The investment advisory agreements entered into between an adviser and its clients serve as the principal documents governing the advisory relationship. Yet, all too often, we see advisers 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 advisers and clients. At the very worst, they expose the adviser to liability and can create unexpected legal or regulatory liability for the adviser that can cost an adviser a significant amount financially and lead to reputational harm.
In this article, we will summarize some of the most common mistakes we come across when reviewing client agreements and how such mistakes can cost an adviser. We will also highlight some helpful best practices when advisers put together their client agreements in order to make their lives easier and to reduce liability risk.
Common Mistakes in Client Agreements
Failing to Choose the Right Client Agreement for the Engagement
In some circumstances, we find that the client agreement entered into by the adviser and the client is the inappropriate type of agreement for the relationship. One example of when this occurs is when advisers are entering into advisory relationships with special types of clients (such as retirement plan sponsors) for specialized retirement plan services and instead utilizing the investment management agreement they use for clients for whom they manage assets through separately-managed accounts (IMAs). Such IMAs do not properly reflect the relationship between the adviser 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 adviser to incur unexpected fiduciary liability under ERISA. For instance, retirement plan agreements typically delineate whether the adviser is acting purely as an investment consultant (i.e., rendering services as a 3(21) fiduciary) or if the adviser 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 adviser by delineating what services the adviser WILL render as an ERISA fiduciary and which services are being rendered without the adviser acting as an ERISA fiduciary. Advisers 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, advisers 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.
Failure to Properly Define the Scope of Services with Specificity
One of the primary functions of a client agreement is to define the universe of services that an adviser will provide to its clients. In many circumstances, an adviser’s baseline agreement contains a litany of services the adviser offers to its entire universe of clients. For instance, an adviser may list all financial planning services offered by the firm in an agreement with clients. However, an adviser 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 adviser. These disputes can lead to potential liability if the client experiences losses as a result of mismatched expectations.
As such, advisers should be careful to only list those specific services that they fully expect to provide to clients in their advisory agreements. If the adviser agrees to provide additional services to clients, the adviser can always add those services to the agreement with the specific client.
Failing to Properly Define or Limit the Adviser’s Scope of Authority
While the vast majority of advisory agreements generally reflect the adviser’s general scope of authority when rendering advisory services to the client (e.g., discretionary authority or non-discretionary authority), advisers do not always account for the fact that they may not always exercise the same level of authority with respect to all of the client’s assets. For instance, an adviser 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 adviser 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 adviser may not have access to such assets in order to provide discretionary investment management services to the client. The adviser should make clear in its advisory agreement that, in such circumstances, the adviser 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 adviser’s recommendations with respect to such assets and for implementing the adviser’s recommendations, if accepted by the client.
Failing to clearly delineate when the adviser’s scope of authority is limited may lead to mismatched expectations with clients which could lead to legal disputes down the road.
Failing to Adequately Outline Client Responsibilities
Although advisory agreements primarily outline the adviser’s responsibilities when it comes to the engagement, clients clearly have a pivotal role to play in ensuring that the adviser can perform its services effectively on behalf of clients and to avoid making mistakes that can cost the client. For instance, in order for advisers to perform their services effectively, clients must provide accurate information and update advisers when their financial or personal circumstances change. Otherwise, the adviser, acting on bad information, will render advice that may not be in line with the client’s best interests. Yet, advisory agreements that fail to outline these client responsibilities inadvertently shift responsibility for client failure to the adviser (e.g., regulators and plaintiff attorneys may suggest that the adviser had the responsibility to verify that the client provided accurate and up-to-date information). As such, it’s vital that advisers clearly communicate their expectations as to the responsibilities that clients will fulfill in order to ensure that the adviser can effectively perform its services and avoid undue liability.
Failure to Clearly Pay Attention to Details Around Adviser Fees
While advisory agreements generally delineate the fees that clients will be responsible for paying to the adviser, 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 adviser 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 adviser may also adjust fees when a client adds assets or withdraws assets from the accounts being managed by the client.
While most advisers include provisions relating to fee adjustments in their client agreements, often these provisions are not clearly thought out as many advisers 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 adviser’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, in the course of 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, advisers 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 adviser’s responsibility for losses incurred by clients relating to the adviser’s provisions for its services except where the adviser 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.
The SEC has, through formal and informal guidance to advisers and through examinations, communicated that these clauses limiting an adviser’s liability confuse clients into thinking they are waiving rights under federal securities laws, and therefore, such clauses, when included in a client agreement, violate the adviser’s fiduciary duty to clients.
Therefore, advisers should ensure that their client agreements do not contain such hedge clauses or they could face regulatory risk.
Best Practices for Advisory Agreements
Below we highlight some best practices with respect to client agreements that can help an adviser achieve operational efficiencies and reduce regulatory risk.
First, under the Investment Advisers Act of 1940, client agreements for SEC-registered investment advisers must contain a clause requiring the adviser to obtain consent from clients in the event an adviser sells its practice or merges its business with another firm (where the client would be served by the new firm after the sale or merger). Advisers should ensure that such clauses are carefully drafted to avoid having to obtain written consent from the client in the event of a merger or acquisition because it can take longer to obtain written consents from each client in the midst of such a transaction, and some clients may not respond timely to such requests. This could potentially jeopardize the number of clients that are moved over to the acquiring adviser in connection with the transaction, which can cost the selling adviser financially.
By not requiring written consent to the assignment of the advisory agreement, advisers can simply obtain negative consents from clients in connection with any merger or acquisition whereby a client will be deemed to have consented to the assignment of its advisory agreement if the client does not object within a certain period of time. Obtaining negative consent is much more appealing to both selling advisers and purchasing advisers in a merger or acquisition, and so advisers should plan ahead and carefully craft assignment provisions in their client agreements if there is any possibility they could sell their practices in the future.
Second, advisers can include a provision in the client agreement requiring the client to consent to electronic delivery of documents. Most advisers typically prefer to send documents electronically (instead of through physical mail) to clients, but SEC rules require, among other things, that the adviser obtain consent from clients prior to sending documents electronically to the client. Including the consent to electronic delivery in the client agreement can help an adviser avoid having to obtain those consents separately from each client.
Third, as found in many advisory agreements, there should be representations whereby clients acknowledge the regulatory disclosures required to be provided to the client at the outset of the client relationship. These regulatory disclosures include the adviser’s Form ADV Part 2A disclosure brochure, any Form ADV Part 2B supplements for individual advisory employees that will render advisory services on the client’s behalf, the Form ADV Part 3 Client Relationship Summary (otherwise known as Form CRS), and the adviser’s privacy policy notice. Including a representation in the client agreement whereby the client acknowledges receiving such documents can help evidence the fact that the adviser delivered such documents to the client as required under applicable laws.
Conclusion
Client agreements do not have to be overly complex, but they do have to be sufficiently tailored to meet the expectations of the adviser and its clients and to help an adviser avoid unnecessary liability and operational headaches.
Therefore, it’s strongly advised that advisers should consult legal counsel experienced in preparing such agreements to ensure that the adviser’s interests are adequately protected.
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