Client Contracts

Now that you understand what advisers cannot promise, let's look at what advisory contracts must include. These contracts are heavily regulated because they define the terms of the fiduciary relationship.

What Must an Advisory Contract Include?

The NASAA model rule on advisory contract contents requires these specific terms to be provided in writing. It doesn't require the entire contract to be a single formal written instrument, just that these terms appear in writing:

Brochure delivery and specific renewal terms are separate obligations, not items the contract itself is required to spell out under this rule.

When Does a Change Count as an Assignment?

• An advisory contract cannot be assigned without the consent of the client or other contracting party. The rule requires consent, but doesn't specifically require that consent be in writing
• Assignment includes, but is not limited to, any transaction or event that changes who has the power, directly or indirectly, to direct the adviser's management or policies, or to vote more than 50% of any class of the adviser's voting securities, compared to who held that power when the contract was made. It also includes a direct or indirect transfer or hypothecation of the contract itself, or of a controlling block of the adviser's assets. There is no separate flat "more than 25%" trigger

Partnership rule:

• A change in the membership of an advisory partnership is treated as an assignment
• Exception: No assignment results when the partner(s) leaving or joining represent only a minority of the partnership's members and hold only a minority interest in the business. A change involving a majority of the partnership (by membership or by interest) is an assignment, even without a change in the firm's name

Exam Tip: Gotchas

• Partnership change = assignment, unless it's a minority change. A change involving only a minority of the members with only a minority interest does not require client consent (clients still get notified separately). A change involving more than half the partnership does require consent.
• The assignment trigger is more-than-50% voting power or management/policy control, not a 25% threshold. Don't teach a flat 25% number.
• Consent, not necessarily written consent. The rule requires the client's or other party's consent to an assignment; it doesn't specifically mandate that consent be in writing.

When Are Performance-Based Fees Allowed?

Performance-based fees are generally prohibited for most clients. Here's why and when exceptions apply.

What Is the General Rule?

• Advisers cannot charge fees based on capital gains or capital appreciation of the client's account
• This prevents advisers from taking excessive risks to boost their own compensation

Who Qualifies for the Exception?

Performance fees are permitted for a qualified client, which includes any of:

• A natural person or company with at least $1.4 million under the adviser's management (immediately after entering the contract), OR a net worth over $2.7 million (excluding primary residence); these thresholds are adjusted for inflation by the SEC every 5 years
• A qualified purchaser (a separate, higher standard used elsewhere in securities law)
• Certain adviser insiders: an executive officer, director, general partner, or similarly-situated person of the adviser, or a qualifying employee who participates in the adviser's investment activities
• For a private investment company, a registered investment company, or a business development company, each equity owner (other than the adviser) is generally treated as a separate "client" for this test

Required written disclosure to a qualified client paying a performance fee must cover: the risk-taking incentive the arrangement creates; whether compensation reflects unrealized appreciation as well as realized gains; the periods used to measure performance; the comparative index used and why it's appropriate; and, if compensation reflects hard-to-value securities, how those securities are valued.

Fulcrum Fee and Other Performance-Compensation Exceptions

• A performance fee charged to a qualified client does not have to be symmetrical: a share of gains only (such as carried interest) is permitted
• The fulcrum fee is a separate exception that applies to (a) a registered investment company (a mutual fund), or (b) any other client with a contract covering more than $1 million in assets. A fulcrum fee is symmetrical: the adviser's fee increases for outperformance and decreases for underperformance relative to a benchmark
• A further, separate exception lets a business development company pay a performance fee of up to 20% of realized net capital gains

How a fulcrum fee works:

• Adviser selects a benchmark (e.g., S&P 500)
• If the portfolio outperforms the benchmark → fee increases
• If the portfolio underperforms the benchmark → fee decreases by the same proportion
• The symmetry protects the client or fund's shareholders from one-sided incentive structures

Exam Tip: Gotchas

• Performance fees are off-limits for most clients. The qualified-client exception isn't just the two dollar tests: it also includes qualified purchasers and certain adviser insiders/employees.
• The fulcrum-fee (symmetrical) structure isn't limited to registered investment companies. It also covers any other client with more than $1 million under contract. A fund's fulcrum fee must move both ways: a fee that only rewards outperformance is not a valid fulcrum fee.
• BDCs have their own separate 20%-of-net-gains exception, distinct from the fulcrum-fee path.

What Does the NASAA Model Rule Add for State-Registered Advisers?

For state-registered advisers, the NASAA model rule on advisory contract contents sets out the required contract contents directly: services, term, fee and fee formula, prepaid-fee refund amount, discretionary-authority disclosure, the no-performance-compensation term, the no-assignment-without-consent term, and (for a partnership adviser) the membership-change notification duty.

These overlap significantly with federal IAA § 205 requirements but apply specifically to state-registered firms.

What Should You Check on Exam Day?

• Can you list every term that must be provided in writing (services, term, fees, prepaid-fee refund, discretionary authority, no performance compensation, no assignment without consent, partnership membership-change notice)? Do you know the rule doesn't require the whole contract to be one written document, and that brochure delivery is a separate obligation?
• Do you know assignment INCLUDES (but isn't limited to) a change in who controls management/policy or who can vote more than 50% of voting securities, plus a direct/indirect transfer or hypothecation of the contract, NOT a flat 25% threshold, and that consent (not necessarily written consent) is what's required?
• Can you state the partnership exception precisely: no assignment when the partners changing are only a minority of members holding only a minority interest?
• Do you know the general rule against performance-based fees and its qualified-client exception, including the non-dollar-threshold paths (qualified purchaser, adviser insiders/employees)?
• Can you state both qualified-client dollar thresholds ($1.4 million or more in assets under management with the adviser, or more than $2.7 million net worth excluding the primary residence)?
• Do you know a qualified-client performance fee can be gains-only, unlike a fulcrum fee, and what a qualified client must be told in writing about the fee arrangement?
• Can you explain when a symmetrical fulcrum fee is required (a registered investment company, OR any other client with more than $1 million under contract), and the separate BDC 20%-of-net-gains exception?
• Do you know what the NASAA Model Rule requires for state-registered advisers' contracts?