IA Compensation Restrictions

Broker-dealer compensation is priced per trade or per service. Investment adviser compensation raises a different concern: a fee tied to the client's investment gains can push the adviser toward outsized risk to inflate its own pay. The Uniform Securities Act addresses that specific incentive directly.

What Does the Performance-Fee Prohibition Require?

• Except as the Administrator permits by rule or order, it is unlawful for an investment adviser to enter into, extend, or renew an advisory contract unless the contract provides in writing that the adviser shall not be compensated on the basis of a share of capital gains upon, or capital appreciation of, the client's funds
• The word is "shall," not "may": the contract must contain this provision, it is not optional language
• The purpose is to prevent an adviser from sharing in client profits in a way that could reward excessive risk-taking

Exam Tip: Gotchas

The prohibition targets performance-based compensation tied to capital gains or appreciation, not fee amount generally. A larger fee is not automatically a violation; the trigger is whether the fee formula is pegged to the client's investment gains.

What Fee Structures Can an IA Charge Instead?

An AUM fee is not a performance fee even though it rises when the account grows. The prohibited structure is compensation tied to gains or appreciation, not compensation tied to total value.

Why Is a Fee Based on Total Asset Value Allowed?

• The performance-fee prohibition does not apply to an advisory contract that provides for compensation based on the total value of a fund averaged over a definite period, or as of definite dates
• For example, an adviser may charge 0.25% of the account's average total value each quarter. The percentage applies to the whole account, not just its investment gains
• The total-value exception does not require an external benchmark. The account can be valued over a stated period or on stated dates
• A fulcrum fee is a different structure: it adjusts compensation proportionately upward or downward for investment performance relative to a benchmark. Averaging account value alone does not make a fee a fulcrum fee

Exam Tip: Gotchas

A rising fee does not by itself establish a performance fee. Ask what the percentage applies to: total assets or investment gains. A deposit can increase an asset-based fee even when the investments have earned nothing.

When Can an IA Charge a True Performance Fee?

• The Administrator may, by rule or order, adopt exemptions from the performance-fee prohibition
• NASAA's model exemption rule permits a performance-fee contract in either of two situations:
  • The adviser is not registered and not required to register under the Act's registration provisions, or
  • The client is a qualified client and the adviser gives the required written disclosure
• Under federal law and SEC rules, a "qualified client" is generally:
  • A client with at least $1,400,000 in assets under management with the adviser, or
  • A client with a net worth of at least $2,700,000 (excluding the primary residence)
  • Qualified purchasers under the Investment Company Act, or knowledgeable employees of the adviser
• These dollar thresholds are periodically adjusted for inflation by SEC order
• Meeting the qualified-client threshold is not the only condition for a registered adviser. Unless Form ADV Part 2 already supplies the information, the adviser must give the client written disclosure of material performance-fee information
• The disclosure covers speculative-investment incentives, treatment of unrealized appreciation alongside realized gains, the measurement period, any comparative index, and valuation of hard-to-value securities

Exam Tip: Gotchas

Qualified-client status alone does not clear a registered adviser to charge a performance fee. The adviser still owes the client written disclosure of the performance-fee mechanics unless Form ADV Part 2 already covers it. A question that stops at "the client is a qualified client" without addressing disclosure has not shown a completed exemption. Separately, an adviser that is not registered and not required to register can use this exemption without meeting the qualified-client test at all.

What Terms Must Every Advisory Contract Include?

Beyond the compensation rules above, the advisory contract must be in writing. Two of its terms are favorite exam points:

• If a client pays a fee in advance, the contract must state the amount of any prepaid fee refunded on early termination or non-performance. The adviser cannot keep an unearned prepaid fee.
• Any grant of discretionary authority to the adviser must be written into the contract, not assumed from the client's conduct.

Exam Tip: Gotchas

A contract that leaves either term out is deficient. Watch for an answer choice that lets the adviser keep an unearned prepaid fee, or one that treats discretion as granted by conduct rather than in writing. Both are wrong.

What Else Must the Advisory Contract State?

Beyond those basic terms, two more provisions come up often on the exam: assignment and partnership changes.

When May an Adviser Assign the Contract?

• The contract must provide that the adviser may not assign it without the client's consent
• The client must actually consent. Advance notice, by itself, does not satisfy this requirement

What If the Adviser Is a Partnership?

• If the adviser is a partnership, the contract must provide that the adviser will notify the client of any change in the partnership's membership within a reasonable time after the change
• This duty is notice after the change, not consent before it

Exam Tip: Gotchas

Assignment takes consent before the transfer; a partnership membership change takes notice after it. An answer choice that says the adviser simply "notifies the client of the assignment" is wrong, because assignment needs consent.

What Should You Check on Exam Day?

• An advisory contract must state in writing that the adviser will not be compensated on a share of capital gains or appreciation, unless the Administrator has granted an exemption.
• An asset-based fee may use total value averaged over a stated period or measured on stated dates. Averaging does not turn it into a fulcrum fee; that structure adds a symmetrical adjustment for performance relative to a benchmark.
• A registered adviser using the qualified-client exemption still owes proper written disclosure. An adviser not registered and not required to register can use a separate exemption without needing a qualified client.
• The advisory contract must be in writing. It must refund any unearned prepaid fee on early termination or non-performance, and any grant of discretionary authority must be in writing.
• Assignment requires client consent; a partnership membership change requires notice within a reasonable time. The contract must state these obligations.