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Investment Advisers Act of 1940 Definition, Overview

Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

Katrina Ávila Munichiello is an experienced editor, writer, fact-checker, and proofreader with more than fourteen years of experience working with print and online publications.

What Is the Investment Advisers Act of 1940?

The Investment Advisers Act of 1940 is a U.S. federal law that regulates and defines the role and responsibilities of an investment adviser .

Prompted in part by a 1935 report to Congress on investment trusts and investment companies prepared by the Securities and Exchange Commission (SEC), the act provides the legal groundwork for monitoring those who advise pension funds, individuals, and institutions on matters of investing. It specifies what qualifies as investment advice and stipulates who must register with state and federal regulators in order to dispense it.

Key Takeaways

• Financial advisers must adhere to the Investment Advisers Act of 1940, which calls on them to perform fiduciary duty and act primarily on behalf of their clients.
• The Act imposes upon the adviser the “affirmative duty of ‘utmost good faith’ and full and fair disclosure of material facts” as part of their duty to exercise client loyalty and care.
• Investment advisers are required to pass a qualifying exam and register with a regulatory body as part of the Act.

Understanding the Investment Advisers Act of 1940

The original impetus of the Investment Advisers Act of 1940, as with several other landmark financial regulations of the 1930s and 1940s, was the stock market crash of 1929 and its disastrous aftermath, the Great Depression . Those calamities inspired the Securities Act of 1933 , which succeeded in introducing more transparency in financial statements and establishing laws against misrepresentation and fraudulent activities in the securities markets.

In 1935, a SEC report to Congress warned of the dangers posed by certain investment counselors and advocated the regulation of those who provided investment advice. The same year as the report, the Public Utility Holding Act of 1935 passed, allowing the SEC to examine investment trusts.

Those developments prompted Congress to begin work not only on the Investment Advisers Act but also the Investment Company Act of 1940 . This related bill clearly defined the responsibilities and requirements of investment companies when offering publicly traded investment products, including open-end mutual funds, closed-end mutual funds, and unit investment trusts.  

Financial Advisers and Fiduciary Duty

Investment advisers are bound to a fiduciary standard that was established as part of the Investment Advisers Act of 1940 and can be regulated either by the SEC or state securities regulators, depending on the scale and scope of their business activities.

The act is very specific in defining what a fiduciary means. It stipulates a duty of loyalty and duty of care , which means that the adviser must put their client's interests above their own.

For example, the adviser cannot buy securities for their account prior to buying them for a client ( front-running ) and is prohibited from making trades that may result in higher commissions for the adviser or their investment firm ( churning ). It also means that the adviser must do their best to make sure investment advice is made using accurate and complete information—basically, that the analysis is thorough and as accurate as possible.

Additionally, the adviser needs to place trades under a " best execution " standard, meaning that they must strive to trade securities with the best combination of low-cost and efficient execution.

Avoiding conflicts of interest are important when acting as a fiduciary. An adviser must disclose any potential conflicts and always put their client's interests first.

Establishing Adviser Criteria

The Investment Advisers Act addressed who is and who is not an adviser by applying three criteria: what kind of advice is offered, how the individual is paid for their advice or method of compensation, and whether or not the lion's share of the adviser's income is generated by providing investment advice (the primary professional function). Also, if an individual leads a client to believe they are an investment adviser—by presenting themselves like that in advertising, for example—they can be considered one.

The act stipulates that anyone providing advice or making a recommendation on securities (as opposed to another type of investment) is considered an adviser. Individuals whose advice is merely incidental to their line of business may not be considered an adviser, however. Some financial planners and accountants may be considered advisers while some may not, for example.

The detailed guidelines for the Investment Advisers Act of 1940 can be found in Title 15 of the United States Code.

Generally, only advisers who have at least $100 million of assets under management or advise a registered investment company are required to register with the SEC under the Investment Advisers Act of 1940.

Registration as a Financial Adviser

The agency with whom advisers need to register depends mostly on the value of the assets they manage, along with whether they advise corporate clients or only individuals. Before the 2010 reforms, advisers who had at least $25 million in  assets under management  or provided advice to investment companies were required to register with the SEC. Advisers managing smaller amounts typically registered with state securities authorities.

Those amounts were amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 , which allowed many advisers who previously registered with the SEC to now do so with their state regulators because they managed less money than the new federal rules required. However, the Dodd-Frank Act also initiated registration requirements for those who advise private funds, such as hedge funds and private equity funds. Previously, such advisers were exempt from registration, despite often managing very large sums of money for investors.

U.S. Congress. " Investment Advisers Act of 1940 ," Pages 1, 7. Accessed Aug. 23, 2021.

U.S. Congress. " Investment Advisers Act of 1940 ," Page 33. Accessed Aug. 23, 2021.

Office of the Federal Register. " Federal Register, Vol. 51, No. 187, 17 CFR Part 275 ," Page 34229. Accessed Aug. 23, 2021.

U.S. Congress. " Investment Advisers Act of 1940 ," Pages 7-9. Accessed Aug. 23, 2021.

U.S. Congress. " Public Utility Holding Company Act of 1935 ," Page 2. Accessed Aug. 23, 2021.

U.S. Congress. " Investment Company Act of 1940 ." Accessed Aug. 23, 2021.

U.S. Securities and Exchange Commission. " Compliance Issues Related to Best Execution by Investment Advisers ," Pages 1-2. Accessed Aug. 23, 2021.

U.S. Securities and Exchange Commission. " Churning ." Accessed Aug. 23, 2021.

U.S. Congress. " Investment Advisers Act of 1940 ," Page 3. Accessed Aug. 23, 2021.

U.S. Code. " 15 USC Chapter 2D Subchapter II: Investment Advisers ." Accessed Aug. 23, 2021.

Electronic Code of Federal Regulations. " Part 275—Rules and Regulations, Investment Advisers Act of 1940 ." Accessed Aug. 23, 2021.

U.S. Securities and Exchange Commission. " Transition of Mid-Sized Investment Advisers From Federal to State Registration ," Pages 1-2. Accessed Aug. 23, 2021.

U.S. Securities and Exchange Commission. " SEC Adopts Dodd-Frank Act Amendments to Investment Advisers Act ." Accessed Aug. 23, 2021.

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August 17, 2022 07:07 am 1 Comment CATEGORY: Regulation & Compliance

Executive Summary

Registered Investment Advisers (RIAs) are generally required to enter into an advisory agreement with their clients prior to being hired for advisory services. And while there is no standard ‘template’ language applicable to all advisory agreements, there are a number of best practices that RIAs can follow in drafting and reviewing their agreements to ensure they can pass legal and regulatory muster.

In this guest post, Chris Stanley, investment management attorney and Founding Principal of Beach Street Legal, lays out the statutory requirements for RIA advisory agreements and some of the essential elements for advisory agreements to include when describing the RIA’s services and fees.

Advisory agreements for SEC-registered RIAs are governed by Section 205 of the Investment Advisers Act of 1940. In terms of specific advisory agreement language, the Advisers Act focuses essentially on three items:

• First, the law restricts RIAs from charging performance-based fees unless the client is a “qualified client” (in most cases, a client with at least $1.1 million under the management of the adviser, or with a total net worth of at least $2.2 million);
• Second, advisory agreements are required to give clients the opportunity to consent to their advisory agreement being ‘assigned’ to another adviser (including when an RIA changes ownership by merging with or being acquired by another firm); and
• Third, advisory agreements of RIAs organized as partnerships are simply required to contain a clause informing the client of any change in the membership of that partnership “within a reasonable time after such change”.

But even though the specific requirements of the Advisers Act are relatively narrow in scope, a well-crafted advisory agreement will contain additional elements, including descriptions of the RIA’s services and fees.

When describing the RIA’s services, advisory agreements should lay out the specific services – such as discretionary or nondiscretionary asset management, and the scope and duration of any financial planning services – to be included in the arrangement.

When it comes to fees charged to clients, advisory agreements should include – at minimum – the exact amount of the fee (either as a dollar amount or percentage of assets under management), when the fee will be charged, how the fee will be prorated at the beginning and end of the agreement, how the client can pay the fee, and which of the client’s accounts may be billed. For AUM-based fees, agreements should also include breakpoints for multi-tiered fee schedules (and whether breakpoints are applied on a ‘cliff’ or ‘blended’ basis) and how AUM is calculated (and whether it is based on assets at a single point in time or averaged over a specific period, and if it includes cash and/or margin balances). Any fees for third-party advisers or subadvisers should also be described in the agreement. While these constitute only two core elements of advisory agreements, there are numerous other essential components for RIAs to include (so many, in fact, that covering them all will require another separate article!).

The key point, however, is that a good advisory agreement requires a solid grasp of the Federal and state statutory requirements, and clearly lays out the RIA’s services and fees. For established firms, understanding these points more deeply will allow RIA owners to review their existing agreements – to ensure not only that they comply with existing regulations, but that they also include the elements constituting a valid agreement between RIA and client!

Author: Chris Stanley

Chris Stanley is the Founder of Beach Street Legal LLC, a law firm and compliance consultancy that focuses exclusively on legal, regulatory compliance, and M&A matters for registered investment advisers and financial planners. He strives to provide simple, practical counsel to those in the fiduciary community, and to keep that community ahead of the regulatory curve. When he’s not poring over the latest SEC release or trying to meet the minimum word count for a Nerd’s Eye View guest post, you’ll find Chris enjoying the outdoors away from civilization. To learn more about Chris or Beach Street Legal, head over to  beachstreetlegal.com .

Read more of Chris’ articles  here .

As unbelievable as it may be, the Investment Advisers Act of 1940 and the rules thereunder don’t require client advisory agreements to be in writing.

Technically speaking, an oral understanding that is never memorialized to a written instrument may be deemed a valid means by which a client can retain an SEC-registered investment adviser to render advice and other services in exchange for compensation. My son’s T-ball league requires that I sign a written agreement waiving every conceivable right I have (and some I didn’t know I had) before he even steps out onto the diamond, yet the fiduciary act of managing someone’s life savings is not deemed statutorily worthy of the same written memorialization.

I cannot emphasize the following enough, though: I do not advocate or endorse oral agreements in lieu of written agreements. This is partially due to my personal marital experience of never remembering what I agreed to do with or for my wife during casual conversations (don’t worry, she remembers everything ), but also because it invites revisionist history of what was actually agreed to between client and adviser, and a resultant battle of he-said, she-said, that never ends well.

In addition, from a practical perspective, professional malpractice insurance carriers, custodians, potential succession partners, and most clients would likely shy away from an adviser that isn’t prepared to sign on the dotted line. It also should be noted that most, if not all, state securities regulators require that client advisory agreements be in writing, so state-registered advisers can simply ignore everything written above.

Whether oral or written, though, Section 205 of the Advisers Act imposes specific requirements and restrictions upon client advisory agreements, most of which are dedicated to the logistics of charging performance fees . Still, in order to comply with Section 205, there are many contractual best practices and drafting techniques that advisers (even those not charging performance fees) can use in the course of updating or replacing their existing advisory agreement(s).

Importantly, state securities regulators often impose different or additional requirements and restrictions with respect to advisory agreements used with their respective state’s constituents. Any state-registered adviser that has the misfortune of enduring multiple different state registrations has likely experienced this first-hand during the registration approval process. While each state’s whims will not be reviewed in this article, sections in which state rules and regulations will likely vary will be flagged.

Lastly, the contractual best practices and drafting techniques offered here are topics squarely within an attorney’s bailiwick. While they are meant to help advisers better understand and comply with advisory agreement requirements, they should not be construed as legal advice.

Editor’s Note: Because of the sheer volume of information related to advisory agreement requirements, this article has been divided into 2 parts. Part 1 will focus only on the statutory requirements of Section 205 of the Advisers Act, as well as the ‘core’ elements of any advisory agreement: a description of the adviser’s services and fees. Part 2 will address the additional considerations that should be made in any advisory agreement. Each part is intended to be read in conjunction with the other, so as to provide a holistic view of a robust and complete advisory agreement.

Section 205 Of The Advisers Act On Investment Advisory Agreements

Relative to the Advisers Act as a whole, Section 205 is fairly short and is the sole section dedicated to “investment advisory contracts”. It focuses on essentially three items:

• charging performance-based fees;
• client consent to the assignment of the agreement; and
• partnership change notifications.

Section 205(f) is also the section of the Advisers Act that reserves the SEC’s authority to restrict an adviser’s use of mandatory pre-dispute arbitration clauses (i.e., that require clients to agree to settle disputes through arbitration before any disputes even arise) – an authority that has yet to be exercised.

Charging Performance-Based Fees

The primary takeaway from Section 205 regarding performance-based fees is that an advisory agreement cannot include a performance-based fee schedule unless the client signing the agreement is a “qualified client”, as such term is defined in Rule 205-3(d)(1) .

A qualified client includes a natural person or company that:

• Has at least $1.1 million under the management of the adviser immediately after entering into the advisory agreement;
• Has a net worth of at least $2.2 million immediately prior to entering into the advisory agreement; or
• Is a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 at the time the client enters into the advisory agreement.

Qualified clients also include executive officers, directors, trustees, general partners, or those serving in a similar capacity to the adviser, as well as certain employees of the adviser.

Notably, the Dodd-Frank Act requires the SEC to adjust the dollar amount thresholds in the rules set forth by Section 205 every 5 years. The SEC’s most recent inflationary adjustment to these dollar thresholds was released in June 2021 .

For a more fulsome explanation of the restrictions imposed on advisers that charge fees “on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client” (i.e., performance-based fees), refer to this article and the rulemaking history described therein.

The dollar thresholds triggering “qualified client” status may differ in certain states, as the automatic inflationary adjustments made by the SEC do not automatically apply to the states. In other words, state securities rules may include a different definition of what constitutes a qualified client, and/or still be using ‘prior’ thresholds not in line with more recent SEC adjustments. This poses a potentially awkward scenario in that a particular client may be charged a performance fee while an adviser is state registered, but not if the adviser later transitions to SEC registration.

Client Consent To Assignment

Section 205(a)(2) prohibits advisers from entering into an investment advisory agreement with a client that “fails to provide, in substance, that no assignment of such contract shall be made by the investment adviser without the consent of the other party to the contract.” In other words, an advisory agreement must, without exception, afford the client the opportunity to consent to his or her advisory agreement being “assigned” to another adviser.

An “assignment” of an agreement occurs when one party transfers its rights and obligations under the agreement to a third party not previously a signatory to the agreement. The new third-party assignee essentially stands in the shoes of the assigning party to the agreement going forward, and the assigning party is no longer considered a party to the agreement. In the context of an adviser-client relationship, an adviser that assigns its rights and obligations to another adviser is no longer the client’s adviser… such that Section 205(a)(2) requires the client to acquiesce to such a change.

Notably, an assignment to a new “adviser” in this context is in reference to the investment adviser (as a firm), not necessarily to a new investment adviser representative within the firm. Still, though, Section 202(a)(1) broadly defines an assignment to include “any direct or indirect transfer or hypothecation of an investment advisory contract by the assignor or of a controlling block of the assignor’s outstanding voting securities by a security holder of the assignor […]”. There are a few more sentences specific to partnerships in the definition, but the general concept of the “assignment” definition is that there are essentially two situations in which an assignment is deemed to have occurred:

• When advisory agreements are transferred to another adviser or pledged as collateral; or
• The equity ownership structure of an adviser changes such that a “controlling block” of the adviser’s outstanding voting securities changes hands.

Both scenarios described above would trigger the need for client consent.

Transferring Advisory Agreements To Another Adviser

A transfer of an advisory agreement from one adviser to another most commonly arises in the context of a sale, merger, or acquisition of one adviser by another (which is also often the case upon the execution of a succession plan).

If Adviser X (the ‘buyer’) is to purchase substantially all of the assets of Adviser Y (the ‘seller’) – including the contractual right to become the investment adviser to the seller’s clients going forward – the seller’s clients must either sign a new advisory agreement with the buyer, or otherwise consent (either affirmatively or passively) to the assignment of their existing advisory agreement with the seller to the buyer.

Controlling Block Of Outstanding Voting Securities

With respect to the second scenario contemplated by the Section 202(a)(1) definition of assignment, the logical next question is: what constitutes a “controlling block?” Unfortunately, the Advisers Act does not define what a “controlling block” is, but based on various sources, including the Adviser Act itself, Form ADV, SEC rulings and no-action letters, and the Investment Company Act of 1940 (a law applicable to mutual funds and separate from the Investment Advisers Act of 1940), we can reasonably conclude that such control is having at least 25% ownership or otherwise being able to control management of the company.

Thus, the logistics of client consent to assignment need to be considered both in adviser sale/merger/acquisition scenarios and in adviser change-of-control scenarios. To come full circle, the existing advisory agreement signed by the client must provide that the adviser can’t assign the advisory agreement without the consent of the client.

Importantly, Section 205(a)(2) does not contain the word “written” before the word “consent,” and does not define what constitutes consent. Must the client affirmatively take some sort of action to provide consent to an assignment, or is the client’s failure to object to an assignment within a reasonable period of time sufficient?

If the existing advisory agreement does require the client’s written consent to an assignment, the assignment cannot occur until the client physically signs something granting his or her approval (i.e., “positive” consent). If the existing advisory agreement does not require written consent, an assignment may automatically occur if the client fails to object within the stated period of time after being notified (i.e., “negative” or “passive” consent). If the existing advisory agreement does not address the assignment consent issue, though, it does not meet the requirements of the Advisers Act.

The important takeaway for SEC-registered advisers, however, is that negative/passive consent is generally permissible in the context of an assignment, so long as the advisory agreement is drafted appropriately. The SEC affirmed this view through a series of no-action letters from the 1980s, which were later reaffirmed in further no-action letters from the 1990s (see, e.g., American Century Co., Inc. / J.P. Morgan and Co. (Dec. 23, 1997) .

Many states prohibit negative/passive consent assignment clauses and require clients to affirmatively consent to any assignment. Texas Board Rule 116.12(c), for example, states that “The advisory contract must contain a provision that prohibits the assignment of the contract by the adviser without the written consent of the client.”

Negative/passive ‘consent to assignment’ clauses should afford the client a reasonable amount of time to object after receiving written notice of the assignment (which ideally would be delivered at least 30 days in advance of the planned assignment). The clause should also make it clear to the client that a failure to object to an assignment within X number of days will be treated as de facto consent to the assignment.

Partnership Change Notifications

The third Section 205 provision with respect to advisory agreements is specific to advisers organized as partnerships and simply requires that advisory agreements contain a clause requiring the adviser to notify the client of any change in the membership of such partnership “within a reasonable time after such change.”

Disclosing Services And Fees In Advisory Agreements

With an understanding of the requirements set forth by Section 205 of the Investment Advisers Act, advisers can now supplement those requirements with additional best practices and techniques when creating or reviewing advisory agreements. Two key considerations include providing a good description of the firm’s services and fees. (Established advisory firms may wish to pull out a copy of their own advisory agreement and read through the sections of their own agreement as they explore the sections discussed below.)

Describing The Firm’s Services

The first keystone component of an advisory agreement (or any agreement) is a complete and accurate description of the services to be provided by the adviser in exchange for the fee paid by the client. The exact nature of services will naturally vary on an adviser-by-adviser basis, but good advisory agreements should account for at least the following services:

If rendering asset management services:

• For discretionary management services, include a specific limited power of attorney granting the adviser the discretionary authority to buy, sell, or otherwise transact in securities or other investment products in one or more of the client’s designated account(s) without necessarily consulting the client in advance or seeking the client’s pre-approval for each transaction. For non-discretionary management services, state that the adviser must obtain the client’s pre-approval before affecting any transactions in the client’s account(s).
• Clarify whether the adviser’s discretionary authority extends to the retention and termination of third-party advisers or subadvisers on behalf of the client.
• Consider provisions that discourage or restrict the client’s unilateral self-direction of transactions if they will interfere or contradict with the implementation of the adviser’s strategy (e.g., that the client shall refrain from executing any transactions or otherwise self-directing any accounts designated to be under the management of the adviser due to the conflicts that may arise).
• Consider identifying the account(s) subject to the adviser’s management by owner, title, and account number (if available) in a table or exhibit, noting that the client may later add or remove accounts subject to the adviser’s management so long as such additions and removals are made in writing (or pursuant to a separate custodial LPOA form). This is particularly important if some accounts are to be managed on a discretionary basis and others are to be managed on a non-discretionary basis (or if some of the client’s accounts will be unmanaged).
• Identify any client-imposed restrictions that the adviser has agreed to (e.g., not investing in certain companies or industries).

If rendering financial planning services:

• Describe whether the rendering of financial planning services is for a fixed/limited duration (e.g., if the adviser is simply engaged to prepare a one-time financial plan, after which the agreement will terminate) or whether the financial planning relationship will continue indefinitely until terminated. For ongoing financial planning service engagements, either describe what financial planning services will be rendered on an ongoing basis or consider preparing a separate financial planning services calendar . Advisers can either limit financial planning topics to an identifiable list (if the adviser and/or client want to be very prescriptive in the scope of the relationship) or generally describe that the adviser will render advice with respect to financial planning topics as the client may direct from time to time (if the adviser and/or client want to keep the scope of potential financial planning topics open-ended).
• Clarify that the adviser is not responsible for the actual implementation of the adviser’s financial planning recommendations and that the client may independently elect to act or not act on the adviser’s recommendations at their sole and absolute discretion. Even though the adviser may assume responsibility for discretionary management of a client’s investment portfolio, the client remains ultimately responsible for actually implementing any separate financial planning recommendations that the adviser cannot implement on behalf of the client.

Just as important as a description of the services to be provided by the adviser is a description of the services not to be provided by the adviser. While it is impossible to identify by exclusion everything the adviser won’t be doing, it is best practice to clarify that the adviser is not responsible for the following activities if not separately agreed to:

• Rendering legal, accounting, or tax advice (unless the adviser is also a CPA, EA, or has otherwise specifically agreed to render accounting and/or tax advice).
• Advising on or voting proxies for securities owned by the client (unless the adviser has adopted proxy voting policies and procedures and will vote such proxies on the client’s behalf).
• Advising on or making elections related to legal proceedings, such as class actions, in which the client may be eligible to participate.

To the extent that the client is a retirement plan (such as a 401(k) plan), it will be important to distinguish what plan-specific services will be provided and whether the adviser is acting as a non-discretionary investment adviser (under Section 3(21)(A)(ii) of ERISA) or a discretionary investment manager (under Section 3(38) of ERISA) , and what specific plan and/or participant related services are being provided by the adviser.

The nuances of ERISA-specific plan agreements are beyond the scope of this article, but suffice to say that plan agreements should generally be relegated to a separate agreement and should not be combined with a natural-person business owner’s standard advisory agreement, as discussed above.

Advisory Fees

The second keystone component of an advisory agreement, and the one most likely to be scrutinized by SEC exam staff, is the description of the adviser’s fees to be charged to the client. Advisory fees have justifiably received a lot of regulatory attention recently, and advisers should consider reviewing the November 2021 SEC Risk Alert which describes how advisers continue to drop the ball in this respect, from miscalculating fees to failing to include accurate (or sometimes any) disclosures, to lapses in fee-billing policies and procedures and reporting.

At a minimum, an advisory agreement should describe the following with respect to an adviser’s fees:

• The exact fee amount itself (e.g., an asset-based fee equal to X%, a flat fee equal to $X, and/or an hourly rate equal to $X per hour).
• The frequency with which the fee is charged to the client (e.g., quarterly or monthly).
• Whether the fee is charged in advance or in arrears of the applicable billing period (e.g., monthly in advance or quarterly in arrears).
• How the fee will be prorated for partial billing periods, both upon the inception and termination of the advisory relationship.
• How the fee will be payable by the client (e.g., via automatic deduction from the client’s investment account(s) upon the adviser’s instruction to the qualified custodian, or via check, ACH, credit card, etc., upon presentation of an invoice to the client).
• If all fees are to be charged to a specific account and not prorated across all accounts under the adviser’s management, the identity of the account(s) that are the ‘bill to’ accounts. Fees can only be payable from a qualified account(s) specifically for services rendered to such qualified account(s) (e.g., fees associated with a client’s taxable brokerage account should not be payable by the client’s IRA).

Asset-Based Fees

Specifically, with respect to asset-based fees, advisory agreements should include the following:

• Whether fees apply to all client assets designated to be under the adviser’s management and whether the client will be entitled to specific asset breakpoints above which the fee will (typically) decrease.
• If the fee starts at 1.00% per annum but then decreases to 0.70% per annum if the client maintains a threshold amount of assets under the adviser’s management, clarify whether the 0.70% fee amount applies to all client assets back to dollar zero (i.e., a cliff schedule), or only to the band of assets above a certain threshold, with assets below that certain threshold charged at 1.00% (i.e., a blended or tiered schedule).
• If fees are calculated upon assets measured at a single point in time, identify whether fees will be prorated at all for any intra-billing period deposits or withdrawals made by the client.

For example, if fees are payable quarterly in advance based on the value of the client’s assets under the adviser’s management as of the last business day in the prior calendar quarter, will the client be issued any prorated fee refund if the client withdraws the vast majority of his or her assets on the first day of the new quarter? In other words, if the billable account value is $1 million on day one of the billing period but the client immediately withdraws $900,000 on day two of the billing period (such that the adviser is only managing $100,000, not $1 million, during 99% of the billing period), is the client afforded any prorated refund?

Conversely, if fees are payable quarterly in arrears based on the value of the client’s assets under the adviser’s management as of the last business day of the quarter, will the client be charged any prorated fee if the client withdraws the vast majority of his or her assets on the day before the adviser bills? In other words, if the adviser manages $1 million of client assets for 99% of the billing period but the client withdraws $900,000 on the last day before the billable value calculation date (such that the billable value is only $100,000 and not $1 million), is the adviser afforded any prorated fee?

• Charging asset-based fees calculated from an average daily balance in arrears can help to avoid either of the potentially awkward scenarios described above and the need/desire to calculate prorated refunds or fees.
• Whether cash and/or outstanding margin balances are included in the assets upon which the fee calculation is applied.

Flat Or Subscription Fees

To the extent an adviser charges for investment management services on a flat-fee basis, be aware that both certain states and the SEC may consider the asset-based fee equivalent of the actual flat fee being charged for purposes of determining whether the fee is reasonable or not.

For example, if an adviser manages a client’s $50,000 account and charges an annual flat fee of $5,000 for a combination of financial planning and investment management, a regulator may take the position that the adviser is charging the equivalent of a 10% per annum asset-based fee, which, if viewed in isolation, is well beyond what is informally considered to be unreasonable (generally, an asset-based fee in excess of 2% per annum).

The 2% asset-based fee threshold traces its roots back to various no-action letters from the 1970s, like Equitable Communications Co., SEC Staff No-Action Letter, 1975 WL 11422 (pub. avail. Feb. 26, 1975) ; Consultant Publications, Inc., SEC Staff No-Action Letter, 1975 WL 12078 (pub. avail. Jan. 29, 1975) ; Financial Counseling Corporation, SEC Staff No-Action Letter (Dec. 7, 1974) ; and John G. Kinnard & Co., Inc., SEC Staff No-Action Letter (Nov. 30, 1973) .

In these letters, the SEC’s Division of Investment Management took the position that an asset-based fee greater than 2% of a client’s assets under the adviser’s management is excessive and would violate Section 206 of the Advisers Act (Prohibited Transactions By Investment Advisers) unless the adviser discloses that its fee is higher than that normally charged in the industry.

Setting aside the dubious reasoning underlying the citation of advisory fee practices from nearly a half-century prior, one potential way to combat such logic is to charge separate flat fees purely for investment management (with the asset-based equivalent remaining under 2% of a client’s assets under management), and separate flat fees for financial planning (while adhering to a financial planning service calendar).

Fees Involving Third-Party Advisers Or Subadvisers

To the extent the adviser may retain a third-party adviser or subadviser to manage all or a portion of a client’s assets, and the client will not separately sign an agreement directly with such third-party adviser or subadviser that discloses the additional fees to be charged to the client, it is prudent to include such third-party adviser or subadviser’s fees in the adviser’s agreement.

Advisory agreements should also generally describe the other fees the client is likely to incur from third parties in the course of the advisory relationship (e.g., product fees and expenses like internal expense ratios, brokerage commissions, or transaction charges for non-wrap program clients, custodial/platform fees, etc.).

Several states take a rather ‘creative’ position with respect to what constitutes an ‘unreasonable’ fee and may either explicitly or implicitly prohibit certain types of fee arrangements, especially with respect to flat or hourly fees for financial planning. At least two states have even been known to cap the hourly rate an adviser may charge. Many states require that advisers present clients with an itemized invoice or statement at the same time they send fee deduction instructions to the qualified custodian. Such itemization, to use California as an example, is expected to include the formula used to calculate the fee, the value of the assets under management on which the fee is based, and the time period covered by the fee.

Ultimately, the foundation of a good advisory agreement consists of many components, including a complete and accurate description of the firm’s services and advisory fees. While these are only two essential components, there are also many other equally important elements to include and best practices to follow that should be accounted for in any advisory agreement, which will be addressed in Part 2 of this article.

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Adviser Changes of Control: An Elusive Definition

In some form or another, nearly every registered investment adviser will at some point be involved in a merger, acquisition, sale, or restructuring. Whether it’s a simple equity ownership stake by a new financier, the addition of a new partner, a union of two practices, the death of a major shareholder or the full-blown execution of a succession plan, RIAs will inevitably need to navigate SEC “change of control” rules and guidance.

Such rules and guidance are rooted in the requirement that investment advisory contracts may not be assigned without client consent. I discussed the interplay of positive and negative consent a few years back in this article , but left open the question of what actually constitutes an “assignment” that would necessitate client consent. Said another way, what types of mergers, acquisitions, sales, or restructurings are considered an assignment of an advisory contract and therefore require client consent?

For starters, the SEC attempts to define “assignment” in the very first definition of the Investment Advisers Act, Section 202(a)(1): “Assignment includes any direct or indirect transfer or hypothecation of an investment advisory contract by the assignor or of a controlling block of the assignor’s outstanding voting securities by a security holder of the assignor […]”.

There are a few more sentences specific to partnerships, but we’ll address that later. The general concept of the “assignment” definition is that there are essentially two situations in which an assignment is deemed to have occurred: (1) when advisory contracts are transferred to another RIA or pledged as collateral, or (2) The equity ownership structure of an RIA changes such that a “controlling block” of the RIA’s outstanding voting securities changes hands.

Both situations would trigger the need for client consent.

With respect to #2, the logical next question is: what constitutes a “controlling block?” What percentage of voting equity interest needs to change hands for the SEC to care? Unfortunately the SEC does not define “controlling block”, but we can cobble together an understanding from a few different guideposts.

The first is Section 202(a)(12) of the Advisers Act, which defines “control” as “the power to exercise a controlling influence over the management or policies of a company, unless such power is solely the result of an official position with such company”. This is only moderately helpful since “controlling influence” is still left undefined, but at least we can discern that such control should be in relation to management of the RIA or its policies. And just because somebody employed by an RIA has a fancy title doesn’t mean he or she automatically has control over the RIA.

The second is the instructions to Form ADV Part 1, the glossary to which presumes that RIA equity owners with the right to vote 25% or more of the securities of that RIA “control” that RIA. Under this framework, the following persons would be deemed to control an RIA:

• A corporate stockholder that owns 25% of its voting stock
• A LLC member that owns 25% of its voting membership units, has contributed 25% of the capital, or has a right to receive 25% of the capital upon dissolution
• A partner that has contributed 25% of the partnership’s capital, or has the right to receive 25% of the capital upon dissolution

The third is actually the section that defines “control” in the Investment Company Act (applicable to mutual funds), not the Advisers Act. In Section 2(a)(9), the SEC establishes a rebuttable presumption that “any person who owns beneficially, either directly or through one or more controlled companies, more than 25% of the voting securities of a company shall be presumed to control such company”. Though technically not applicable to RIA change of control scenarios, many have looked to this percentage as a helpful guidepost regardless.

The fourth is SEC Rule 202(a)(1)-1, which states that “a transaction which does not result in a change of actual control or management of an investment adviser is not an assignment for purposes of section 205(a)(2) of the [Investment Advisers] Act”. This mainly applies to reorganizations, and the SEC cites a scenario in which an RIA changes its state of incorporation as one example of a transaction that would not constitute a change of control.

The fifth and final guidepost is several no-action letters that, though fact-specific to the complex transactions described therein, generally stand for the proposition that the SEC is ultimately concerned with the “trafficking” in investment advisory contracts to the detriment of investors. So long as there is no actual change in control or management of an RIA, the trafficking concern is moot.

Side bar about RIAs organized as partnerships: minority partners that are admitted to the partnership, die, or otherwise withdraw from the partnership do not trigger an advisory contract assignment. That said, any change in the membership of the partnership triggers a client notification obligation within a reasonable time.

This is all a tortuous way of saying that determining whether or not an advisory contract assignment or change in control has occurred may not be as straightforward as it seems. Complete lift-outs or cash-for-stock transactions are likely a no-brainer, but private equity infusions, partial buyouts and certain mergers likely require a more nuanced analysis.

The 25% voting security threshold is by analogy only, and higher or lower thresholds may very well be justified given the right facts.

When in doubt, simply send clients a negative consent to borderline control changes (assuming your advisory contracts permit negative consent) and let them decide whether or not to continue the advisory relationship.

This article originally appeared on October 28, 2016 in ThinkAdvisor .

AI for IAs: How Artificial Intelligence Will Impact Investment Advisers

AI has the potential to be used for portfolio management, customer service, compliance, investor communications, and fraud detection, though RIAs should review emerging rules regulating AI

The use of artificial intelligence and machine learning technology solutions ("AI") is becoming increasingly common in all industries, including the registered investment adviser ("RIA") space. A recent survey by AI platform Totumai and market research firm 8 Acre Perspective found that 12% of RIAs currently use AI technology in their businesses and 48% plan to use the technology at some point, which means there is a realistic expectation that 60% of RIAs will be using AI in the near future. Among other use-cases, AI has the potential to be used by RIAs for portfolio management, customer service, compliance, investor communications, and fraud detection.

While regulators are not likely to prohibit the use of AI in the industry, they are likely to closely monitor and regulate specific applications and use-cases, which is why it is essential for RIAs to understand these emerging rules and regulatory frameworks so they can appropriately leverage the many benefits of AI while ensuring their business remains compliant with these new rules of the road. DWT has recently launched a series of webinars titled " AI Across Industries " that has gone in-depth on the legal issues surrounding the use of AI.

Rules of the Road

The SEC maintains that their rules are platform and technology neutral, so it is important to remember that although the technology may be new, many existing rules may apply. Additionally, we expect more new proposed rules in this area (like those discussed below), so RIAs must ensure their use of AI complies with the existing, and emerging, regulatory framework.

Disclosures

First and foremost, RIAs must disclose their use of AI in their investment management business under Section 206 of the Investment Advisers Act of 1940 ("Advisers Act"). Disclosure is the bedrock of SEC regulation and will be the first place regulators or examiners will look when reviewing the use of AI in the industry. RIAs must ensure that they are fully and fairly disclosing how and where AI is being used in their investment management business. Additionally, it is essential for RIAs to actually understand the technology and be able to explain how the technology works to both clients and regulators. In March, the outgoing director of the SEC's Investment Management Division, William Birdthistle, spoke at the Investment Advisers Association Conference where he suggested that "it is simply not good enough that, for many advisers, their understanding of AI is that information goes into a black box, 'magic happens' and something comes out." RIAs must take ownership of AI if they are to incorporate it in their business, and, as RIAs, they must properly disclose use of AI to their clients and the SEC in furtherance of their fiduciary duty. This can be a fine line to walk for many RIAs who attempt to keep a competitive edge in limiting any disclosure of how they run their business while maintaining compliance with the rules.

• We recommend that at a minimum RIAs should disclose the use of AI in their investment management business in their ADV brochures, client agreements, and in communications where AI is being leveraged.

Division of Investment Management 2017 Guidance on "Robo-Advisers"

In February 2017, the SEC's Investment Management Division provided guidance on the use of automated advisers, also known as "robo-advisers" (" 2017 Guidance "). SEC staff noted in the 2017 Guidance that "Robo-advisers, like all registered investment advisers, are subject to the substantive and fiduciary obligations of the Advisers Act. Because robo-advisers rely on algorithms, provide advisory services over the internet, and may offer limited, if any, direct human interaction to their clients, their unique business models may raise certain considerations when seeking to comply with the Advisers Act". This point reaffirms the concept that even as technology changes, the existing regulatory framework will continue to apply in many instances.

The 2017 Guidance focuses on three distinct areas that robo-advisers must address:

• The substance and presentation of disclosures to clients about the robo-adviser and the investment advisory services it offers;
• The obligation to obtain information from clients to support the robo-adviser's duty to provide suitable advice; and
• The adoption and implementation of effective compliance programs reasonably designed to address particular concerns relevant to providing automated advice.

If a RIA is using AI to automate their investment advice, it is very likely they would be considered a robo-adviser. Firms who are currently using or plan to use an AI solution to support their advisory services should consider the above three areas to ensure compliance with the Advisers Act. Opponents of the SEC's proposed Predictive Data Analytics Rule, discussed below, often argue that the Rule is unnecessary because the SEC has given RIAs guidance in this space through the 2017 Guidance.

The 2017 Guidance includes robo-adviser specific disclosure requirements which requires them to include the following information in disclosures:

• A description of the business model and related algorithms (including the assumptions and limitations of the algorithm used to manage client accounts);
• The scope of the automated advisory services;
• A description of when (if ever) a client will have human interaction;
• The reliance on questionnaires for the robo-adviser to gather client information;
• A description of the particular risks inherent in the use of an algorithm to manage client accounts;
• A description of any involvement by a third party in the development, management, or ownership of the algorithm used to manage client accounts;
• An explanation of any fees the client will be charged directly by the robo-adviser, and of any other costs that the client may bear either directly or indirectly; and
• An explanation of how and when a client should update information that he or she has provided to the robo-adviser.

We recommend that RIAs familiarize themselves with the 2017 Guidance and incorporate these principles in their compliance program if they will be using AI in their investment management business.

The New Marketing Rule

The SEC's new Marketing Rule 206(4)(1) under the Advisers Act (the " Marketing Rule ") also impacts how RIAs will use AI. DWT has analyzed how RIAs are complying with the new Marketing Rule. RIAs who are using or intend to use AI in their business and market themselves as such must be very careful to assure compliance with the Marketing Rule. Recently, in March 2024, the SEC separately charged a former and current RIA with making false and misleading statements about their use of artificial intelligence. In both cases, the RIAs held themselves out and promoted themselves as leveraging AI when in fact they did not have the ability or technology to do so – a concept now known as "AI Washing." RIAs must ensure that they are following the Marketing Rule disclosure requirements at all times, including when discussing AI, and most importantly say what they do, and do what they say.

The Proposed Predictive Data Analytics Rule

In July 2023, SEC Chair Gary Gensler announced the Commission would propose new requirements to address risks to investors from conflicts of interest associated with the use of predictive data analytics by Broker-Dealers and RIAs, through the proposed " Predictive Data Analytics Rule ." The Rule would cover a broad range of technology that includes not just AI, but also any other "analytical, technological, or computational function, algorithm, model, correlation matrix, or similar method or process that optimizes for, predicts, guides, forecasts, or directs investment-related behaviors or outcomes in an investor interaction" (Covered Technology). [1] The rule would also require RIAs to: (i) identify conflicts of interests when using certain technology in interactions with investors; and (ii) adopt policies and procedures that eliminate or neutralize (rather than disclose or mitigate) those conflicts of interests. [2]

The proposed Predictive Data Analytics Rule has been criticized by the industry as being overly broad and unnecessary given previous guidance (such as the 2017 Guidance discussed above). Despite industry objections, both Chair Gensler and former IM Director Birdthistle support the proposal. The Rule has not been finalized, and we expect more discourse surrounding the costs and benefits of adopting the rule, but the expectation at this point is that it will be finalized in some form in the near future. Either way, the SEC has made it clear they intend to closely scrutinize the use of AI in the industry, so it is imperative that RIAs stay current with changing regulations if they intend to use AI or any other Covered Technology to make predictions, manage portfolios, provide investment advice, or use chatbot technologies to communicate with investors and make investment decisions.

AI is here to stay. As regulators and the industry grapple with the intended and unintended consequences of harnessing AI, it is imperative that RIAs understand both the technology and the rules. The SEC will continue to scrutinize RIAs who use (or say they use) AI in their investment management business in examinations and enforcement proceedings.

[2] Id at 40.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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Yet another version of the fiduciary rule is coming

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Retirement savings advisers having to put their clients’ interests first over making a buck for themselves — that wasn’t formalized for years, and then it was under President Barrack Obama.

Just a couple years later, a court overturned these rules for retirement planners, and then the Donald Trump administration came in with its own set of regulations for all of this. It’s something important but with a bureaucratic-sounding name: the fiduciary standard. And it’s getting yet another overhaul with the Joe Biden administration.

Marketplace’s senior economics contributor, Chris Farrell, has been following this story for a long time. He spoke with “Marketplace Morning Report” host David Brancaccio, and the following is an edited transcript of their conversation.

David Brancaccio: So it’s this fiduciary standard for retirement savings. Tell us more.

Chris Farrell: OK, so briefly, what the fiduciary rule says is advisers must put their clients’ interests first. They must eliminate conflicts of interest and promote transparency in all dealings. Now, David, common sense says if you’re working with a professional adviser, you’re going to assume that they’re already acting in your best interest. So the rule codifies the expectation. And the shift also acknowledges that difficulties have emerged in an era that’s been dominated by workplace accounts like 401(k)s and IRAs.

Brancaccio: All right, formalizing the standard and making it apply to retirement plan advisers — making them act in the client’s best interest — was long in the making. I mean, you and I have been covering this for years .

Farrell: I mean, the rule took something like eight years to write, and it was completed in the twilight of the Obama administration. The Trump administration, they didn’t like the rule and industry groups challenged the regulation in court. Now, the U.S. Court of Appeals for the Fifth Circuit overturned the rule change in 2018, saying that the Labor Department had overreached. The Biden administration’s new version is slated to start going into effect on Sept. 23.

Brancaccio: What do you think — the new version’s going to stick?

Farrell: It’s almost certain lawsuits are going to be filed challenging the new rules. Nevertheless, David, it just seems to me it’s a no-brainer. If you say to retiree, “I’m a trusted financial advisor,” that you should act as a fiduciary and put the client’s interests ahead of your own.

Brancaccio: But sometimes, especially on something like this, the very hardest parts are in the nitty-gritty.

Farrell: Yes. Well, let me highlight two. They come from Morningstar , the research firm, and they say, look, small workplace plans — they tend to come with high fees, the 401(k)s. And they believe that this new rule will push for the plan sponsors to construct portfolio choices that will have more lower-fee options. And that could save plan participants — and this is their estimate — $55 billion over 10 years. Morningstar also believes the new rule, it will drive down commissions on fixed-index annuities. Estimated savings for workers, over 10 years: nearly $33 billion. And that’s not chump change.

Brancaccio: Yeah, I mean, it’s a “b” in that — $55 billion and $33 billion.

Farrell: That’s right. So my takeaway: There is no doubt that the financial benefits from requiring the fiduciary standard are real for ordinary workers who are saving for their retirement. And that is what matters.

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