Advisory agreements for Registered Investment Advisers (RIAs) contain many sections that are important both for the purposes of complying with SEC and state securities regulations, and for constituting a valid agreement between the RIA and the client.
In his latest article for the Nerd’s Eye View blog, Chris Stanley, investment management attorney and Founding Principal of Beach Street Legal, laid out the statutory requirements for RIA advisory agreements and what to include in the agreement when describing the RIA’s services and fees. In this follow-up guest post, Chris expands upon the best practices for drafting advisory agreements and covers numerous other essential elements for advisory agreements to contain, including identifying the client and effective date of the agreement, disclosure responsibilities for the RIA and client, the language around both parties’ rights and responsibilities in the event of a dispute, and how the agreement can be modified or terminated.
To start, the agreement should contain basic information about the adviser-client relationship, including who the client is (e.g., a single person, a couple, a business, or a retirement plan) and the date on which the agreement will become effective.
The agreement should also lay out some acknowledgments for the client to review. These include the acknowledgment that the adviser has provided required disclosure documents like Forms ADV Part 2A/B and Form CRS (and, importantly, has obtained consent to have those documents delivered electronically), acknowledgment of the client’s responsibilities to provide complete and accurate information needed by the adviser in a timely manner and to communicate any changes relevant that might affect the advice given by the adviser, and an acknowledgment that investment and financial planning recommendations involve risk and that there is no guarantee of future performance.
Another important section of the agreement concerns the resolution of disputes between the adviser and the client. While many IRAs include a clause in their advisory agreements limiting their liability in giving financial advice in good faith, the SEC and state regulators have recently been scrutinizing such ‘hedge clauses’ to the extent that they may be found impermissible going forward. At a minimum, the agreement should describe in detail how and where such disputes should be resolved (including which state’s laws the proceedings would be pursuant to).
Finally, the advisory agreement should include provisions for how it may be amended, modified, or terminated, as well as standard legal ‘boilerplate’ language and, of course, a space for the adviser and client to sign the agreement (either physically or electronically).
The key point is that, while the specific requirements for advisory agreements required by the Advisers Act may be fairly narrow in scope, in reality, there are many contractual best practices that advisers can follow to fully comply with Federal and state securities regulations. And even though many advisory agreement provisions can be standardized, agreements should still accurately reflect the advisory relationship with each client (meaning they shouldn’t be so broadly worded as to not reflect the specific services provided and fees charged by the adviser). And while it may not be necessary to have an attorney review every individual agreement signed by a client, it may be wise to obtain some legal advice to aid in the drafting of template agreements (especially given the many state-specific nuances in securities regulation that may diverge from the broad provisions of the Advisers Act).
Welcome to the ‘back nine’ of our 2-part discussion addressing the ins and outs of advisory agreement requirements and best practices. Readers who stayed on course during Part 1 of this article will have a firm grip on the statutory foundation laid by Section 205 of the Advisers Act as well as the core elements to be contained in an advisory agreement’s description of services and fees. Readers who instead only took a swing or two before directing their carts to the clubhouse bar are highly encouraged to go back to the tee box and wade through the front nine of Part 1 before making the transition to this one. If you’re not familiar with golf colloquialisms, I promise not to take any more shots at the pin for the rest of this article.
Before diving into some of the key points and best practices concerning advisory agreement requirements, there are two important reminders to bear in mind:
First, state securities regulators often impose different or additional requirements and restrictions with respect to advisory agreements used with their 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. This article should certainly not be construed as encompassing each state’s whims in this regard, but I will endeavor to flag sections in which state rules and regulations will likely vary.
Second, even though this discussion offers contractual best practices and drafting techniques, these are topics squarely within an attorney’s bailiwick and should not be construed as legal advice.
Advisory Agreement Basics
While understanding the requirements set forth by Section 205 of the Investment Advisers Act along with the guidelines around describing the firm’s fees and services is important for understanding how to develop a well-crafted advisory agreement, there are additional factors for advisers to consider when creating or reviewing their firms’ advisory agreements as discussed below. (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.)
Identify The Client
This may seem obvious, but it is crucial to specifically identify who the client is. Are they a single natural person? A joint agreement between two spouses? A separate business organization like a corporation or a limited liability company? A retirement plan?
If there are to be multiple natural person clients (such as joint account holders, spouses, or domestic partners), consider adding language that clarifies that the adviser will be rendering advice and/or managing accounts based on the joint and collective goals of such multiple individuals.
Also, consider describing whether the adviser can act on account-related instructions provided by just one of the joint clients or if both joint clients must jointly instruct the adviser. As a fiduciary, an adviser cannot favor one joint client to the detriment of the other joint client, so this language can be particularly helpful in the event that joint clients later separate or divorce or otherwise become adversarial.
To the extent that a retirement plan itself is the client (such as a multi-participant 401(k) plan), the advisory relationship should not be swept under the same advisory agreement that the adviser has utilized for the natural person owner(s) of the business sponsoring such retirement plan. In other words, a retirement plan should not be a joint client of a natural person and should be recognized as a distinct legal organization separate and apart from its natural person owners (even if the adviser is working with both the business owner as a client and their employer retirement plan).
In addition, the specific legal and fiduciary nuances inherent in the Employee Retirement Income Security Act of 1974 (ERISA) would necessitate untenable gerrymandering in the advisory-agreement-drafting process as to when ERISA would and would not apply. In short, advisers should relegate multi-participant ERISA plan relationships to a separate, ERISA-specific advisory agreement.
Identify The Effective Date
The effective date of an agreement is the date that the agreement first becomes legally binding on its parties. In the context of an advisory agreement, the effective date generally reflects the official inception of the advisory relationship, the date from which fees can be calculated, and the date that a prospect converts to a client.
The effective date can either be hard-coded (i.e., write the actual date in the opening paragraph of the agreement itself) or be referred to as the date the advisory agreement is signed by the adviser (assuming the client signs the agreement first and the adviser’s final signature is the last in the sequence that consummates the contract).
Adviser And Client Disclosure Responsibilities Alongside Advisory Agreements
Disclosure Document Delivery
All advisers (hopefully) know that they are required to deliver their Form ADV Part 2A, Form ADV Part 2B, Privacy Notice, and Form CRS (to retail investors) before or at the time the adviser enters into an advisory agreement with that client. While it is important to maintain a record that demonstrates when such disclosure documents have been delivered to clients, the advisory agreement itself should also contain a short representation or acknowledgment by the client that the client has received all such disclosure documents in a timely manner.
Specifically, requiring the client to initial and date such acknowledgment of receipt may be beneficial in situations where such disclosure documents are hand-delivered or when there is no other record to prove that documents were actually delivered. Using a modern digital signature service (e.g., HelloSign) can be an alternative option to asking clients to initial and date acknowledgment of receipt of disclosure documents, as they will generally provide a time-stamped audit trail to prove document receipt.
However, bear in mind that the advisory agreement should also explicitly include the client’s consent to electronic delivery of disclosure documents, as such electronic delivery consent is still technically required under hilariously old SEC guidance dating back to 1996. Similarly, it’s not a bad idea to include a section that specifically authorizes the use of electronic signature services and the permissibility of a digital signature in lieu of an actual ‘wet’ signature.
An advisory relationship is a two-way street, and the adviser’s advice is often wholly contingent upon the client’s full and fair disclosure of various documents and information upon which the adviser will rely. The advisory agreement should therefore set clear expectations for and require certain representations from the client. For example, such expectations and representations could include the following:
- Providing the adviser with complete, current, and accurate information in a timely manner, with the understanding that the adviser will be relying on such information without independent verification.
- Reviewing the adviser’s disclosure documents provided by the adviser, the qualified custodian, and applicable product sponsors.
- Informing the adviser in a timely manner of any changes to the client’s financial situation that may affect the advice that the adviser renders or the way in which the adviser manages the client’s account(s).
- Informing the adviser of any restrictions to be imposed with respect to the securities or other investment products to be held in the client’s account(s) (e.g., not investing in certain industries, securities, countries, etc.).
The bottom line here is that investment advice is not rendered in a vacuum, and it should be incumbent on the client to provide the adviser with the information it needs to act in the client’s best interest.
Financial Exploitation Reporting
Notwithstanding the fact that financial exploitation reporting requirements can vary from state to state (some states require advisers to report reasonably-suspected financial exploitation of certain vulnerable adults, e.g.), advisers should consider including a contractual provision that expressly permits the adviser to report any incidences of such reasonably-suspected financial exploitation for the client’s benefit (for example, to a state securities regulator and/or state adult protective services agency). Such a provision can also grant the adviser the authority to temporarily delay disbursements from the client’s account(s) if such disbursements are reasonably believed to be in furtherance of such financial exploitation. Again, state law will vary on this particular nuance.
To take the protection of potentially vulnerable clients one step further, an adviser might also consider adding an optional “Trusted Contact Form” to the end of its advisory agreement that lists a confidant or advocate that the adviser is authorized to communicate with about the client in the event the adviser has concerns about financial exploitation, diminished capacity, or other erratic financial behavior.
Disclosure Of Risks
Though an adviser need not cut and paste the risk disclosures from Item 8 of its Form ADV Part 2A (which requires advisers to provide a narrative description of their Methods of Analysis, Investment Strategies, and Risk of Loss) into its advisory agreement, there should be at least some disclosure that all investment and financial planning recommendations involve risks that the client should be prepared to bear, and that the adviser cannot and does not guarantee any future performance.
This can also be a place for the adviser to disclaim the risks associated with a client self-directing trades in their account(s), as such rogue trading can conflict with the adviser’s investment approach or otherwise jeopardize the adviser’s ability to achieve the asset allocation, risk profile, or other portfolio objectives.
When Things Go Wrong – Preventing, Mitigating, And Managing Adviser Liability
Limitation Of Liability
While it should be fairly noncontroversial for an adviser to contractually limit its liability for the acts of certain third parties (e.g., a custodial broker-dealer’s trade error) and the client’s own actions (e.g., the client’s self-directed trading), the extent to which an adviser can limit liability for its own actions (via what’s known as a ‘hedge clause’) has recently started to garner more SEC attention.
A hedge clause is a contractual provision that purports to limit one party’s potential liability to the other party. Historically, liability limitation provisions have commonly been included as part of advisers’ standard advisory agreements (typically in a section entitled “Limitation of Liability” or something along those lines). For example, an adviser’s existing advisory agreement may contain language purporting to limit the adviser’s liability to “gross negligence” or “willful disregard,” perhaps followed by a statement that the client is not waiving any rights that the client may have under state and/or Federal securities laws.
The SEC’s extreme skepticism with respect to hedge clauses is beginning to come to light. The use of an improper hedge clause was cited as part of a recent settlement involving Comprehensive Capital Management in January 2022, and the SEC’s Division of Exams even cited “potentially misleading” hedge clauses that “may not align with [advisers’] fiduciary duty” in the January 2022 Private Fund Risk Alert and the November 2021 Electronic Investment Advice Risk Alert.
SEC Exam staff have also apparently been scrutinizing hedge clauses in the course of recent routine adviser exams. Though the roots of the SEC’s renewed skepticism can be traced back to the SEC’s Interpretation Regarding Standard of Conduct for Investment Advisers, more of the iceberg now appears visible above the surface.
While the above-referenced January 2022 settlement should not necessarily be viewed as an indication that all limitation of liability clauses will result in an enforcement proceeding in isolation (there were other alleged ADV misstatements, books and records failures, and compliance failures cited in the settlement), when viewed in combination with the recent Risk Alert, Standard of Conduct Interpretation, and general word on the street, it seems clear that advisers should reconsider any language in their advisory agreements that may be viewed as an impermissible hedge clause.
Regardless of how an adviser may want to contractually thread this needle, it would still be prudent to include language making it clear that state and Federal securities laws impose liabilities under certain circumstances on persons who act in good faith, and that nothing in the advisory agreement shall in any way constitute a waiver or limitation of any rights, which a client may have under any state or Federal securities laws.
Dispute Resolution & Choice Of Law
If a client relationship breaks down and one of the parties desires to seek recovery from the other for an alleged loss, the advisory agreement should describe in reasonable detail how and where such disputes are to be resolved and pursuant to which state’s laws.
The parties can theoretically agree to any number of combinations in this regard (e.g., arbitration in St. Louis, Superior Court in Los Angeles County, Bob’s E-Z Mediation in Kissimmee, etc.), but generally, the venue, forum, and choice of law should have some nexus to the parties to the agreement.
The dispute resolution clause can also be structured as a ‘waterfall’, such that the parties first try to resolve the dispute in good faith among themselves. If that doesn’t work, the parties can next try to resolve the dispute through mediation (which is voluntary). If mediation doesn’t result in a settlement, the last stop can be either binding arbitration or court.
Regardless of how disputes are to be resolved, a good dispute resolution clause should at least address the following:
- The city or county where the dispute is to physically be resolved (e.g., Dade County);
- The forum in which the dispute is to be resolved (e.g., arbitration or court);
- If mediation is an option, who pays for the mediation (e.g., split 50/50); and
- Which state’s laws will apply (e.g., Arkansas).
To be even more granular with respect to arbitration, the dispute resolution clause can even specify the arbitration organization (e.g., JAMS or the American Arbitration Association), how many arbitrators are to oversee the arbitration (e.g., a single arbitrator or multiple arbitrators), and how arbitrators are to be selected (e.g., jointly via nomination or mutual agreement).
Changing And Terminating The Agreement
Amendment & Modification
Generally speaking, an agreement may not be amended or modified without the mutual consent of parties to such agreement. An advisory agreement is no exception.
However, much like the earlier section regarding consent to the assignment of an advisory agreement, the question again becomes how such consent to an amendment or modification must be obtained. The agreement should specify whether any amendment or modification may only be effective upon the express written consent of the parties or, alternatively, whether the adviser may amend or modify the agreement via passive/negative consent upon advance written notice to the client.
The termination provision in an advisory agreement has two primary objectives:
- Describing how a party can terminate the agreement and with how much advance notice (if any); and
- Describing how fees will be prorated through the date of termination.
As a general rule, requiring a terminating party to provide the non-terminating party with notice of termination a certain number of days in advance of its effectiveness (e.g., 30 days advance written notice) is not advisable. If a client or an adviser wants to exit a toxic advisory relationship, he or she should be able to do so immediately, without requiring a potentially awkward number of days to elapse between when notice of termination is provided and when the termination is actually effective.
Regardless of whether any advance notice of termination is required, such notice should be in writing and should include a specific effective date (e.g., “termination will be effective as of the date a party’s notification of termination is provided in writing”) to avoid ambiguities of when the adviser’s obligation to manage accounts or render advice has ceased, and through what date fees should be prorated.
If the client has paid fees in advance in consideration of any period after the termination date, the portion of the fees attributable to the period of time after the termination date should be promptly refunded to the client.
If the adviser charges in arrears and, at the time of termination, hasn’t yet charged the client fees for the period of time before the termination date, the adviser may charge the client the prorated amount of such fees. However, the advisory agreement should clearly describe how fees are prorated at termination to avoid any ambiguity.
An advisory agreement (like any good agreement) should contain standardized boilerplate language that addresses the miscellaneous contractual formalities that are otherwise not captured in the prior sections. This boilerplate should address the following, if not otherwise addressed earlier in the advisory agreement:
- The manner in which the parties are to provide each other ‘notice’ of the exercise of certain contractual rights (e.g., termination of the agreement, initiation of adversarial proceedings, etc.). This clause typically includes the full mailing and email addresses of the parties and describes whether notice must be provided by certified mail, email with a confirmation of delivery, etc.
- A savings/reformation clause that ‘saves’ the agreement from being terminated in its entirety if only certain provisions of the agreement are deemed to be invalid, illegal, or unenforceable. This clause can also allow for the agreement to be ‘reformed’ (i.e., modified) to the extent necessary to make the agreement not invalid, illegal, or unenforceable.
- A statement that the advisory agreement is the sole and entire agreement between the parties and that it supersedes any prior agreements, oral discussions, etc.
Both the adviser and the client should sign the agreement. Signatures may be obtained the old-fashioned way with a pen and ink, but electronic signature services are generally fine as well. The Federal Electronic Signatures In Global and National Commerce Act (ESIGN) of 2000 affords legal enforceability to electronic signatures, but it’s not a bad idea to include a provision in the advisory agreement that makes it clear that electronic signatures will have the same legal effect as a wet signature.
If you really want to be persnickety (like me), consider adhering to the following formatting guidelines (which are generally applicable to any legal agreement):
- Include the page number and the total number of pages in the agreement on all pages (e.g., “Page 6 of 7”). This makes it easier to reference certain provisions and to identify whether any pages are missing.
- For similar reasons as the above, enumerate each section and subsection (e.g., Section 1, Section 2, paragraph (a), paragraph (b), etc.).
- If you don’t otherwise have a version control system built into your document management system, include a version date so it is readily apparent when the agreement was last updated.
- The signatures for all parties should fit onto a single page and not be broken up into separate pages unless such pages are specifically identified as signature pages.
- If the body text of the agreement ends midway through a page such that a large white space remains below it, include a statement along the lines of “The remainder of this page has intentionally been left blank.” If the signature page follows on the next page, state that fact. (This helps to clarify that nothing from the agreement was removed after the fact to create that empty white space.)
- Be very careful with pronouns and informal references to the parties. Ideally, each party would be identified in the opening paragraph and assigned its own shorthand definition. For example, “XYZ Wealth Management and Financial Planning Services LLC” could be abbreviated to “XYZ” or “Adviser,” and that shorthand abbreviation can be used in the rest of the agreement instead of the laborious recitation of the entire legal name. Similarly, the client’s name can be ascribed the shorthand “Client”. If the agreement uses terms like “you”, “your”, “we”, “us”, or “our”, be sure to clarify the identity to whom such terms should be ascribed.
CFP Board guides CFP certificants to have an Engagement letter and provides sample letters that CFP professionals can tailor to fit their particular circumstances, which can also support a more formal legal advisory agreement. Furthermore, CFP professionals should be familiar with the contents of CFP Board’s Code of Ethics And Standards Of Conduct, with particular attention given to Sections 10(a) and 10(b) when providing financial advice or providing financial planning, respectively.
One of the most common questions I’m asked by advisers as it relates to advisory agreements goes something like this: “My advisory agreement seems really long and I don’t want to intimidate my clients. Can you shorten it to just a page or two but still make sure I’m protected?”
I generally respond by very politely explaining in some form or another that you can’t have your cake and eat it too. While an agreement’s length is certainly not directly proportional to its validity or effectiveness, there is a ‘Goldilocks sweet spot’ that strikes the right balance between unnecessarily long, complex, and verbose on the one hand, and impractically short, informal, and incomplete on the other.
The ultimate goal of an advisory agreement (or any agreement, for that matter) is to script the desired outcomes of the parties with reasonable certainty that, regardless of whether everything goes according to plan or not, the parties need to part ways (either amicably or not).
One way to crack the Goldilocks paradox with respect to an advisory agreement could be, for example, to include the services, fees, and signature lines front and center on the first page with some marketing flourish, and then to include the other terms and conditions on the pages that follow as an exhibit of sorts.
Ultimately, an agreement is part art and part science. By better understanding the key components of an advisory agreement and some of the best practices used, advisers will be able to find the happy medium between the two that works most effectively for them.