Basic Terms of Investment Management Agreements
The arrangements between an investment adviser and its client are memorialized in an investment management agreement. While the adviser will normally tender its own form of agreement, the client will need to make certain decisions, may want to negotiate certain items, and should in any event understand the basic terms of the agreement. If you are the client, some of the basic terms you will want to bear in mind are:
The agreement will grant the adviser discretionary or non-discretionary authority. With discretionary authority, the adviser will be able to invest your account without prior consultation with you. With non-discretionary authority, the adviser will need to obtain your prior consent to each transaction. With either type of authority, the agreement should indicate clearly what assets are to be managed. This is commonly done by reference to a specific account or accounts held in your name with a particular custodian.
The agreement, or an appendix to the agreement, should set forth the investment guidelines by which the account will be managed. These guidelines should specify not only the investment objective of the account (e.g., capital appreciation), but also any investment allocations (e.g., a target of 60% equity and 40% debt) and investment limitations (e.g., no more than 20% in foreign securities, only investment grade debt, no derivatives). You will want to discuss with the adviser what the initial guidelines should be given your current circumstances and risk tolerances and to revisit those guidelines periodically. The investment guidelines are the primary means by which you control the activities of the adviser, so you should make sure that they are clear and that you are comfortable with them.
Fees and Expenses
The fees payable to the adviser should be set forth in the agreement or an appendix. Commonly, the fees are stated as a percentage of the account assets (e.g., 1% per annum) and are payable in advance or arrears on a quarterly basis. Although advisers will have standard fee schedules, fees can be negotiated. For example, the adviser should be willing to charge a lower fee for a larger account and for portions of the account that are easier to manage (e.g., bonds and cash). In addition to the adviser's fees, you will be responsible for brokerage commissions and the fees and expenses of the custodian and any other service providers (unless this is a "wrap" account).
Use of Pooled Vehicles and Other Managers
Advisers frequently invest all or a portion of their accounts in mutual funds, hedge funds, bank funds and other pooled vehicles. These vehicles may be managed by the adviser or by unaffiliated managers. Advisers may also contract with unaffiliated managers to invest all or part of your assets as a separate account. All of these arrangements carry their own expenses, which will be passed through to your account. You should understand the extent and structure of these expenses and consider whether the adviser's fee is offset appropriately by the fees paid to the manager of the pooled vehicle or separate account. You should also be comfortable with the diligence conducted by the adviser on any unaffiliated managers (to avoid the Madoff situation).
The agreement should name the custodian that will hold the assets in the account. The custodian should be a reputable financial organization, such as a large bank or brokerage firm, and should be independent of the adviser (again, to avoid the Madoff situation). If the adviser recommends a particular custodian, it should explain the basis for its recommendation (e.g., lower cost, better services, or the adviser's familiarity with the custodian's personnel and systems). The adviser should also be willing to work with the custodian that you are currently using or would otherwise prefer.
The agreement should set forth the nature and frequency of written and oral reports. Reports are normally quarterly and should cover general market conditions, any activity in the account, current holdings in the account, and the performance of the account against relevant benchmarks. The agreement should also provide for additional reports upon reasonable request.
The agreement should describe how the adviser will trade assets in the account once a decision to buy or sell is made. If the adviser trades through an affiliated broker, you should obtain some assurance that you are getting the best overall price. The agreement will often allow the adviser to receive research or brokerage services from the brokers it uses. This is permissible, but you should be aware that the adviser will have a financial interest in using those brokers. You may also direct the adviser to trade through a particular broker, but that may increase your trading costs.
The agreement should state whether the adviser or you will be responsible for voting proxies relating to the securities in the account. Some advisers do not like to vote proxies because of the administrative burden. However, proxies can be important (e.g., a vote on a pending acquisition), and the adviser is often better suited to evaluate the issues and make sure your vote is recorded in a timely fashion. For similar reasons, you might also require the adviser to submit class action claims on your behalf.
The agreement should state that the adviser will perform its services in compliance with all laws and regulations. The agreement may also identify particular requirements, such as registration of the adviser under the federal Investment Advisers Act of 1940 or under state law.
Investment management agreements typically provide that the adviser will not be liable to the client in the absence of its willful misconduct, bad faith, simple or gross negligence, and/or breach of fiduciary duty. Some agreements may also provide that the client will indemnify the adviser against claims by third parties. While you should attempt to narrow these types of provisions, advisers tend to resist significant changes. In addition, advisers are not permitted to limit liabilities they might otherwise have under the securities laws.
The agreement should provide that it may be terminated by you without penalty either at any time or upon relatively short notice (e.g., 30 days). If you are not satisfied with the adviser, you should be able to terminate the relationship without incurring further cost.
If you have questions about any of the issues raised in this newsletter, contact André Brewster at 415.677.6255 or your usual Howard Rice attorney.