Compliance FAQ: Contracts

Lexington Compliance looks at contracts, a category where RIAs commonly experience compliance deficiencies.

Coordinated state exams conducted by members of the North American Securities Administration Association (NASAA) for 2015 uncovered the top registered investment adviser (RIA) compliance deficiencies across 20 categories. In a previous article, we discussed the most common investment adviser compliance deficiencies in the books and records category, specifically suitability documentation, missing written agreements, and issues with financial statements.

In this month’s bonus installment, we cover another common RIA compliance deficiency category: contracts. The latest report from NASAA shows that of the 1,170 investment advisory firms examined in 2015, 49.5% of all firms with assets under management (AUM) examined had at least one contracts-related regulatory deficiency. This figure is particularly notable due to the fact there was a 5.5% increase in this category compared to the results from the 2013 NASAA investment adviser examination report. In the 2013 report, 44% of advisory firms that were audited were found to have a contracts-related compliance deficiency.

In this most recent 2015 report, about 45% of RIA firms with AUM greater than $30 million had at least one such deficiency compared to roughly 50% of investment advisory firms with less than $30 million in AUM. Also notable is the fact that there was no significant difference observed in the number of contracts-related deficiencies for firms with one or more than one investment adviser representative at the firm. In the contracts category, about 50% of firms with only one investment adviser representative (IAR) had at least one deficiency. On the other hand, about 48% of firms with more than one IAR had one or more deficiencies related to contracts. In other words, contracts-related compliance issues can plague both small and large RIA firms.

The Chief Compliance Officer (CCO) at every investment advisory firm needs to be aware of the top contracts-related compliance deficiencies. In 2015, the top five issues were:

1. Fee (12.3%)
2. In writing (9.6%)
3. Fee formula (9.5%)
4. Not properly executed (9.3%)
5. 48-hour rescission clause (9.2%)

In 2013, the top five issues were:

1.Not properly executed (10.9%)
2. Fee (10.5%)
3. Fee formula (10.4%)
4. Hedge clauses (9.0%)
5. In writing (6.4%)

Other contracts-related issues flagged in the 2015 report include contracts not being updated, issues in regard to capital gains compensation, hedge clauses, outline of services, refund of pre-paid fees, discretionary authority, and non-assignment clauses.

Given the increase in contracts-related deficiencies from 2013 to 2015, it is apparent that RIA firms need to take a step back and ensure that the investment advisory agreements that the firm has in place with clients are in proper compliance with the relevant state or federal statutes. Investment adviser examiners, particularly at the state level, will often spend considerable time reviewing an investment advisory firm’s contracts. As RIA compliance consultants, we encourage the CCO of the investment advisory firm to consider these RIA compliance-related questions as he or she reviews the firm's client agreements:

  • Does the firm have a properly executed, written client agreement on file for each client relationship?
  • Do the services outlined in the agreement match the current services being provided to the client?
  • Does the fee amount, calculation formula, and frequency match how the client is billed
  • Does the contract include any hedge clauses that may conflict with the firm’s fiduciary responsibility?
  • If the firm has discretionary authority, is it properly outlined in the executed agreement?
  • Does the contract properly address how pre-paid fees will be refunded in the event of termination?

Be sure to check back next month as we cover another common RIA regulatory deficiencies category: firm registration filing issues.

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