Chapter 5: Ethical Practices and Obligations - A. Compensation and Other Issues

Question 1

Fees

Answer 1

An investment adviser may not charge a client a fee that would be considered unreasonable by a “prudent man.” Prior to giving any advice, an adviser must disclose to the client in writing the advisory fee to be charged, the formula for computing the fee, and the amount of the fee that has been prepaid, and will be returned if the contract is terminated prematurely.

Question 2

Commissions

Answer 2

Due to the inherent conflict of interest, an investment adviser must disclose to a prospective client, prior to giving any investment advice, any type of compensation plan that includes both an advisory fee and a commission generated by the sale of securities being recommended. Generally, combined fee and commission arrangements should be avoided.

Question 3

Performance-based Fees

Answer 3

In contrast to a flat-fee or commission-based compensation plan, a performance-based fee plan compensates advisers and managers at a higher level when they “outperform” the benchmark indicator and at a lower level when they “underperform” the benchmark indicator. Since performance-based plans depend upon past performance as the indicator of growth or decline, the challenge with such plans is developing a calculation model that meets the SEC guidelines for a “rolling” performance period.

As a general rule, performance-based fees are not allowed; however, there are a few exceptions that would allow this type of fee arrangement:

• Registered investment companies;
• Qualified clients:
  - Persons with a minimum of $1.1 million invested; or
  - Persons with a net worth of more than $2.2 million, excluding the person’s primary residence.

Fees based on total assets under management are not considered performance-based fees.

Question 4

Soft dollars

Answer 4

The concept behind “soft dollars” is that mutual fund managers form an alliance with specific broker/dealers who provide research or brokerage services in exchange for potential future transactions with that broker/dealer. However, a possible conflict of interest exists due to the possibility that the manager will exclusively select a broker/dealer with which an alliance exists regardless of the quality with which the broker/dealer executes the transactions. Therefore, the investment adviser must regularly review its soft dollar relationships for any conflicts of interest.

In addition, there are restrictions on the broker/dealer’s soft dollar expenditures provided to the investment adviser. Soft dollars may only be spent on items which directly benefit investment adviser customers. Examples include securities research, subscriptions to research or other securities publications, applicable software, and educational seminar fees. Disqualified items include new office furniture or computers for the investment adviser’s office, additional personnel, and travel expenses to educational seminars.

Question 5

Markups / Markdowns

Answer 5

When a broker/dealer is acting in a principal capacity and trading from its inventory account, it earns money by marking up the cost of the security sold to a customer. The broker/dealer also makes money by marking down the cost of a security purchased from a customer. This markup/markdown is the firm’s compensation in a principal trade.

Question 6

Disclosure of Compensation

Answer 6

There are many different ways that both investment advisers and broker/dealers can structure fees and/or commissions. It is important to remember that in all cases, full compensation disclosure must be given to customers. If a broker/dealer charges commissions to both the buyer and seller through a cross transaction, both customers must be informed that both sides of the transaction are paying the firm.

If the investment adviser charges a wrap fee, the wrap fee includes both a transaction-based fee and a fee for providing investment advice. Any transaction compensation must be disclosed to the customer. In addition, to be compensated through wrap fees, the associated individual must be registered as both an investment adviser representative and as agent for a broker/dealer. The customer must receive a wrap fee brochure which fully discloses the fee structure.