3 FAQs on RIA Ks

I recently received a call from an RIA firm that had been cited during an audit for having an improper RIA client contract.  The CEO explained that they had tried to save some money by copying an advisory contract from one of the form books at a law school.  Being familiar with the form book in question, I questioned whether the CEO was being honest with me.

I asked the CEO to e-mail me a copy of his contract.  I then drove over to one of the law schools in Atlanta to check the form book for myself.  Much to my surprise, the form book’s advisory contract did not provide some of the mandatory and recommended disclosure language for investment advisory contracts.  Unfortunately, the CEO and his firm paid a high price for the lesson learned.

I know, everyone hates attorneys.  Everyone is quick to remind me that Shakespeare said “first, let’s kill all the attorneys.”  Everyone knows the quote, but few know the rationale behind the quote.

During my time as RIA Compliance Manager for FSC Securities, I drafted several model advisory contracts for both FSC’s proprietary RIA and the independent RIAs affiliated with FSC.  I’m proud to say that FSC is apparently still using those contracts, as I still run across them.  Sixteen years later, I still use a slightly modified version of those model contracts today for my consulting clients.

Based on my experience, many RIA firms have advisory contracts which do not meet the required legal standards.  What RIA firms need to understand is that the use of a non-compliant advisory contract can have severe consequences.  A non-compliant advisory contract generally entitles a client to rescind the contract and recover all fees paid to the investment adviser, with interest thereon, from the original date of the ineffective contract. Clients can also attempt to recover any losses or other financial costs sustained as a result of the adviser’s actions pursuant to the non-compliant contract.

From a regulatory perspective, use of a non-compliant advisory contract can subject an RIA to an enforcement proceeding by the SEC for fraud pursuant to the Investment Advisers Act of 1940 (“Act”).   Advisers may also face regulatory actions from their state, as most states also have rules and regulations that require certain disclosure language in investment advisory contracts.  Many RIAs are surprised that they can face both state and federal prosecution.  The key is that under the National Securities Market Improvement Act of 1996 (NSMIA), the states retained the right to prosecute for fraud.

Fortunately, most of the state requirements track the federal requirements, making compliance relatively easy.  Some of the key requirements under the Act, the rules and regulations promulgated under the Act, and similar state provisions are that every advisory contract must contain language that provides

  • that the advisory contract cannot be assigned without the clients consent;
  • that the client must be given the right to rescind the advisory contract unless the client is provided with a copy of the RIA’s advisory contract and disclosure document a certain amount of time prior to entering into an advisory relationship (generally no less than 48 hours prior to signing the advisory contract); and
  • details regarding the adviser’s termination/refund policy as well as the manner that refunds will be calculated.

State laws should always be reviewed to ensure that an adviser’s contracts do not raise regulatory issues, including potential fraud issues.  Some states have special disclosure requirements for investment advisory contracts (e.g., Texas and Minnesota).  Anyone engaging in advisory business in a state with such special requirements could arguably be prosecuted by the state for fraud for failing to comply with the state’s contract requirements, regardless of whether the RIA is SEC or a state registered.  An RIA simply cannot overlook the broad power of the states to prosecute for fraud.

Exculpatory, or “hedge” clauses, while not prohibited,  are frowned upon by regulators due to their potential for confusing or misleading clients.  I generally advise my clients not to include such clauses, as I believe it sends a negative message to a potential client and such clauses are generally not going to protect an adviser from any wrongdoing, as RIAs are fiduciaries under the law and are held to a very high standard of conduct.

A common mistake that I see with advisory contracts is a lack of consistency between the disclosures contained in the RIA’s Form ADV and the RIA’s advisory contract.  I have been told that this is an area that is going to receive greater attention during audits.  The advisory contract is the actual legal document that controls the adviser/client relationship.  However, discrepancies between an adviser’s Form ADV and an adviser’s advisory contract can be the grounds for an action against the adviser for fraud and misrepresentation.

My experience has been that most non-compliant investment advisory contracts were either self-written by RIA firm or by a non-attorney compliance consultant.  I know a number of securities/RIA compliance consultants that are excellent at advising on the applicable compliance standards.  However, when it comes to legal drafting, they consult with an experienced compliance attorney to ensure that their clients are protected.  As I mentioned earlier, hate on attorneys all you want, but remember, you get what you pay for.  On more than one occasion I have heard regulatory personnel ask the RIA who drafted the non-compliant advisory contract, followed by a suggestion that they consult with an experienced securities compliance attorney.

In the situation I discussed at the beginning of this post, the RIA firm is looking at having to reimburse the client for all fees and commissions received, with interest thereon.  They are looking at having to deal with negative publicity.  Furthermore, since the contract pre-dated the 2008 bear market, they are facing the possibility of having to reimburse the client for losses suffered during that time, with interest thereon, since technically there was no contract which gave them the authority to manage the account.  And then there are the regulators waiting in the wings.

An ounce of prevention….

About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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