Client Contracts

Every investment adviser (IA) relationship starts with a contract, but the required contents depend on who regulates the adviser. The Investment Advisers Act of 1940 (IAA) sets a federal minimum for SEC-registered advisers. State-registered advisers face a broader set of requirements under the Uniform Securities Act (USA) and the NASAA Model Rule on advisory contracts (the NASAA Contents of Investment Advisory Contract Model Rule).

What Are the Required Contract Elements?

Federal law and state law do not impose the same requirements, and the exam tests the difference directly:

• Federal law (the IAA's advisory-contract requirements) applies to SEC-registered advisers. It requires only three things, and it does not require the contract to be in writing: no performance-based fee except for qualified clients (covered below), no assignment without the client's consent, and (for a partnership adviser) notice of membership changes.
• State law (the Uniform Securities Act and the NASAA Model Rule on advisory contracts) applies to state-registered advisers. It requires the entire contract to be in writing and adds five more disclosure elements on top of the three shared requirements: no performance fee except as permitted, no assignment without consent, and partnership notice.

Exam Tip: Gotchas

• "Non-performance" in the prepaid fee refund term is not about investment performance. It means the adviser did not perform the services the contract promised, so the unearned part of the prepaid fee goes back to the client. The performance fee ban is a separate row: it bars pay based on a share of the client's capital gains, and it has nothing to do with refunding a prepayment.

Think of it this way: A federal-covered adviser only has to hit the three IAA marks, and can even do it in an oral agreement. A state-registered adviser's written contract is the client's roadmap for the entire relationship: it tells them what they are getting, what it costs, who controls their money, and what happens if the firm changes hands. Every required element exists to protect the client from a specific type of harm.

What Counts as Assignment of the IA Contract?

Assigning the contract means transferring the adviser's side of it to a different adviser, as when the firm is sold or merged. Moving the client to another representative inside the same advisory firm is not an assignment, because the firm stays the party to the contract.

An advisory contract must provide that no assignment shall be made by the investment adviser without the consent of the other party.

What counts as assignment:

• Any direct or indirect transfer or hypothecation (pledge) of the contract
• Any direct or indirect transfer or hypothecation of a controlling block of the adviser's outstanding voting securities. The statute sets no percentage figure; the presumption used on Form ADV, and the number the exam tests, is a holding of 25% or more of a class of voting securities
• If an adviser is acquired or merges, this constitutes an assignment and client consent is required

The statute does not specify written consent; the contract itself defines whether consent must be affirmative or negative (failure to object).

How Does This Interact With the Partnership Notice Requirement?

A partnership adviser faces two separate tests. They use different measures, not one combined percentage:

• Voting-securities test (above): a transfer of 25% or more of a class of the adviser's voting securities is presumed to be a change of control, which is an assignment
• Partnership-membership test: a change in the partnership's membership is not an assignment only when the partners entering or leaving are both a minority of the members and hold only a minority interest in the business. A change involving a majority of the partnership, by headcount or by interest, is an assignment, even without a change in the firm's name
• Every partnership membership change, minority or majority, also triggers the separate notice duty: the contract must require notifying the other party within a reasonable time. A majority change adds the consent requirement on top of that notice

Exam Tip: Gotchas

• "Assignment" does not just mean physically handing over the contract. A transfer of a controlling block of voting securities is ALSO an assignment. If Firm A buys Firm B (an advisory firm), all of Firm B's client contracts are deemed "assigned" and clients must consent. This is heavily tested.
• The voting-securities test and the partnership test are independent. The 25% figure applies only to a transfer of voting securities. It plays no part in the partnership-membership test, which turns on whether the changing partners are a majority of members or hold a majority interest, not a fixed percentage. Small ownership changes do not add up toward either threshold.
• Notice and consent are not the same obligation. Every partnership membership change requires notice; only a majority (by members or by interest) change additionally requires consent.

What Is the Performance-Based Fee Prohibition?

Advisers generally may not charge fees based on a share of capital gains or capital appreciation (the performance-fee restriction in the IAA).

Exception for qualified clients (Securities and Exchange Commission (SEC) qualified-client thresholds):

A client qualifies by meeting at least one of these two tests (meeting both also qualifies, but neither is required in addition to the other):

Two more categories are qualified clients without meeting either test: qualified purchasers and knowledgeable employees of the adviser.

What Extra Duty Do State-Registered Advisers Face?

A state-registered adviser may charge a performance fee under the NASAA Performance-Based Compensation Exemption for Investment Advisers Model Rule. The model rule sets two conditions, and both must be met:

• The client is a qualified client, defined by the same federal rule and thresholds shown above.
• The adviser gives the client written disclosure of all material information about the arrangement, to the extent Form ADV Part 2 does not already disclose it. The disclosure includes:
  • That the fee may create an incentive to make riskier or more speculative investments than the adviser would make without a performance fee
  • Where relevant, that the adviser may earn more on unrealized appreciation, not only on realized gains
  • The periods used to measure performance and why they matter to the fee
  • The nature of any index used as a benchmark, its significance, and why the adviser believes it is appropriate
  • For compensation based partly on unrealized appreciation of securities with no readily available market quotations, how those securities are valued and how far the valuation is independently determined

The federal qualified-client exception has no matching written-disclosure duty. A state-registered adviser therefore meets the federal qualified-client test and the disclosure duty. This is why the federal standard is the more lenient one and the state standard is the stricter one.

Exam Tip: Gotchas

• If a question asks whether a performance fee is allowed, check: Is the client a qualified client?
• If a question compares federal and state performance-fee rules, the state rule is stricter. It adds written disclosure on top of the qualified-client test; it does not use a higher dollar threshold.
• A client with $900,000 in AUM and $3 million net worth (excluding primary residence) does qualify (meets the net worth test).

What Is the Prohibition on Waiver of Client Rights?

No advisory contract may require a client to waive any rights under:

• The Uniform Securities Act (USA)
• The Investment Advisers Act of 1940 (IAA)

Any waiver clause is void and unenforceable, regardless of whether the client agreed to it.

• Advisory contracts must not contain exculpatory clauses (also called hedge clauses) that waive fiduciary duties
• A client who signs a contract containing a waiver provision does not lose any legal protections
• The waiver clause itself is simply treated as if it does not exist

Exam Tip: Gotchas

• A signed waiver does not waive anything. Even if a client voluntarily agrees to waive their rights under the USA or IAA, that waiver is void. The client retains full legal protection regardless of what the contract says.

What Are Wrap Fee Programs?

Contracts for wrap fee programs must disclose additional information about bundled services and fees. A wrap fee bundles advisory services, trade execution, clearing, and custody into a single all-inclusive fee.

How it's billed: Like a standard asset-based advisory fee, a wrap fee is quoted as a percentage of assets under management (AUM) (e.g., 1.5% annually) and billed periodically against the account, typically quarterly.

There is no separate rule setting wrap-fee billing frequency; the exact schedule, and whether it is billed in advance or in arrears, is set by the adviser and must appear in the contract's fee schedule, the same required contract element that applies to any advisory fee.

How it compares to a normal (unbundled) advisory fee: A standard asset-based advisory fee pays only for advice. Trade execution, clearing, and custody are billed separately (commissions per trade, custodian fees, etc.). A wrap fee folds all of those costs into the single AUM-based rate, so the client writes one check instead of several.

Exam Tip: Gotchas

• Wrap fees are not always a good deal. Because the wrap rate is priced assuming a normal level of trading, a client who trades infrequently pays for bundled execution costs they barely use. That same client would often pay less under an unbundled advisory fee plus per-trade commissions.

What Should You Check on Exam Day?

• Federal requirements address performance fees, assignment consent, and notice of partnership membership changes without requiring a written contract. State advisers also need a written contract covering services, term, fees, prepaid-fee refunds, and discretion.
• Assignment requires consent for a controlling-block transfer or a majority partnership change; partnership notice is separate. The statute does not require written consent, and the contract addresses affirmative or negative consent.
• Qualified clients meet the $1,400,000 assets-under-management test or the net-worth test over $2,700,000 (excluding the primary residence), or are qualified purchasers or knowledgeable employees. The state rule adds written disclosure, so it is stricter.
• Clients cannot waive rights under the Uniform Securities Act or Investment Advisers Act. A signed waiver is still unenforceable.
• Wrap programs bundle advisory, execution, clearing, and custody services into an asset-based fee and require disclosure of the bundled services and fees.