The purpose of compliance examinations is to determine whether RIAs are operating their businesses in accordance with the Investment Advisers Act, as well as the rules adopted to interpret the statute. Additionally, examiners attempt to ascertain whether RIAs are making full disclosure to existing and prospective clients. Examiners analyze RIAs’ policies and procedures to learn whether they are thorough, effective, and designed to protect investors. Policies and procedures should effectively address the RIA’s compliance risks.
The SEC has been criticized for not examining RIAs on a regular basis. On November 16, 2011, Carlo di Florio, the director of the SEC’s Office of Compliance Inspections and Examinations (OCIE), testified before a Senate subcommittee and stated that only eight percent of RIAs were examined in 2011. Furthermore, di Florio said that thirty-eight percent of SEC-registered investment advisors have never undergone an examination by the Commission. As we saw in Risk-Based Oversight of Investment Advisors, examinations are more likely to be prompted by tips, complaints, or aspects of an RIA’s business model that make it appear to pose a greater risk to investors. The SEC is more likely to examine a firm that is viewed as a higher risk.
State securities regulators have their own criteria for choosing which RIAs to examine. Many states are making a concerted effort to examine every advisory firm at least once every few years. Certainly, in almost every state, examinations are likely to be prompted by tips or complaints. A Pennsylvania compliance examiner recently said he will sometimes look at RIA advertisements to determine which firms to examine. If an advertisement is misleading or promises too much, the RIA may become the subject of an examination.
In preparation for a compliance examination, securities regulators will request numerous records. In almost all cases, they will ask to see copies of an RIA’s advisory agreements. The examination is likely to end badly if the RIA cannot produce a contract requested or if the firm’s records are incomplete. There will also be a problem if advisory contracts do not comply with applicable SEC or state rules.
Requirements for Advisory Contracts
If an investment advisor merely looked at the statute, the requirements for advisory contracts would seem to be relatively simple. Section 205(a)(1) of the Investment Advisers Act states that advisory contracts shall not:
- provide for compensation to the 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 to the contract; or
- 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.
These requirements ensure that clients do not enter an agreement that will jeopardize their well-being. For example, when an RIA is permitted to charge a fee based on performance, the advisor may put a client’s portfolio at risk in order to generate a better return. In Dealings With Qualified Clients and Accredited Investors, we will discuss situations where an RIA is permitted to charge a performance fee.
Examiners will scrutinize client agreements during examinations. Over time, these contracts may become outdated. Although the RIA’s fees and business model may have changed, a new advisory contract may never have been executed. Quite often, examiners uncover instances where contracts are inconsistent with regulatory requirements. Furthermore, the advisor may not be living up to the terms of the agreement.
The RIA’s advisory contract should state clearly if the firm has discretionary or non-discretionary authority. Obviously, RIAs should only take actions that are within the scope of the authority authorized by the advisory agreement. Clients grant an RIA authority to make trades on either a discretionary or non-discretionary basis. The contractual language might appear as follows:
By execution of this Agreement, Client hereby establishes an Investment Advisory Account (Account) and appoints Advisor as the investment manager to supervise and direct the investments of the Account on a discretionary basis. Accordingly, Advisor will solely assume all investment authority and investment decision making over the Account. Advisor shall have discretion to trade in securities and to execute transactions with respect to the Account assets without any obligation on its part to give prior notice to the Client or the Custodian.
By execution of this Agreement, Client hereby establishes an Investment Advisory Account (Account) and appoints Advisor as the investment manager to supervise and direct the investments of the Account on a non-discretionary basis. Accordingly, Advisor will seek client approval prior to placing orders for any transaction.
During the course of their relationship, a client might tell the advisor that it is not necessary to seek approval before a trade is made. If that occurs on an account managed on a non-discretionary basis, the advisory contract should be revised to reflect that change in the RIA’s authority. Otherwise, examiners will expect to find books and records showing that clients approved transactions in advance. It is important to note, however, that granting discretionary authority to an RIA does not mean the firm can buy unsuitable investments for a client.
Outdated Advisory Contracts
There are many circumstances in which contracts might become outdated. It is the CCO’s responsibility to ensure that all contracts comply with the latest rules and regulations. The CCO should also make certain that the firm’s practices are consistent with the agreement signed by the client. An RIA’s CCO should document that contracts were reviewed on a regular basis to determine that they still satisfy regulatory standards.
Regarding advisory contracts, investment advisors sometimes commit the same mistake that people make with their wills. They create a will and then forget about it for the next decade or two. In the interim, their life has changed dramatically, which means some unintended beneficiary may receive their estate.
Similarly, RIAs may be using an advisory contract that is outdated. The agreement may have been drafted months or years ago. The firm’s attorney and compliance department probably gave it their blessing. The agreement might even have been reviewed by an examiner during a previous compliance exam. Nevertheless, that document might now be noncompliant. For example, the firm or the client might want to change who is responsible for voting proxies.
It is also 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.
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 time frame, the RIA was charging a fee of one and a half percent per year. However, the advisory agreement specified that an advisory fee of one percent was owed. Therefore, the client was being overcharged.
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. If an RIA does not respond promptly that it has taken the requested action, the Commission might refer the file to the Division of Enforcement. An RIA should also revise its policies and procedures in order to prevent similar errors from occurring in the future.
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. A hedge clause is language in an investment advisory agreement that causes 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.
In a no-action letter to Heitman Capital Management LLC (publicly available February 12, 2007), SEC staff said 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 advisor 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; and
- whether the client was assisted by a sophisticated intermediary.
Based on this no-action letter, an RIA is likely to have violated its fiduciary duty if it used a hedge clause with an unsophisticated client without explaining its legal implications.
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 meeting specified 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 the deficiency letter against Heitman Capital discussed in the previous section and issued by the Atlanta Regional Office of the SEC, the RIA was criticized for entering into a number of different solicitation agreements, that did not require the solicitor to perform the necessary duties required by Rule 206(4)-3.
Language to Include in Advisory Contracts
There may also be specific language required by the state in which the advisor is registered. For example, Chapter 116.12 of the Texas Administrative Code requires that the following language be included in every advisory agreement:
“Client acknowledges receipt of Part 2 of Form ADV; a disclosure statement containing the equivalent information; or a disclosure statement containing at least the information required by Part 2A Appendix 1 of Form ADV, if the client is entering into a wrap fee program sponsored by the investment adviser. If the appropriate disclosure statement was not delivered to the client at least 48 hours prior to the client entering into any written or oral advisory contract with this investment adviser, then the client has the right to terminate the contract without penalty within five business days after entering into the contract. For the purposes of this provision, a contract is considered entered into when all parties to the contract have signed the contract, or, in the case of an oral contract, otherwise signified their acceptance, any other provisions of this contract notwithstanding.”
It is wise for advisory contracts to state that clients must notify the RIA if their goals or financial circumstances change. To protect the RIA, the contract should indicate that the firm is permitted to take action based on instructions from any client who signs the agreement. Otherwise, the RIA may find itself in a situation where one client objects to decisions made by another party to the contract.
The Big Picture
The North American Securities Administrators Association’s (NASAA) model rule entitled, “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 nonperformance. Contracts must also state whether discretionary power is granted. No assignment of the contract may occur without the consent of the other party. In addition, NASAA’s model rule 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.
Older advisory agreements may not address issues such as whether the client consents to electronic delivery of documents. Furthermore, for SEC-registered advisors and many state RIAs, there is no longer a requirement that new clients be given five days to terminate the contract after the inception of the agreement. As we saw in the previous section, however, states like Texas still retain the five day period during which clients may terminate an advisory contract without penalty.
In imposing these restrictions, securities regulators are ensuring that investors do not sign away protection in advisory contracts. The level of protection is higher for unsophisticated investors. As we will see in the Dealings With Qualified Clients and Accredited Investors, securities regulators permit certain investors to take on more risk in pursuit of higher returns.