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.
Advisory Contract Requirements
Every investment advisory contract must be in writing and include the following:
| Required Provision | Purpose |
|---|---|
| Description of services | What the adviser will do for the client |
| Fee schedule and compensation method | How much, how often, how calculated |
| Discretionary authority disclosure | Whether the adviser can trade without prior approval |
| Form ADV Part 2 delivery obligation | Adviser must deliver the brochure |
| Term, termination, and renewal provisions | How long the contract lasts, how to end it |
| No assignment without consent | Contract cannot be transferred without the client's written consent |
Assignment of Contracts
- An advisory contract cannot be assigned without the client's prior written consent
- Assignment includes:
- Any direct or indirect transfer of the contract
- Transfer of a controlling block of the adviser's voting securities (more than 25% = presumed control)
Partnership rule:
- A change in the membership of an advisory partnership constitutes an assignment
- Exception: The contract may provide otherwise, or the change may not be material to the advisory relationship
Exam Tip: Gotchas
- Partnership change = assignment. A change in partnership membership is treated as an assignment unless the contract says otherwise. This is a frequent exam question.
- 25% voting securities = presumed control. Any transfer of more than 25% of voting securities is presumed to be a change of control, triggering the assignment provision.
Performance-Based Fees
Performance-based fees are generally prohibited for most clients. Here's why and when exceptions apply.
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
The Exception: Qualified Clients
Performance fees are permitted for qualified clients, defined as individuals who meet either threshold:
- Assets under management with the adviser: $1.1 million or more (immediately after entering the contract)
- Net worth: more than $2.2 million
- These thresholds are adjusted for inflation by the SEC every 5 years
- Primary residence is excluded from the net worth calculation
Fulcrum Fee Requirement
- Performance fee arrangements must use a fulcrum fee structure
- A fulcrum fee is symmetrical - the adviser's fee increases for outperformance and decreases for underperformance relative to a benchmark
- This prevents advisers from profiting from gains without sharing in the pain of losses
How it 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 clients from one-sided incentive structures
Exam Tip: Gotchas
- Performance fees are off-limits for most clients. Only qualified clients ($1.1M AUM with the adviser OR more than $2.2M net worth, excluding primary residence) can be charged performance-based fees.
- Fulcrum fees must be symmetrical. The adviser shares in both gains AND losses relative to the benchmark. A fee that only rewards outperformance is not a valid fulcrum fee.
NASAA Model Rule
For state-registered advisers, the NASAA Model Rule specifies additional contract requirements:
- Must disclose all conflicts of interest
- Must disclose compensation arrangements
- Must include termination provisions
- Must include assignment restrictions (no assignment without client consent)
These overlap significantly with federal requirements but apply specifically to state-registered firms.