Compensation
Because investment advisers (IAs) are fiduciaries, compensation arrangements require careful disclosure and sometimes client consent.
Think of it this way: When you pay a contractor to renovate your home, you want to know whether they charge by the hour, by the job, or receive kickbacks from suppliers. The same transparency principle applies to investment advisers. Clients deserve to know exactly how their adviser gets paid and whether any hidden incentives might influence recommendations.
Fee Types and When Each Is Appropriate
| Fee Type | Description | Key Considerations |
|---|---|---|
| Asset-based fees | Percentage of assets under management (AUM) (e.g., 1% annually) | Most common for IAs; aligns adviser interest with account growth |
| Hourly fees | Flat rate per hour of advice | Common for financial planning; no ongoing relationship required |
| Fixed/flat fees | Set dollar amount for a defined service | Must be disclosed in advance |
| Commissions | Per-transaction payments | Creates conflict of interest; must be disclosed if IA also receives commissions |
| Wrap fees | Single fee covering advice + execution + custody | Must disclose that client may pay more than purchasing services separately |
- An advisory fee is unreasonable if it is excessive relative to the services provided
- All compensation arrangements must be disclosed in writing before advice is rendered
Compensation Disclosure Requirements
- All forms of compensation must be disclosed in writing to clients
- Must disclose conflicts of interest arising from compensation arrangements (e.g., receiving commissions in addition to advisory fees)
- Dual registrants (IA + broker-dealer (BD)) must disclose the capacity in which they act for each transaction
- Failing to disclose compensation arrangements is an unethical business practice
Performance Fees: Qualified Clients Only (Investment Advisers Act Section 205)
General rule: Performance-based fees (fees tied to capital gains or appreciation) are prohibited for investment advisers.
Exception (Rule 205-3): Permitted if the client is a "qualified client":
| Qualification Method | Threshold | Key Detail |
|---|---|---|
| AUM Test | At least $1,100,000 in assets under the adviser's management | Assets under this specific adviser's management, not total net worth |
| Net Worth Test | Net worth exceeding $2,200,000 (excluding primary residence value) | Primary residence excluded from calculation |
| Qualified Purchaser | Meets the definition under the Investment Company Act (generally $5 million+ in investments) | Automatically qualifies |
| Knowledgeable Employee | Officers, directors, or employees who participate in the investment activities of the adviser | Internal personnel |
- State-registered IAs also have a Performance-Based Compensation Exemption available
Exam Tip: Gotchas
- The net worth test excludes the value of the primary residence. A client with a $3 million home and $1.5 million in other assets does NOT meet the $2,200,000 net worth threshold.
- The AUM test is assets under that specific adviser's management, not total net worth.
Fulcrum Fee
Performance-based fees must be structured as a fulcrum fee (symmetrical: adviser shares in both gains and losses relative to a benchmark) for registered investment companies:
- Outperform the benchmark: fee increases proportionally
- Underperform the benchmark: fee decreases proportionally
Symmetry requirement: An IA sharing in gains must also share proportionally in losses. Gains-only performance arrangements are prohibited.
Soft Dollars: Section 28(e) Safe Harbor
Definition: Arrangements where an IA directs client brokerage to a broker-dealer in exchange for research and brokerage services (rather than a cash rebate).
Think of it this way: Imagine your employer pays for all your office supplies with money from client fees. That's essentially what soft dollars are. The adviser gets free research by routing trades through a specific broker, but the client pays slightly higher commissions.
The Conflict
When an IA uses client commission dollars to pay for research, the IA receives a benefit (it doesn't have to pay for research itself), creating a conflict between the IA's interests and getting best execution for clients.
Section 28(e) Safe Harbor
Section 28(e) of the Securities Exchange Act of 1934 provides a safe harbor for soft dollar arrangements.
Three-step test for eligibility:
- Determine the product or service is eligible research or brokerage
- Determine it provides lawful and appropriate assistance in investment decision-making
- Determine the commissions paid are reasonable relative to the value received
Eligible products/services under the safe harbor:
| Category | Examples |
|---|---|
| Research | Research reports, financial analyses, seminars, portfolio analytics software, corporate governance research |
| Brokerage | Order execution, clearance and settlement, short-term custody for trade settlement, dedicated trading lines |
NOT eligible under the safe harbor:
- Office rent, furniture, or equipment
- Employee salaries or overhead
- Travel expenses
- Marketing or advertising costs
- Computer hardware (general purpose)
- Non-research software (accounting, word processing)
Disclosure Requirements
IAs must disclose soft dollar arrangements in Form ADV Part 2A (Item 12):
- Products, research, and services received
- Whether clients may pay higher commissions for research
- Whether research is used for all accounts or just those paying
- Procedures for directing transactions
Failure to disclose soft dollar arrangements is a breach of fiduciary duty.
Exam Tip: Gotchas
- A research report qualifies for the soft dollar safe harbor, but the computer used to read it does not. Hardware is a general business expense.
- Soft dollar arrangements create a conflict of interest because the adviser has an incentive to direct trades to brokers who provide soft dollar benefits rather than seeking best execution.
Pay-to-Play Rules
Pay-to-play - making political contributions to government officials to influence the awarding of advisory contracts for public pension funds and other government accounts.
Securities and Exchange Commission (SEC) Rule 206(4)-5 (Investment Advisers)
| Provision | Details |
|---|---|
| Two-year ban | Adviser cannot receive compensation for advisory services to a government entity for 2 years after the adviser or a covered associate makes a political contribution to an official who can influence the selection of the adviser |
| De minimis exception | Contributions of $350 or less per election to officials for whom the contributor is entitled to vote do not trigger the ban |
| Covered associates | General partners, managing members, executive officers, employees who solicit government entities, and their supervisors |
| Third-party solicitation | Cannot pay third parties to solicit government advisory business unless the solicitor is a registered BD or IA, and the solicitor is subject to pay-to-play restrictions |
Municipal Securities Rulemaking Board (MSRB) Rule G-37 (Municipal Securities Dealers)
- Similar pay-to-play rule for municipal securities dealers
- $250 per election de minimis for officials the contributor can vote for
- Any contribution to an official the contributor cannot vote for (even $1) triggers a 2-year ban on municipal securities business with that entity
Exam Tip: Gotchas
- The SEC Rule 206(4)-5 de minimis is $350 per election. The MSRB Rule G-37 de minimis is $250 per election. Both apply only when the contributor can vote for the official. Both impose a 2-year cooling-off period.
- The exam may test the specific dollar amounts.