Referral Fees, Testimonials, Custody, and Performance Fees
You are an IAR at a small RIA. A local estate attorney, Diane, refers clients to you. You pay her $750 per referred client who opens an account, deducted from your advisory fee. You also plan to post a client testimonial on your website saying you 'beat the market by 4% last year.' Your firm's compliance manual permits testimonials only if they are not misleading and disclose that they may not be representative. Separately, a client mailed you a $50,000 check payable to the qualified custodian; you logged it and forwarded it to the custodian two business days later. Another client, age 72, with a $400,000 account and a $900,000 net worth including her $300,000 home, wants to pay you a performance fee equal to 20% of the account's realized capital gains.
1. Identify the regulatory issues in the referral arrangement and the testimonial. What must be disclosed, and what conduct is prohibited?
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Paying Diane $750 per client is a solicitation arrangement. Under the Advisers Act solicitor rule, the adviser must have a written agreement with the solicitor, the solicitor must provide the client a disclosure statement describing the compensation and any conflicts, and the adviser must obtain the client's signed acknowledgment. The payment must be disclosed in the adviser's brochure (Form ADV Part 2A) and the fee must be reasonable. The testimonial is permitted under the modern marketing rule if it is not misleading, but 'beat the market by 4% last year' is likely misleading without context: it may not be representative, may omit risk, and may imply future results. The firm must disclose that the testimonial may not be representative, that it is a client's experience, and whether the client was compensated. The compliance manual's conditions are necessary but not sufficient; the adviser must also have a reasonable basis for the claim.
2. Analyze the custody issue and the performance fee request. Is the performance fee permissible? Why or why not?
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Receiving a $50,000 check payable to the qualified custodian and forwarding it within two business days likely falls under the inadvertent custody exception, which requires forwarding within three business days. But the adviser must document the receipt, not negotiate the check, and ensure the custodian sends statements directly to the client. If the adviser has any authority to withdraw funds, custody is triggered and a surprise exam is required. The performance fee is the bigger problem. Under Rule 205-3, performance fees are allowed only for 'qualified clients': at least $1.1 million in assets under management with the adviser or a net worth above $2.2 million excluding the primary residence. This client has a $400,000 account and $900,000 net worth including a $300,000 home, so she is not qualified. The fee is prohibited. The adviser should decline and offer a flat or asset-based fee.