Assignment: Know the Requirements and Avoid the Pitfalls
Make sure your clients – and your firm – are protected when there is change in control of your firm that may result in an assignment.
Assignment of client contracts can be a major issue for advisers and clients when a firm changes hands, merges with another firm or takes on a major new partner. All of these events may mean a change in control of the firm, and when that happens, firm clients may find themselves working with another adviser.
Advisory firms not prepared for such an eventuality will be doing their clients a disservice if they do not recognize when an assignment is about to occur or get their clients’ consent to the assignment. That will leave them open to charges of not putting their clients’ needs first, as well as failing to comply with Section 205(a)(2) of the Advisers Act, which requires that client contracts include a client consent provision.
Assignment and control
The key point to remember is knowing that an assignment occurs when there is a change in control of the advisory firm, according to Advisers Act Rule 202(a)(1), which states that "a transaction which does not result in a change of actual control or management of an investment adviser is not an assignment."
Just what is "control"? Advisers Act Section 202(a)(12) makes clear that "control" means "the power to exercise a controlling influence over the management or policies of a company." It also ties the control question to Section 2(a)(9) of the Investment Company Act, which makes it clear that in order to have control, a person must beneficially own, either directly or through other controlled companies, more than 25 percent of the voting securities.
Consider the following scenarios, provided by Shearman and Sterling counsel Thomas Majewski, that show how the concept of control might apply:
An adviser moves its client from one subsidiary to another, but the overarching ownership structure of the firm remains the same. In many such situations, there is no change in actual control or management, so there is no assignment of the investment management agreement with the client.
An adviser sells a minority share of ownership, say 10 percent. This is not a change in control, as it is less than the 25 percent presumption of control specified in the Investment Company Act, so there is no assignment of advisory contracts.
An adviser sells 10 percent ownership, but those purchasing the 10 percent also obtain significant rights, such as the right to hire and fire the portfolio managers and make other management decisions. "This is somewhat of a gray area and the question of control is a question of facts and circumstances," Majewski said.
An adviser sells more than 50 percent of the firm. This is clearly a change in control and, therefore, would result in an assignment of any advisory contracts.
Section 205(a)(2) of the Advisers Act makes clear, in regard to advisory contracts, that "no assignment of such contract shall be made by the investment adviser without the consent of the other party by the contract." Note those last three words. The Advisers Act itself is not requiring consent; it is requiring that the advisory contract address the issue. This is legally important because any violation of the consent provision will not be seen as a violation of the law, but of the business contract. This point was also made in the SEC’s December 1997 American Century Companies no-action letter, which states that assignment of a non-investment company advisory contract, "without obtaining client consent, could constitute a breach of the advisory contract, but not a violation of Section 205(a)(2)."
"The key question," Majewski said, "is whether client consent has to be active or passive." Active consent means that the client must provide written consent to the assignment of the contract. Passive consent means that the client, after being notified by the adviser of a change in assignment, simply acquiesces by not responding within a certain time period, such as 30 or 45 days.
The SEC staff has historically endorsed passive consent, said Willkie Farr attorney Justin Browder, but in the American Century Companies no-action letter, which many see as the current agency point of view, the SEC staff suggested that form of consent is a matter of state contract law.
Of course, if your advisory contract’s assignment clause specifies active consent, you will need to follow that provision.
Assignments are more likely to happen with sales or mergers of advisers that are privately owned, rather than with large, publicly owned advisers that merge, said Morgan Lewis partner John McGuire. When Dean Witter and Morgan Stanley merged, for instance, the SEC staff in April 1997 issued a no-action letter stating that while a new corporation was formed, because the ownership of both firms was spread among public investors, there was no change in control. In addition, the letter noted, much of the same management remained.
"The merger of DWD and MS will not result in an assignment of the advisory contracts of either company’s subsidiaries within the meaning of the Acts because neither company’s subsidiaries will transfer any advisory contracts or transfer a controlling block of shares," the letter states.
Consider the following steps to ensure that your contracts with clients will be correctly handled should a change in ownership include a change in control and assignment:
Make sure your contracts have a consent provision. "Choose the wording carefully," said Majewski. "If you want to permit assignment without written client consent, be sure not to use the word ‘written’ in the consent provision of the agreement. Make sure you are in compliance with Section 205(a)(2) of the Advisers Act."
Avoid giving up control without knowing it. Be aware of when your firm may be entering into an agreement that alters its equity structure, as this may result in a shift in control and, possibly, trigger an assignment of the client agreement, said Majewski. This can occur in situations where such a loss of control is not intended, such as when a firm rewards the performance of portfolio managers or key employees by giving them an equity stake in the firm, he said.
Beware of internal reorganizations that may affect control. These may not raise problems under the Advisers Act, but, for instance, an internal reorganization at a large firm with one or more advisers that have different boards of directors and/or different intermediate parent companies could warrant a close examination, Browder said.