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News January 4, 2016 Issue

Terminate that Advisory Contract the Right Way

Keep your client’s interests first – even when terminating an advisory contract. That is, after all, your fiduciary duty. But contracts can be terminated in a way that helps your firm, as well.

Advisory firms certainly have the right to terminate contracts with their clients. "An investment adviser is not an indentured servant," said Shearman & Sterling partner Nathan Greene, noting that most advisory contracts contain written provisions that allow termination within a specified period of time, such as 30 days or 60 days.

There are a number of reasons an adviser might want to end its contractual relationship with a client. These include:

  • The advisory services provided are no longer consistent with the client’s needs. "This could happen, for instance, if your firm specializes in high-risk investments that once made sense for a client, but that client is now approaching age 75 and wants to take a more conservative approach," said Mayer Brown attorney Adam Kanter. "The client’s investment needs have become more conservative, but those are not the kinds of investments your firm specializes in, so it might be appropriate to discuss with the client whether your firm’s services are still in the client’s best interests."
  • A key employee for an account left. An employee had specialized experience and credentials to handle a specific account, and the advisory firm may not want to make the investment to hire a new employee with matching expertise, suggested Greene.
  • The client is no longer using the adviser’s services. This could occur if the adviser has a number of non-discretionary accounts, some of which may have had no transactions during the past 12 months, Kanter suggested. "Maybe the client no longer wants your services, but he should be asked. After all, he has been paying for them. Others may want to keep the adviser, even though there have been no transactions in recent months, simply because it is convenient for the client to have the adviser there if it believes new investment opportunities might be on the horizon."
  • Relationship is no longer working out. "The people involved on both sides are fed up with each other," said Greene. This could be a situation where the client is on the phone all the time with demands, and the adviser simply cannot afford the expense, given the relatively small size of the account.
  • The advisory firm has grown and it is no longer consistent with the firm’s strategy to continue servicing clients under a certain size. As an advisory firm grows over time, it can shift its focus in the types of clients it services and the way it implements its investment strategy - such as from making fixed-income investments through ETFs and other funds to making fixed-income investments through individual bonds. Continuing to service smaller accounts that are not able to fully implement the firm’s investment strategy could burden the firm, suggested Kanter.
  • The client is suspected of engaging in improper activities. These suspicions may turn out to be true or false, but as a business matter, "depending on the nature of the suspicions, it may simply make sense not to do business with that client," said Kanter, as it would leave the adviser open to possible reputational and regulatory risk.
  • The client is engaged in improper activities. This is the worst case scenario, but it can happen. Such improper activities might include money laundering or being included on the Treasury Department’s Office of Foreign Assets Control list, which would mean the client was subject to sanctions prohibiting the firm from doing business with it.

How to do it

The most important thing to do first is to review the termination provisions of the advisory contract itself, said Greene. "Check out the time period for termination, the means of notice required, and who you must provide the notice to. For instance, if your client is a pension plan, the consultant you regularly deal with may not be the correct person to hand the termination notice to. It may be the trustee."

Other steps to consider when terminating an advisory relationship, keeping your fiduciary duty to the client foremost in mind, include:

  • Ensure that custody issues are properly handled. "If an adviser has only advisory rights, that most likely means the custody rights are held by a third party," said Perkins Coie partner Andrew Cross. "If the adviser has some form of custody rights – not usually physical custody, but indirect custody of some kind – it is more complicated." Assets may have to be moved from one custodian to another, said Greene, and the adviser will need to ensure this is done properly and to the client’s satisfaction.
  • Cooperate with the successor adviser. This may be a complicated matter or something as basic as providing records. "The terminating adviser should allow time for a successor adviser to take over," said Greene. "Remember that if a transition is mishandled, it is possible that there will be egg on the face of the terminating adviser."
  • Take steps when the client is ready, not before. "Don’t convert assets to cash at an inopportune time, or hand assets back to the client when the client is not able to handle them," said Greene.
  • Refund excess fees. Some contracts require clients to pre-pay advisory fees at certain intervals, such as every quarter. "Be sure to return the pro-rated portion of these if the termination occurs during such a period," Greene said.
  • Modify Form ADV as necessary. This is particularly true in the unlikely situation where the client terminated is a client that is critical to your business (such situations may occur when the client is the one to terminate the relationship). For instance, if the terminated client was an adviser’s only pension fund client, the adviser should consider reducing references to pension funds in its Form ADV, Greene suggested. "Bookmark any possible Form ADV changes for your next round of updates."

"You are required to act in the client’s best interests," said Kanter. "That doesn’t mean you can’t terminate an advisory agreement, but use caution if you are doing so in a way that may cause harm to a client, particularly if the actions you take look like they have a personal pecuniary motivation."

In addition, "how you handle every situation goes to your business reputation," said Cross. Some future clients may, in the process of performing due diligence on your advisory firm, speak to past clients, he said. "Handling a termination in a professional manner is just as important as handling your advisory duties."