- Under federal securities law, an investment adviser with discretionary authority may use client brokerage commissions to obtain all of the following research services from a broker-dealer EXCEPT:
Answer: A subscription to a general financial newspaper delivered for the adviser's staff to read daily.
Governing authority: Section 28(e) of the Securities Exchange Act of 1934. The safe harbor permits an investment adviser with discretionary authority over client accounts to use client brokerage commissions to obtain research services that provide lawful and appropriate assistance in the investment decision-making process. The statutory list includes analyses and reports concerning issuers, industries, securities, and economic factors and trends; advice and reports on portfolio strategy and account performance; and advice or reports on the availability of securities and the advisability of buying or selling them. A subscription to a general financial newspaper is a general-circulation news product, not a research service, and therefore is not within the safe harbor. The three listed research categories all appear on the Section 28(e) list, which is why the newspaper subscription is the exception.
A state-registered investment adviser has investment discretion over its client accounts and directs client trades to a broker-dealer that provides a proprietary portfolio-analytics system. Portfolio managers use the system to monitor client portfolios, and the firm's marketing staff uses the same system to create performance charts for the website. The broker-dealer is paid entirely from client commissions, and the adviser's Form ADV describes the system as a research benefit.
Which statement is correct? Answer: The arrangement is permitted only if the adviser allocates a reasonable portion of the system's cost to the marketing use and pays that portion from its own funds.
Governing authority: Securities Exchange Act section 28(e), including SEC guidance on mixed-use products. When a research-related product is used for both eligible client services and the adviser's own marketing, the adviser must allocate a reasonable portion of the cost to the non-client use and pay that portion from its own funds. Paying the entire cost from client commissions exceeds the safe harbor. Disclosure alone is not enough, the product can be eligible research, and a blanket prohibition on any marketing use is too broad.
An SEC-registered investment adviser manages a mutual fund. The proposed advisory contract sets the fee at 0.70% of the fund's average daily net assets, adjusted upward or downward by up to 0.15% depending on the fund's investment performance over the preceding 12 months relative to the S&P 500 Index.
Under federal law, is this fee arrangement permitted? Answer: Yes, because it is a fulcrum fee that increases and decreases symmetrically with the fund's performance relative to an appropriate benchmark.
Governing authority: Investment Advisers Act section 205(b). A fulcrum fee is permitted for a registered investment company when the fee moves both upward and downward, within a stated range, based on the fund's performance relative to an appropriate index. The arrangement described is symmetrical and capped, so it is not the prohibited uncapped share of capital appreciation. Performance-based fees are not per se prohibited, and an appropriate index may be used for a fulcrum fee.
- Under the Uniform Securities Act, a state-registered investment adviser enters into an advisory contract with a client who is a qualified client. The contract provides for performance-based compensation. Which of the following additional provisions would make the contract unlawful?
Answer: A provision permitting the adviser to assign the contract to an affiliate without the client's written consent.
Governing authority: Uniform Securities Act § 102 and SEC Rule 205-3. The written advisory contract may not be assigned without the client's consent, so a provision allowing assignment to an affiliate without written consent is unlawful. For a qualified client, a performance fee based on realized and unrealized capital appreciation is permitted; a one-year measurement period with a high-water mark is a permissible fee formula; and a provision calling for notice of partnership membership changes satisfies, rather than violates, the Act's requirement that the client be notified of such changes.
An individual client has had $1.35 million under management with a state-registered investment adviser for the past three years. The client's net worth, excluding the primary residence, is $2.75 million. The adviser proposes to add a 15% incentive fee based on the annual capital appreciation of the account and asks the client to sign a revised written advisory contract.
Under the Uniform Securities Act, may the adviser charge this performance fee? Answer: Yes, because the client's net worth, excluding the primary residence, exceeds the qualified-client threshold and the proposed fee would be included in a written contract.
Governing authority: Uniform Securities Act § 102, which uses SEC Rule 205-3's qualified-client definition for performance-fee contracts. A performance fee may be charged only under a written contract with a qualified client. This client fails the $1.4 million assets-under-management test, but the net-worth test is an alternative, and $2.75 million excluding the primary residence exceeds the $2.7 million threshold. Written consent plus full disclosure does not create qualified-client status; the AUM shortfall is not disqualifying when the net-worth test is met; and the net-worth test is available to individual clients, so natural persons may be charged incentive fees when they satisfy the qualified-client tests.
- An investment adviser directs client trades to a broker-dealer that supplies the adviser with both a proprietary research service and, at no separate charge, administrative support such as routine recordkeeping. The adviser's payment of client commissions is within the federal soft-dollar safe harbor only if:
Answer: The adviser makes a good-faith determination of the value of the brokerage and research services and finds the commissions reasonable in relation to that value.
Governing authority: Section 28(e) of the Securities Exchange Act of 1934. The safe harbor turns on the adviser's good-faith determination that the commission is reasonable in relation to the value of the brokerage and research services provided by the broker-dealer. Administrative support is not an eligible Section 28(e) service, so it cannot be used to justify client commissions. Disclosing the arrangement in Form ADV Part 2A and receiving no written objection from clients is not the Section 28(e) test; disclosure does not convert ineligible services into eligible research. The statement that the administrative support can be ignored because it is provided at no separate charge is wrong: bundled services are still provided in connection with the adviser's commission business, and the adviser must justify commissions with eligible services. The statement that client direction brings the arrangement within the safe harbor is wrong because Section 28(e) protects the adviser's exercise of investment discretion; when the client directs the broker, the adviser is not exercising that discretion as to the commission.
- On August 1, 2026, a state-registered investment adviser enters into a performance-fee contract with a client. Immediately after entering the contract, the client has $1,180,000 under the adviser's management and a net worth, excluding the primary residence, of $2,500,000. The client had $1,480,000 under management on July 1 and withdrew $300,000 on July 20. Which statement is true regarding the client's eligibility for performance-based compensation?
Answer: The client is not a qualified client because the $1,180,000 under management and the $2,500,000 net worth are both below the required thresholds.
Governing authority: SEC Rule 205-3 (the qualified-client standard for performance-based compensation, as incorporated in state-adviser performance-fee rules). The contract is dated August 1, 2026, after the June 29, 2026 adjustment, so the current thresholds apply. The assets-under-management test is measured immediately after entering into the contract, so the $1,180,000 under management on the contract date controls; the July 1 balance is irrelevant. Because $1,180,000 is below $1,400,000 and the $2,500,000 net worth (excluding the primary residence) is below $2,700,000, the client is not a qualified client. The statement relying on the July 1 balance is wrong because qualification is not measured from an earlier date; the statement invoking a highest-balance-within-12-months rule is wrong because no such look-back exists—a high-water mark is a fee-computation device, not an eligibility test; and the statement asserting a $2,000,000 assets-under-management threshold is wrong because the applicable threshold is $1,400,000.
A state-registered investment adviser has discretionary authority over client accounts. It directs trades to a broker-dealer that offers execution at the lowest commission rate available in the area. The broker-dealer also uses a portion of those commissions to pay for the adviser's subscription to an independent research service and to install a new telephone system in the adviser's office. The adviser's Form ADV describes the receipt of both benefits.
Which statement about this arrangement is correct? Answer: The arrangement is a prohibited practice because client commissions may not be used to pay for the adviser's general office operating expenses, even if disclosed.
Governing authority: Securities Exchange Act section 28(e) and fiduciary obligations under the Investment Advisers Act. The soft-dollar safe harbor covers brokerage and research services that provide lawful and appropriate assistance in investment decision-making. A general office telephone system is overhead, not an eligible research or brokerage service, so paying for it with client commissions is prohibited even if disclosed. Best execution and ADV disclosure do not make an ineligible expense eligible, and the broker's registration status or client consent is not the deciding condition.
An SEC-registered investment adviser proposes a performance-fee agreement with an individual client. The client has $1.2 million under management with the adviser, a net worth excluding the primary residence of $2.0 million, and annual income of $300,000. The client qualifies as an accredited investor and is willing to sign the written agreement. Assume the SEC qualified-client thresholds are $1.4 million of assets under management or $2.7 million of net worth excluding the primary residence.
May the adviser charge the performance fee? Answer: No, because the client does not meet either the assets-under-management threshold or the net-worth test for qualified-client status.
Governing authority: SEC Rule 205-3. Performance fees require qualified-client status, not accredited-investor status. The client fails the assets-under-management test because $1.2 million is below the $1.4 million threshold, and fails the net-worth test because $2.0 million excluding the primary residence is below the $2.7 million threshold. Annual income is relevant to accredited-investor status but is not a qualified-client test. The $5 million and $10 million figures describe a different standard, not the SEC performance-fee rule.
- Under the ethical practices rules, which statement is true regarding a state-registered investment adviser's receipt of a 12b-1 fee from a mutual fund it recommends to a client?
Answer: It must be disclosed to the client because it is a material conflict of interest in the recommendation.
Governing authority: NASAA Unethical Business Practices of Investment Advisers Model Rule. A 12b-1 fee received by an adviser from a fund it recommends is a material conflict of interest, so the receipt must be disclosed to the client. The statement that the receipt is prohibited is wrong because 12b-1 compensation is permitted when disclosed. The statement requiring an annual refund is wrong because no rule requires the adviser to rebate the fee. The statement excusing disclosure because the fund is SEC-registered and its prospectus states the fee is wrong because the fund's disclosure does not satisfy the adviser's independent duty to disclose compensation it receives and the resulting conflict.
- A state-registered investment adviser proposes to charge a performance-based fee to a married client. Immediately after the contract is signed, the client will have $1,350,000 under the adviser's management. The client's net worth is $3,100,000 including the primary residence, or $2,650,000 excluding it, and the couple's joint annual income was $310,000 in each of the last two years, with the same expected this year. Which statement is true regarding the proposed fee?
Answer: The client is not a qualified client, and the proposed performance fee is therefore prohibited.
Governing authority: SEC Rule 205-3, as applied to state-registered advisers under the NASAA performance-fee rule and the Uniform Securities Act. A natural person is a qualified client only if, immediately after entering the contract, the client has at least $1,400,000 under the adviser's management, OR has a net worth above $2,700,000 excluding the primary residence. Here the client fails both tests: only $1,350,000 is under management, and net worth excluding the residence is only $2,650,000. The statement basing qualification on $310,000 of joint income is wrong because income is an accredited-investor test under Rule 501(a), not a qualified-client test. The statement including the primary residence in net worth is wrong because the residence is expressly excluded from the qualified-client net-worth test. The statement that prior written consent permits the fee is wrong because consent cannot cure the failure to meet the qualified-client tests; a state-registered adviser may not charge a performance fee to a client who is not a qualified client.
A state-registered investment adviser signs a written performance-fee contract with a new individual client. At the moment the contract is signed, the client's account contains $1.2 million. The client has also signed a binding written commitment to contribute an additional $300,000 to the account within 60 days. The client's net worth, excluding the primary residence, is $2.0 million. Assume that, at contract signing, the qualified-client thresholds are $1.4 million of assets under management with the adviser immediately after entering into the contract, or a net worth above $2.7 million excluding the primary residence. Six months later, after the contribution has been made, the account contains $1.6 million.
Was the performance-fee arrangement lawful when it was made? Answer: No, because the client met neither the assets-under-management test nor the net-worth test for a qualified client at the time the contract was entered into.
Governing authority: Uniform Securities Act § 102; the qualified-client standard is SEC Rule 205-3 as incorporated in the Uniform Securities Act. Qualified-client status for a performance fee is measured when the performance-fee contract is entered into, and the assets-under-management threshold applies immediately after entering into the contract. A binding future commitment is not yet an asset under management, so the client had only $1.2 million under management at signing, below the $1.4 million threshold. The client's $2.0 million net worth, excluding the primary residence, is also below the $2.7 million threshold. A later contribution and account growth cannot make the arrangement lawful as of the time it was made, and no 12-month waiting period is required.
An SEC-registered investment adviser directs client equity trades to a particular broker-dealer. The broker-dealer charges a commission about 20% higher than another broker-dealer offering comparable execution. The higher commissions pay for proprietary research reports and earnings estimates that the adviser's portfolio managers use exclusively in making recommendations for client accounts. The adviser believes the research justifies the higher commission and describes the arrangement in Form ADV.
Which statement is correct about this use of client commissions? Answer: The arrangement is permitted because the adviser may pay a higher commission when it determines in good faith that the commission is reasonable in relation to the research received.
Governing authority: Securities Exchange Act section 28(e). The safe harbor permits an adviser to pay a commission higher than another broker's commission if the adviser determines in good faith that the commission is reasonable in relation to the value of the research received. Best execution does not require the lowest available commission on every trade. Advance client consent is not a condition of the safe harbor, and the research need not be distributed to every similar client account.
A federal covered investment adviser with investment discretion over client accounts directs client trades to a broker-dealer that charges a higher commission than another broker-dealer offering comparable execution. In return for the order flow, the broker-dealer provides the adviser with third-party research reports that the adviser uses in making investment decisions and a portfolio accounting module that the adviser uses to prepare client account statements. The adviser believes the higher commission is reasonable in relation to the value of the research, discloses the arrangement in its Form ADV brochure, and has not allocated the cost of the package between the research reports and the accounting module.
Under federal securities law, which statement is correct regarding this arrangement? Answer: The arrangement is outside the safe harbor because the adviser is receiving both eligible research reports and an ineligible administrative service without a reasonable cost allocation.
Under Section 28(e) of the Securities Exchange Act of 1934, an investment manager may use client commissions to obtain eligible brokerage and research services if the manager determines in good faith that the commissions are reasonable in relation to the value of those services. Where a package includes both an eligible service, such as the research reports, and an ineligible administrative service, such as the accounting module used to prepare client account statements, the adviser must reasonably allocate the package's cost and may use client commissions only for the research portion. Because the facts state that no allocation was made, the arrangement is outside the safe harbor. The good-faith reasonableness determination alone does not cure the mixed-use failure; Form ADV disclosure does not make an ineligible administrative service eligible; and client commissions are not categorically prohibited from being used for third-party research reports.
