Some client agreements say way too much. Some of them say much too little. What will ultimately determine the effectiveness of your agreements in protecting both you and your clients, however, is whether they say the right things.

Hands down, the greatest problem that exists with advisory agreements today is the shortcut approach too many advisors take. Simply finding an agreement you like from another firm, changing a few words and rebranding it with your logo is a recipe for disaster. First and foremost, you have no clue about the regulatory knowledge and competency of the individual who drafted the document. More important, the likelihood of your firm being identical in service offering, fee structure and brokerage practices to the firm that the agreement was drafted for is next to impossible.

You wouldn't just copy verbatim another firm's Form ADV, right? The same should hold true for your client agreements.

Are Client Agreements Even Necessary?
The challenges you face in crafting effective and comprehensive client agreements are plentiful. And one of these challenges is knowing whether the agreement is even mandated. The Investment Advisers Act of 1940 only expressly requires a written advisory agreement if you are an advisor to an investment company, not individual clients.

But not only is there extensive language in the Advisers Act that seems to presume the existence of written client agreements, they simply make sense. Not only do well-crafted agreements afford a measure of protection and peace of mind for your clients, they can also serve as your first line of defense when and if a dispute ever arises.

As a fiduciary, it's incumbent upon you to deal fairly with your clients, and that includes making full disclosure of all material information regarding the proposed relationship, including any potential conflicts of interest. The client agreement is the means for doing so. Keep in mind that the general terms of agreement outlined in your client contracts need to be consistent with your Form ADV, as well as your policies and procedures and your marketing materials.

So what information and disclosure should you include in your client agreements and what should you keep out? There are a few general rules of thumb (see sidebar). But be advised, disclosure requirements can vary greatly from state to state, as well as between the SEC and state-registered advisors. So consultation with your attorney is strongly encouraged.

Your Porridge-Fees and Expenses
Fees are the sustenance that feeds your business and fuels your growth. Thus, your investment advisory agreements must clearly describe all fees and expenses that clients may incur. These will include any advisory fees, fees for execution services, administrative fees, wrap fees and any fees imposed by third parties. And in the case of wrap fees, it's important that you clearly disclose within your agreements precisely what services are covered under the fee. All client agreements should at a minimum state:

1. The amount of the fee to be paid;

2. The method that will be used to calculate the fee; and

3. How and when the fee will be paid by the client.

Furthermore, if you are deemed to charge "high fees" and/or "performance fees," additional disclosure will need to be included in your client agreements.

High Fees
While the SEC provides no clearly defined threshold for what constitutes high fees, it does mandate that an advisor who charges higher fees than those charged by other advisors providing similar services should disclose that "the same or similar services may be available elsewhere at a lower fee" in his or her client agreements.

The commonly accepted viewpoint is that fees of 3% or higher need to include additional disclosure. It's important to note, though, that this relates to the client's cumulative fee. So for advisors using third-party money managers, if the combination of their fee plus the manager's fee is 3% or higher, then it should be disclosed within the client agreement.

Performance Fees
Generally speaking, the SEC prohibits advisors from being compensated via "performance fees." There are, however, certain notable exceptions-the most common being that performance fee arrangements may be entered into with "qualified clients."
In accordance with full and fair disclosure requirements, any applicable performance fees must be clearly articulated in your client agreements with appropriate disclosure noting the following:

The time periods used to measure investment performance and their significance in the computation of the fee;

The nature, significance and perceived appropriateness of any index that will be used as a benchmark for comparative performance purposes;

The possibility that the performance fee may create an incentive for your firm to make riskier or more speculative investments;

When applicable, the fact that you may receive increased compensation with respect to unrealized appreciation, not just realized gains; and

If the fee pertains to any securities for which market quotations are not readily available, how those securities will be independently valued.

Although business development companies and private investment companies are excluded from these performance fee disclosure requirements, hedge funds are not exempt. It should be noted, however, that state regulations vary widely in this regard. Therefore, state-registered advisors should carefully review the specific regulations of the specific states where they are registered.

Your Chair-Standard Structural Provisions
It's vital that your client agreements build a strong relationship foundation that will allow you to appropriately serve your client. Structural provisions you'll want to articulate include whether you will have discretionary power over your client's assets, any relevant investment guidelines or restrictions pertaining to the client's investment policy statement, and ideally your approach to determining investment suitability.

Agreements should detail your brokerage practices, including disclosure of any soft-dollar arrangements, any compensation derived from anyone other than the client, and your policies and procedures on principal transactions and ensuring the best execution. Your firm's proxy voting policies need to be detailed, along with your procedures for transmitting notices and communications. And if your firm either recommends or hires and fires subadvisors, that too must be disclosed.

Conversely, many advisors run into problems of "over-disclosing" when it comes to privacy and confidentiality. While SEC-registered advisors must comply with Regulation S-P and state-registered advisors need to abide by FTC regulations and applicable state laws, there's a tendency on the part of many advisors to try and provide such tight confidentiality assurances that they often include language that, if strictly adhered to, would prohibit them from effectively carrying out their duties.
Keep in mind that the sharing of client information with third parties such as custodians and portfolio management and reporting firms is an essential part of your business. Don't make the mistake of too tightly restricting your ability to share client information with these partners.

Your Bed-Ensuring Peace Of Mind For You And Your Client
In an effort to stave off potential litigation, the temptation among advisors and attorneys alike is to litter their client agreements with a litany of hedge clauses such as "the advisor shall not be liable for losses resulting from any actions taken in good faith." The SEC has taken a strong stance that hedge clauses likely to lead a client to believe they've waived any right of action against their advisor can be considered a fraudulent and deceptive practice. So it's best to be judicious when using them. Make sure you include language to the effect that "nothing in this contract should be construed as a waiver or limitation of any rights that you may have under applicable state or federal law."

Arbitration
When it comes to the inclusion of arbitration provisions, the difficult question is, "Who do you listen to?" The SEC has traditionally expressed concern about advisors including mandatory arbitration clauses in agreements. In addition, Congress recently asked the SEC under Dodd-Frank to consider whether mandatory arbitration clauses should be allowed. The U.S. Supreme Court, however, has held that pre-dispute arbitration agreements are both valid and enforceable.

In light of the uncertainty, it may be best to refrain from including any arbitration provision to your client agreements. If you do choose to add one, however, the inclusion of some language that provides "this agreement to arbitrate does not constitute a waiver of your right to seek a judicial forum where such waiver would be void under federal or applicable state securities laws" will help you avoid the wrath of the SEC.

Assignment
The SEC also requires that your advisory contracts include language stating that the contract may not be assigned without the client's consent. Depending on the specific circumstances of the assignment, that consent may be obtained either expressly or implied after sufficient notice. Keep in mind, however, that for state-registered advisors, some states mandate written consent before agreements can be assigned.

Termination
The SEC has stated that a client has the right to terminate an advisory relationship at any time, so this right must be clearly articulated. If a client does terminate an advisory contract, you must make a pro rata refund of any prepaid advisory fees. The SEC does, however, allow for reasonable start-up or termination expenses to be charged, assuming those expenses are disclosed in your client agreements.

Non-Exclusivity
Your client agreements should also include non-exclusivity representations that not only elucidate the fact that your services are not exclusive to that client, but also that you may manage assets in a different manner for other clients. This will afford you some protection from future claims that might arise when Client A learns of Client B's significantly better portfolio performance and feels mistreated.

Governing Law
Finally, you'll want to include a provision for which state's governing law will apply to the agreement, but it is important that you also include language that indicates that the governing state's law will apply "only to the extent that it is not inconsistent with applicable federal law."

Much like a prenuptial contract, your client agreements set the relationship expectations right from the start. That way, should trouble ever occur, cooler heads can prevail. Just remember, however, that the process of structuring a solid client agreement is all about finding that balance between saying too much and saying too little. It's about finding the language that's just right for your firm.

Five Common Client Agreement Pitfalls
Unsigned or lost agreements. If you don't have an executed copy, you don't have an agreement. It's a commonly cited deficiency during SEC audits, so follow through.

Stated fees that aren't updated. A change to your fee structure, even a lowering of fees, requires some action such as notification or consent.

Setting the bar too high on assignment. Don't include language that mandates written consent to assignment when negative consent may be all that's required.

Over-committing on privacy. The sharing of client data with custodians, regulators and other third parties is essential, so don't include language that precludes you from doing business.

Forgetting about the states. State-registered advisors need to remember that many states have specific agreement requirements, and many do not allow arbitration clauses.

Daniel Bernstein is the director of professional services of MarketCounsel, a leading business and regulatory compliance consulting firm to independent investment advisors, and a principal of the Hamburger Law Firm, a boutique firm practicing in virtually all areas pertaining to investment and securities law as well as relevant corporate and employment matters.