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.

What Fee Types Do Advisers Charge, and When Is Each Appropriate?

• 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

On the exam these fee and disclosure standards appear in the NASAA Unethical Business Practices of Investment Advisers, Investment Adviser Representatives, and Federal Covered Advisers Model Rule.

What Must Advisers Disclose About Their Compensation?

• 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
• Receiving commissions in addition to advisory fees is not banned. The violation is staying silent about it. Nondisclosure of a material conflict can also be called a fiduciary failure, but the NASAA model rule classifies it as an unethical business practice

When Are Performance-Based Fees Allowed?

General rule: Performance-based fees (fees tied to capital gains or appreciation) are prohibited for investment advisers under the Investment Advisers Act of 1940 contract requirements.

Exception (the qualified-client / performance-fee exemption): Permitted if the client is a "qualified client", meaning they meet at least one of the following (meeting more than one also qualifies):

• State-registered IAs also have an exemption available under the NASAA Performance-Based Compensation Exemption for Investment Advisers Model Rule. If not already disclosed on Form ADV Part 2, the adviser must disclose in writing:
  • That the fee arrangement may create an incentive to make riskier or more speculative investments
  • That the adviser may receive increased compensation based on unrealized appreciation, not just realized gains
  • The periods used to measure investment performance and their significance in computing the fee
  • The nature of any benchmark index used to measure performance, 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

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 $2,700,000 net worth threshold.
• The AUM test is assets under that specific adviser's management, not total net worth.
• The two tests use different words. The AUM test is at least $1,400,000, so exactly $1,400,000 qualifies. The net worth test is more than $2,700,000, so exactly $2,700,000 does not.

What Is a 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: For a registered investment company, an IA sharing in gains must also share proportionally in losses; gains-only performance arrangements are prohibited. This fulcrum-fee symmetry rule applies to registered investment companies specifically, not to every qualified-client performance fee arrangement.

What Is the Soft-Dollar 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.

What Conflict Do Soft Dollars Create?

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.

How Does the Safe Harbor Work?

The Securities Exchange Act of 1934 provides a safe harbor for soft dollar arrangements.

Three-step test for eligibility:

1. Determine the product or service is eligible research or brokerage
2. Determine it provides lawful and appropriate assistance in investment decision-making
3. Determine the commissions paid are reasonable relative to the value received

Eligible products/services under the safe harbor:

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)
• Long-term custody of client assets (only short-term custody tied to settling a trade qualifies)

Mixed-use items. Some research products also serve administrative needs. The adviser makes a reasonable allocation. The research share may be paid with soft dollars. The administrative share is paid with the adviser's own funds (hard dollars). The adviser keeps records of how it allocated. This rule splits a research service. It does not make general-purpose hardware eligible: a computer used 70% for research is still ineligible.

What Must Be Disclosed About Soft Dollars?

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.
• The statute lists "custody" as a brokerage function, but only short-term custody tied to settling a particular trade qualifies. Holding client assets long after settlement does not, and custody is never "research," which covers only advice, analyses, and reports.
• 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.

Can an Adviser Pay Someone for Client Referrals?

Yes, with conditions. An adviser can pay a promoter (a person who recommends the adviser for pay; older material calls this person a solicitor) for referring clients. The SEC Marketing Rule and the current NASAA model rule on unethical practices both allow it when the adviser meets all of these conditions:

An ineligible person is someone subject to a disqualifying event within the prior ten years. Examples include a felony conviction, a final regulatory order that bars or suspends the person from the securities industry, and a cease-and-desist order for a scienter-based fraud violation.

Think of it this way: Hiring a referral agent has two separate checks. First, tell the client about the deal. Second, check the agent's record. Passing the first check does not pass the second.

Exam Tip: Gotchas

• Client disclosure alone never makes a paid referral permissible. An adviser that pays a promoter with a disqualifying event in the prior ten years breaks the rule, even when the client knows about the payment and a written agreement exists.
• Cash is not the problem. A paid referral is allowed when every condition is met. Do not pick "solicitors can never be paid in cash" as the reason.
• Do not mix this up with the pay-to-play row on third-party solicitation. Pay-to-play limits payments to solicit government-entity business. The conditions above govern paid endorsements in general.
• The ineligible-person bar has a time limit. It reaches disqualifying events within the prior ten years, so read the date in the question.

What Are the 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.

What Does the SEC Pay-to-Play Rule Require?

The SEC adopted this rule under the Investment Advisers Act of 1940.

What Does the MSRB Pay-to-Play Rule Require?

• Similar pay-to-play rule for municipal securities dealers, adopted by the Municipal Securities Rulemaking Board (MSRB)
• The two-year ban is triggered by a contribution from the dealer, one of its municipal finance professionals, or a political action committee controlled by the dealer or a municipal finance professional; a contribution by a generic employee does not establish this trigger
• $250 per election de minimis, but only for a municipal finance professional who is entitled to vote for the official. The dealer itself and a political action committee get no de minimis allowance
• A contribution by the dealer or a controlled political action committee (any amount), or by a municipal finance professional to an official that professional cannot vote for (even $1), triggers a 2-year ban on municipal securities business with that entity

Exam Tip: Gotchas

• The SEC pay-to-play de minimis is two-tier: $350 per election for an official you can vote for, and $150 per election for one you cannot. A contribution above either tier triggers a 2-year ban.
• The MSRB de minimis is a single $250 per election. It applies only to a municipal finance professional who can vote for the official. The dealer itself has no allowance, and any contribution to a non-votable official triggers the ban.
• For the MSRB rule, identify the contributor. The dealer, a municipal finance professional, or their controlled political action committee can trigger the ban. The word "employee" alone is not enough.
• The exam may test the specific dollar amounts.
• A paid outside solicitor for government business must be a regulated person. The category list is investment adviser, broker-dealer, and municipal adviser, not only the first two. Registration alone is not enough: the solicitor must also fall under rules that restrict solicitation after political contributions. A signed referral agreement does not cure a solicitor outside every category.
• When a new hire becomes a covered associate, the look-back on their prior contributions is only 6 months if they will not solicit government clients, but the full 2 years if they are (or later become) a solicitor. Do not apply the 6-month figure to every new hire.
• A disqualifying contribution can still be cured: discovered within 4 months, $350 or less, and returned within 60 calendar days of discovery. A firm with more than 50 employees gets up to 3 of these cures per year; a firm with 50 or fewer employees gets up to 2. Do not confuse the cure's $350 cap with the $150 de minimis for non-votable officials; the cure applies regardless of which de minimis tier the contribution would otherwise fall under.
• The $350 cure cap is not redundant with the $350 de minimis. The de minimis tests the total given to one official per election. The cure tests the one contribution that triggered the ban.
• So the cure can rescue a contribution of $350 or less that the de minimis does not cover, for example when the contributor cannot vote for the official and gave more than $150, or when the contribution pushed the per-election total above the de minimis.

What Should You Check on Exam Day?

• All compensation arrangements must be disclosed in writing before advice is rendered; failing to disclose is an unethical business practice
• Performance-based fees are prohibited unless the client is a qualified client: at least $1,400,000 AUM with that adviser, or net worth over $2,700,000 (excluding primary residence), or a qualified purchaser, or a knowledgeable employee (officers/directors/general partners need no minimum tenure; a participating employee needs at least 12 months in that role)
• State-registered advisers relying on the NASAA Performance-Based Compensation Exemption must give written disclosure of the riskier-investment incentive, compensation on unrealized appreciation, measurement-period significance, and the benchmark index used
• Registered investment company performance fees must use a symmetrical fulcrum fee structure
• Soft dollars fall under the safe harbor only for eligible research and brokerage services that pass the three-step reasonableness test; hardware, salaries, rent, and marketing do not qualify
• Soft dollar arrangements must be disclosed on Form ADV Part 2A, Item 12
• SEC pay-to-play de minimis: $350 per election for an official you can vote for, $150 for one you cannot; both trigger a 2-year ban above the threshold
• New covered associate look-back: 6 months for a new hire who will not solicit government clients, 2 years for one who is or becomes a solicitor
• Returned contribution (cure) exception: discovered within 4 months, $350 or less, and returned within 60 calendar days; capped at 3 cures per year for a firm with more than 50 employees or 2 for a firm with 50 or fewer
• MSRB pay-to-play applies to the dealer, a municipal finance professional, or their controlled political action committee; only a municipal finance professional who can vote for the official gets the $250 de minimis
• Dual registrants (IA + BD) must disclose the capacity in which they act for each transaction