshell

It’s likely that your RIA offers a few different advisory services, each of which should have its own advisory agreement. These may include: wealth or portfolio management services with asset-based fees, financial planning with hourly or flat (project) fees, or consulting services (with hourly or flat fees.) Each of these agreements should include a number of required regulatory items (listed below.)

Please note that this list covers universal regulatory requirements. Based on your business model or home state, your firm’s agreements may require additional provisions.

Trading Authorization
This section describes the extent to which you have discretion to buy or sell securities on behalf of your clients. Your authority (or lack of authority) to place trades must be explained in the agreements you execute.

You must also include language about brokerage discretion. If you have discretion to select which broker(s) to use, you will be expected to document your efforts to achieve trade-level best execution. If you only “recommend” a broker/dealer, your agreements (and ADV) should reflect this. Your advisory agreement should also state the frequency in which clients will receive brokerage statements from the custodian.

A frequent source of confusion here is the difference between “custodian” and “broker/dealer.” For RIA firms “recommending” that their clients use a particular custodian, you are essentially recommending the broker/dealer affiliate of that custodian.

Advisory agreements should also describe additional trading-related practices, like trade aggregation (block trading), portfolio rebalancing, and responsibility for payment of commissions or ticket charges.

Proxy Voting
Your agreements should explicitly state whether you will vote proxies on behalf of your clients. And of course, this should be consistent with proxy voting practices delineated in your ADV and compliance manual.

Fee Methodologies
This includes the calculation method (e.g. percent of assets under management, fixed fee, hourly, in advance or arrears), how calculations are made, how frequently fees are calculated, and how you receive payment (e.g. directly from their account, directly from client.)

One of our previous posts discusses the custody implications of debiting fees directly from client accounts.

You must also include how you treat fees for partial billing periods and fee refunds, if you bill in advance.

Non-assignment Clause
Advisory agreements are non-assignable, in that they cannot be transferred to another advisor without written client consent. This client right should be disclosed. You must also note that you will notify clients of significant changes (>25%) in your firm’s ownership.

Termination Clause
Advisory clients must maintain the right to terminate agreements with written notice. (Your firm should also retain this right.)

Acknowledgement of ADV and Privacy Policy Delivery
By signing the advisory agreement, your client is acknowledging prior receipt of your Form ADV Part 2 and your firm’s Privacy Policy. Your agreements should note this clearly, while also clarifying the client’s privacy rights with respect to confidential information you obtain from them.

Through the Regulator's Eyes

Regulators expect to see consistency and accuracy among your advisory agreements, your regulatory filings. and your marketing materials. If they see outdated statements or inconsistencies between what your prospects rely on and what clients ultimately sign, they will be concerned.

Interestingly, SEC-registered advisors are not required to have written advisory agreements. State-registered firms, however do because virtually every state regulator requires written agreements. I mention this really as an interesting point of regulatory trivia (I understand if you don’t find it as interesting as I do!). Advisors should adopt a best practice of maintaining written agreements.

A recent regulatory concern involves advisory agreement clauses that mandate arbitration. The thinking behind this (which I happen to agree with) is that binding a client to arbitrate a dispute may not be in that client’s best interests, and therefore would be inconsistent with your fiduciary duty to place client interests first at all times.

Massachusetts has taken the lead in petitioning the SEC to ban pre-dispute mandatory arbitration clauses. While a ubiquitous practice among Finra-regulated registered representatives, we suspect that the day will come soon when mandatory arbitration is banned for RIA firms.

CCO Best Practices for Advisory Agreements

  • Don’t “borrow” language from another firm’s advisory agreement. Your agreements must be both internally consistent and in alignment with the language and declarations in your ADV.

  • Use a separate agreement for ongoing advisory services (both discretionary and nondiscretionary) as well as “project-based” services, like financial planning.

  • Maintain one set of agreements as “production versions” and store retired versions in your books and records files. Take steps to ensure that IARs are pulling from the production version.

  • Ensure that you track the delivery and receipt of advisory agreements and maintain a signed agreement for each client. Test the completeness of these files periodically.

  • Be clear about which types of accounts are included in the scope of each agreement. (e.g. brokerage, 401(k), etc.)

  • Don’t let concern about the length of your agreements get in the way of readability or completeness. Clients should understand that there is a heavy burden placed on their fiduciaries A two or three page agreement should not deter them from hiring you.

  • If you haven’t already, get in the habit of including the most recent version of your Form ADV Part 2 and Privacy Policy with each advisory agreement your deliver.

  • If you do have an arbitration clause in your agreements, confirm that it includes language to the effect that arbitration does not constitute a waiver of their right to seek a judicial forum for disputes.

The AdvisorAssist CCO Series is a collection of blog posts that cover each of the elements of your RIA's compliance program.  Each post will provide an overview of one compliance topic, including our insights on how regulators view each topic as well as some practical steps to help Chief Compliance Officers address this topic. As always, we would welcome your comments and thoughts.

Brian Lauzon


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