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The investment advisory agreements entered into between an advisor and their clients are the principal documents governing the advisory relationship. Yet we too often see advisors using templates provided by third parties that do not properly reflect their desired terms for their relationship with their clients.
At the very least, these mistakes can create confusion for advisors and clients. At the very worst, they expose the advisor to liability and can create unexpected legal or regulatory liability for the advisor that can cost a significant amount financially and lead to reputational harm.
In this article, I summarize some of the most common mistakes I come across when reviewing client agreements and how such mistakes can cost an advisor.
Choosing the wrong client agreement for the engagement
In some circumstances, we find that the client agreement entered into by the advisor and the client is an inappropriate type of agreement for the relationship. This occurs, for example, when advisors entering into advisory relationships with special types of clients (such as retirement plan sponsors) for specialized retirement plan services utilize the investment management agreement (IMA) they use for clients for whom they manage assets through separately managed accounts (SMAs).
Such IMAs do not properly reflect the relationship between the advisor and the retirement plan sponsor (including services to be provided), do not address the regulatory issues typically applicable to such relationships (such as prohibited transaction and other issues under ERISA), and can cause an advisor to incur unexpected fiduciary liability under ERISA. For instance, retirement plan agreements typically delineate whether the advisor is acting purely as an investment consultant (i.e., rendering services as a 3(21) fiduciary) or if the advisor is providing discretionary investment management services to the plan (i.e., rendering services as a 3(38) fiduciary). These retirement plan agreements also typically protect an advisor by delineating what services the advisor will render as an ERISA fiduciary versus which services are being rendered without the advisor acting as an ERISA fiduciary.
Advisors that enter into the wrong type of agreement can therefore trigger unexpected liability where the relationship with the retirement plan sponsor has not been clearly spelled out. Therefore, advisors should review with their attorneys the most appropriate agreement to use with different types of clients to ensure the proper type of advisory agreement is being utilized.
Failing to define the scope of services with specificity
One of the primary functions of a client agreement is to define the scope of services that an advisor will provide to its clients. In many circumstances, an advisor’s baseline agreement contains a litany of services the advisor offers to its entire universe of clients. For instance, an advisor may list all financial planning services offered by the firm in an agreement with clients. However, an advisor that fails to adequately tailor individual client agreements to only reflect the services offered to that specific client may find itself later embroiled in disputes if the client points to services that are listed in the agreement but have not been rendered by the advisor. These disputes can lead to liability if the client experiences losses as a result of mismatched expectations.
As such, advisors should be careful to only list those specific services that they fully expect to provide to clients in their advisory agreements. If the advisor agrees to provide additional services to clients, the advisor can always add those services to the agreement with the specific client.
Failing to define or limit the advisor’s scope of authority
While most advisory agreements reflect the advisor’s scope of authority when rendering advisory services to the client (e.g., discretionary authority or non-discretionary authority), advisors do not always account for the fact that they may not exercise the same level of authority with respect to all of the client’s assets.
For instance, an advisor may generally exercise discretionary authority to manage a client’s assets maintained with a custodian. However, the client may have other assets for which the advisor is rendering advisory services, such as assets held in a 401(k) plan or private fund assets held away from the custodian. In such circumstances, the advisor may not have access to such assets in order to provide discretionary investment management services to the client.
The advisor should make clear in its advisory agreement that, in such circumstances, the advisor does not have access to such assets and will therefore not be responsible for implementing any recommendation made with respect to such assets. Therefore, the client has sole responsibility for accepting or rejecting the advisor’s recommendations with respect to such assets and for implementing the advisor’s recommendations, if accepted by the client.
Failing to clearly delineate when the advisor’s scope of authority is limited may lead to mismatched expectations with clients, which could lead to legal disputes down the road.
Inadequately outlining client responsibilities
Although advisory agreements primarily outline the advisor’s responsibilities when it comes to the engagement, clients have a pivotal role to play in ensuring that the advisor can perform their services effectively on behalf of clients and to avoid making mistakes that can cost the client. For instance, in order for advisors to perform their services effectively, clients must provide accurate information and update advisors when their financial or personal circumstances change. Otherwise, the advisor, acting on bad information, will render advice that may not be in line with the client’s best interests.
Advisory agreements that fail to outline these client responsibilities inadvertently shift responsibility for client failure to the advisor (e.g., regulators and plaintiff attorneys may suggest that the advisor had the responsibility to verify that the client provided accurate and up-to-date information). As such, it’s vital that advisors clearly communicate the responsibilities that clients are expected to fulfill in order to ensure that the advisor can effectively perform their services and avoid undue liability.
Ignoring details around advisor fees
While advisory agreements generally delineate the fees that clients will be responsible for paying to the advisor, often details around adjustments to those fees are underappreciated and glossed over when preparing client agreements. For instance, in many client agreements, fee adjustments may occur if the advisor commences services on a day other than the first day of a billing period or terminates services on a day other than the last day of a billing period. An advisor may also adjust fees when a client adds assets or withdraws assets from the accounts being managed by the advisor.
While most advisors include provisions relating to fee adjustments in their client agreements, often these provisions are not clearly thought out. Many advisors do not have systems in place designed to ensure that these fee adjustments can be adequately enforced to ensure clients are being billed properly for the advisor’s fees.
Failing to adhere to all details outlined in the client agreement pertaining to fee billing can lead to regulatory as well as legal liability. In recent years, the SEC, while conducting exams of advisory firms, has been verifying that fees have been properly calculated and assessed based on the details contained in client agreements. Therefore, advisors should pay attention to client agreement language around fee billing adjustments to ensure that they can properly implement such arrangements before including such adjustments in client agreements.
Including prohibited hedge clauses in client agreements
Historically, most advisory client agreements have contained provisions that limit an advisor’s responsibility for losses incurred by clients relating to the advisor’s provisions for their services except where the advisor acted with gross negligence, willful misconduct, or bad faith. Often, the applicability of these provisions was curtailed by sentences communicating that these limitations on liability would not apply if the circumstances would cause the client to waive rights that are unwaivable under the federal securities laws.
Through formal and informal guidance to advisors and through examinations, the SEC has communicated that these clauses limiting an advisor’s liability confuse clients into thinking they are waiving rights under federal securities laws. Therefore, such clauses, when included in a client agreement, violate the advisor’s fiduciary duty to clients.
Therefore, advisors should ensure that their client agreements do not contain such hedge clauses or they could face regulatory risk.
Forgetting whistleblower protection provisions
Advisors often want to include confidentiality provisions in their advisory agreements to ensure clients do not use or disclose sensitive information as to how the advisor manages investments and performs other services. However, when drafted too broadly, such confidentiality provisions can create regulatory liability for the advisor.
The Securities Exchange Act of 1934 requires investment advisors to provide protection for employees and clients who wish to report compliance violations to the SEC. Confidentiality provisions that are drafted too broadly can be seen as restricting a client’s ability to report any compliance violations to the SEC, and the SEC has begun to sanction investment advisors for failing to provide adequate whistleblower protections in their client agreements.
Conclusion
Client agreements do not have to be overly complex, but they do have to be sufficiently tailored to meet the expectations of the advisor and its clients and to help an advisor avoid unnecessary liability and operational headaches.
Therefore, it’s strongly advised that advisors should consult legal counsel experienced in preparing such agreements to ensure that the advisor’s interests are adequately protected.
Richard Chen is a managing partner with Brightstar Law Group, a law firm that serves investment advisory firms by providing proactive business-minded solutions pertaining to corporate and securities-law-related matters. Among other things, our firm provides counsel with respect to securities and compliance matters (including representation in SEC examinations), private fund formation, corporate formation and structuring, business transactions (including M&A and joint ventures), contract drafting and negotiation, employment law matters, operational due diligence, and succession planning. For more information, please visit our website at www.brightstarlawgroup.com or call us at 917-838-7398.
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