Engagement Letter

An engagement letter is a written agreement between a client and a professional that sets the terms of a specific engagement before the work starts: the services to be provided and those excluded, the fee and how it is billed, how long the agreement lasts, and how either side can end it. The name is used well beyond financial planning: New York's court rules, for example, require attorneys, with listed exceptions, to give a client a written "letter of engagement" that explains the scope of the services and the fees (22 NYCRR 1215.1). When the professional is an investment adviser, the document is what the Investment Advisers Act calls an "investment advisory contract," and some of its contents are set by law.

What federal law requires of an adviser's contract. Section 205 of the Investment Advisers Act bars an SEC-registered adviser from entering into an investment advisory contract that pays the adviser "on the basis of a share of capital gains upon or capital appreciation of the funds" of the client, unless an exemption applies, such as the SEC's rule for qualified clients (Rule 205-3). The contract must also provide, "in substance," that the adviser will not assign it without the client's consent, and an adviser organized as a partnership must agree to notify the client of changes in its membership (15 U.S.C. 80b-5(a)).

Disclosure comes with the contract, not after it. An adviser must deliver its current Form ADV brochure "before or at the time you enter into an investment advisory contract" (17 CFR 275.204-3(b)(1)), and its Form CRS relationship summary to a retail investor on the same timing (17 CFR 275.204-5). The brochure describes services, fees and conflicts at the firm level; the engagement letter is what the client and the adviser actually agree to.

The fiduciary duty is not a contract term to bargain away. The SEC's 2019 interpretation of advisers' standard of conduct states that "an adviser's federal fiduciary duty may not be waived, though it will apply in a manner that reflects the agreed-upon scope of the relationship." A contract provision purporting to waive the duty generally, such as a statement that the adviser will not act as a fiduciary or a blanket waiver of all conflicts of interest, would be inconsistent with the Advisers Act. So the scope section of an engagement letter matters, because it defines what the duty covers.

State rules can add a writing requirement. NASAA, whose members include the state securities regulators, publishes a model rule listing unethical practices by investment advisers. It includes entering into an advisory contract unless it "is in writing and discloses, in substance, the services to be provided, the term of the contract, the advisory fee, the formula for computing the fee, the amount of prepaid fee to be returned in the event of contract termination or non-performance, whether the contract grants discretionary power to the adviser" and the no-assignment term. A model rule binds only where a state has adopted it, so the obligation depends on the state.

After an introductory conversation, the professional sends a letter or agreement describing the proposed engagement. The client reviews it, asks questions, and signs; work begins under its terms. A useful letter answers, at minimum: what exactly is included and excluded; what the fee is, when it is billed and whether any part is paid in advance; how long the engagement lasts and whether it renews; how either side ends it and what happens to a prepaid fee; whether the professional will have discretionary authority over any account; and, for a couple, who the client is.

For example: Darnell signs an engagement letter for a retirement plan with a flat fee of $3,500, half due at signing and half at delivery of the plan. The letter says that if either side ends the engagement early, he pays for work completed at the planner's stated hourly rate of $250 and any unearned prepaid amount is refunded. After two meetings and four hours of work, Darnell takes a job offer that changes his plans and ends the engagement. He paid $1,750 at signing; the work completed is 4 × $250 = $1,000, so the refund under the letter is $1,750 − $1,000 = $750.

Pros

• Puts the scope, fee and exit terms in writing before any work or payment, so both sides know what was agreed.
• For an adviser, the contract terms federal law requires give the client protections, such as consent before the contract is assigned.
• A clear scope section shows exactly what the professional's duty to the client covers in that engagement.

Cons

• A letter can be written broadly or narrowly, and a vague scope leaves room for disagreement about what was promised.
• The terms that matter most when an engagement goes wrong, termination, prepaid fees and discretionary authority, are easy to skim past at signing.
• The letter alone does not show the firm's conflicts; those are in the Form ADV brochure and Form CRS, which have to be read alongside it.