Commodity trading advisors (CTAs) are asked to sign a variety of contracts on a regular basis: technology agreements, office leases, licensing contracts and third party marketing agreements, just to name a few. However, arguably the most important contracts for CTAs are the managed account agreements, sometimes called “advisory agreements,” with their clients. For those CTAs with an in-house legal staff or enough assets under management to afford experienced outside counsel to review all of the advisory agreements, their interests are being protected by their attorneys. But, for CTAs without a legal staff, this article will alert you to the most critical and often overlooked provisions in a managed account agreement.
Advisory agreements are the contracts that govern the relationship between the CTA and its client. The contract is designed to set forth all of the business terms of the advisory relationship. The substance of each contract is essentially the same, even though the terms may be significantly different. CTAs often want to have a standardized version of an advisory agreement to provide to their clients. However, sophisticated institutional clients may want to use their own contract or make major revisions to the CTA’s contract. Further, if the CTA’s client is a pool operated by a third party commodity pool operator (CPO), that CPO may have its version of an advisory agreement. In that case, it would be the CTA that may have revisions to the CPO’s version of the agreement.
The fee section of an advisory agreement may say 2 and 20 (the relatively standard 2% management fee and 20% incentive fee structure), but it is rarely that simple and there are opportunities to maximize the CTA’s fees and to avoid some unpleasant surprises by paying attention to the details.
Incentive fees are calculated in two ways; based either on trading profits or increase in NAV (net asset value). If the incentive fee is based on trading profits, the CTA doesn’t have to recoup all of the expenses of the account or fund (accounting, audit, legal, CPO fees) to get its incentive. It only has to make back the advisor’s management fees, brokerage commissions and other transaction fees. If instead the incentive fee is based on increase in NAV, the CTA would have to generate additional trading profits to make back all of the expenses of the account or pool, even those unrelated to trading, before an incentive fee is earned.
Incentive fees can include interest income earned on the account’s assets. Interest rates currently are at such low levels that inclusion of interest in the incentive fee would not make a significant difference in revenues to the CTA. However, interest rates may increase significantly in the coming years and could make a big difference in the incentive payments if such income were included in the calculation. Even if interest is not included in the incentive fee, it is included in the performance of the account. If rates were to increase, such increase would boost CTA rates of return.
Asset-based or management fees can be calculated either at the beginning or end of the period. In the long run, the differences in these approaches should be negligible, but initially it may help a CTA’s cash flow if the fee is charged and paid at the beginning of the period. However, if trading is profitable, it is best to calculate the fee in arrears when the NAV of the account is higher.
Clients sometimes make additions to their accounts during drawdowns. The issue here is whether the profits attributable to the new capital are subject to an immediate incentive fee (treated as if it were a separate account for incentive fee calculations) or whether all of the previous losses have to be made back before any incentive fee is earned (treated as if the client had one account). The latter method is more pro-investor and may encourage investors to add to their accounts during drawdowns.
Some clients withdraw capital from their account during drawdowns. Typically, the amount of the carry forward loss (the amount that the CTA has to make back before it is entitled to a new incentive fee) is reduced if there is a capital withdrawal or reduction in the notional level. The idea is that the CTA has a smaller capital base to make back a specific dollar amount and it is therefore appropriate to reduce the carry forward loss in the same proportion that the withdrawal bears to the NAV of the account immediately prior to the withdrawal. If a CTA doesn’t have this language in its agreement, it would have to make back all of the carry forward loss even if the client had withdrawn a significant portion of the capital (see “Details matter,” above).
Many CTAs permit clients to select a trading level for their accounts with “notional” funds. For example, a client may deposit $100,000 with their futures commission merchant (FCM) and direct the CTA to trade the account as if it had a total size of $300,000. Management fees are based on the notional level of $300,000. Incentive fees are based on actual profits in the account, which will be higher (if profitable) or lower (if not profitable) than if the account were traded at the level of the actual assets ($100,000). It is important that the advisory agreement clearly states how the fees will be charged on notional accounts, including a legend required by CFTC rules (see “Effect of notional funding,” below). Some CTAs increase the trading level of the account by the actual trading profits, while others leave the trading level at the initial level until the CTA and the client agree on a different level. It also is critical that any changes in the notional level be agreed in writing between the client and the CTA.
Often, the longest and most tedious section of an advisory agreement is the indemnification section. Although challenging to read, it is the most important section to get right. In essence, the indemnification section creates the legal basis for the client to have its costs, liabilities and attorneys’ fees paid by the CTA if the CTA fails to meet specified standards of conduct. For example, if the CTA engages in reckless behavior by abandoning its trading program and throwing darts to pick trades, resulting in losses to the client, and the client sues the CTA, the client can be reimbursed for its attorneys’ fees in recovering its losses.
The CTA should be careful to select a standard of liability that is commercially reasonable. For example, if the agreement uses a “simple negligence” standard, the CTA may be liable for trading errors and other good faith mistakes. Clients, of course, prefer the broadest standards for CTAs, but need to understand that CTAs should not have to put their business at risk on every trade.
The agreement also should ensure that the indemnification language is not so broad that it creates leverage for an unhappy client. For example, a reasonable provision in the agreement would provide that the client will be indemnified for any losses or liabilities arising out of any willful misconduct, material breaches of the agreement or violations of law by the CTA. However, some agreements with CPOs also provide for indemnification for “alleged” misconduct, breaches, etc. Thus, if the CPO alleges that the CTA has engaged in wrongful conduct, the CPO could assert that the CTA would have to indemnify the CPO for its legal fees and the like in investigating the claim and defending the suit, even if the CTA eventually proved that it had not engaged in any misconduct. Investigations and litigation often are very expensive, so CTAs should carefully review their indemnification provisions, especially with pools and institutions.
Most advisory agreements provide for arbitration in the event of any dispute between the client and the CTA. (CFTC rules provide for certain required disclosures in the agreement if the arbitration is mandatory.) The primary benefits of arbitration, as opposed to civil litigation in the courts, are that the dispute is heard more quickly in an arbitration and usually is less expensive. Another advantage of arbitration is that arbitrators often have industry experience. The arbitration forum at the National Futures Association is a good location for a CTA and client to arbitrate a dispute because the arbitrators generally have a significant knowledge of the futures industry and the business issues underlying such disputes.
The disadvantage to arbitration is that there is limited opportunity to participate in “discovery.” This is the process in civil litigation where either party can require other parties and third parties to produce vast amounts of documents and be questioned under oath in depositions. Arbitrations often have some opportunity for discovery, though generally it is very limited relative to the scope of discovery in civil cases. This is one of the reasons why arbitration is less expensive than civil litigation.
Sometimes, a party may prefer civil litigation to arbitration. A party may need extensive discovery to obtain the proof to their claims or their defenses. A party may want to delay the resolution of the case, and there are many ways to slow the process in civil litigation. Also, one party may have significantly greater economic resources than the other party and may prefer the more expensive court system as a means to capitalize on the disparity in resources. Lastly, courts tend to render verdicts giving a clear victory or loss to the plaintiff, whereas arbitrators usually give the petitioner something but less than all it has asked for, a phenomenon known as “splitting the baby.” If a party wants or needs to seek a total victory (and assume the risk of a total loss), it may prefer civil litigation over arbitration.
If the client agreement has a provision for arbitration, the parties need to determine whether they want the arbitration provision to be permissive or mandatory. If permissive, a party that wants to go to court cannot be compelled to go to arbitration. If mandatory, it is the only forum that the parties may use (unless all the parties agree otherwise when the dispute arises). Of course, even if the parties have agreed to mandatory arbitration, they can (and should) attempt resolution of their dispute through settlement prior to filing an arbitration.
There are many other provisions of a standard advisory agreement in addition to the ones discussed in this article. The most important point from the perspective of both the CTA and client is that both parties understand all of the provisions and how all of the structures work. Even if a CTA is on sound legal ground, if his client feels an element of the fee structure was not appropriately disclosed, that client may choose to withdraw funds or terminate the relationship. When CTAs know what they are agreeing to and the consequences of those provisions, they and their clients will get what they bargained for, with a minimum of surprises.
David Matteson is a partner with Drinker Biddle & Reath LLP and heads their managed futures practice.