Regulatory Alert
During the last several years, the United States Securities and Exchange Commission (“SEC”) has intensified its scrutiny of liability hedge clauses within investment advisory client agreements used by investment adviser firms.
This renewed regulatory focus on the use of contractual limitations of liability by investment adviser follows the guidance provided in SEC Release No. IA-5248: Commission Interpretation Regarding Standard of Conduct for Investment Advisers (6/5/2019). The Commission specifically addressed the permissibility of a clause in an investment advisory client agreement that purports to limit an adviser’s liability (commonly referred to as a “hedge clause”):
[T]here are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with those antifraud provisions, where the hedge clause purports to relieve the adviser from liability for conduct as to which the client has a non-waivable cause of action against the adviser provided by state or federal law. Such a hedge clause generally is likely to mislead those retail clients into not exercising their legal rights, in violation of the antifraud provisions, even where the agreement otherwise specifies that the client may continue to retain its non-waivable rights. Whether a hedge clause in an agreement with an institutional client would violate the [Investment] Advisers Act’s antifraud provisions will be determined based on the particular facts and circumstances.
The SEC Division of Examinations has explicitly incorporated the Commission’s guidance on hedge clauses into its 2023 Investment Adviser Examination Priorities and explained that “…examinations will review whether [investment adviser] firms have … client agreements that purport to inappropriately waive or limit their standard of conduct, such as through the use of hedge clauses.”
In the last two years, the SEC has initiated at least two enforcement actions against investment adviser firms for allegedly misleading retail clients by using contractual provisions that attempted to limit the liability of such firms. See In the Matter of Titan Global Capital Management USA LLC and In the Matter of Comprehensive Capital Management, Inc.
The regulatory scrutiny of liability hedge clauses is not limited to SEC registered investment adviser firms. As part of the 2023 Investment Adviser Coordinated Exams sponsored by the North American Securities Administrators Association (“NASAA”), state securities regulators conducted routine examinations of 683 state registered investment adviser firms. NASAA reported that the second most frequent contract violation identified during these examinations was the inclusion of impermissible hedge clauses in investment advisory agreements.
As a result, it would be advisable for an investment adviser to review (with the assistance of legal counsel) its existing client agreements for any impermissible waivers of fiduciary duty and limitations of liability. Based upon the Commission’s Interpretation and the SEC’s subsequent cease-and-desist orders, the following are key takeaways and best practices that an investment adviser should consider during such a review.
- SEC’s position is that an investment adviser’s federal fiduciary duty may not be waived regardless of the sophistication of the client.
- Several recent SEC enforcement actions against investment adviser firms involve use of liability hedge clauses in investment advisory agreements. Likewise, SEC staff are finding the use of hedge clauses as deficiencies during investment adviser examinations.
- Hedge clauses that purport to limit an investment adviser’s fiduciary duty and/or liability are viewed generally by the SEC as misleading to “retail” clients.
- Savings clause (e.g., nothing in this agreement waives a client’s rights under federal or state law) within an investment advisory client agreement does not negate the misleading nature of a hedge clause used with a retail client, according to the SEC.
- Whether a hedge clause in an agreement with an institutional client would violate the Investment Advisers Act’s antifraud provisions will be determined based on the particular facts and circumstances.
- For purposes of identifying hedge clauses, an investment adviser’s chief compliance officer (“CCO”) should review the firm’s investment advisory client agreement for language which limits (i) fiduciary duty (especially to gross negligence), (ii) liability for errors made in good faith or with reasonable care, and/or (iii) liability for only fraud or malfeasance.
- Additionally, the CCO should identify whether there are any indemnification clause within the investment advisory client agreement which may limit an investment adviser’s fiduciary duty obligations such as a hold harmless for all claims arising from any act.
To the extent that the CCO identifies language within its advisory agreement which may constitute a waiver of fiduciary duty or liability hedge clause, a securities lawyer should be consulted for further guidance and assistance.
Resources
SEC Enforcement Action: In the Matter of Titan Global Capital Management USA LLC (8/21/2023)
Key Takeaways from NASAA’s 2023 Investment Adviser Coordinated Exam (8/15/2023)
SEC Issues Investment Adviser Exam Priorities for 2023 (2/16/2023)
Recorded Webinar: Reviewing and Updating Investment Adviser Client Agreements (4/27/2022)
- Included with an Annual Compliance Program (Bronze, Silver, Gold, Platinum & Titanium packages) through our Knowledge Base at
https://www.ria-compliance-consultants.com/knowledge-base/reviewing-and-updating-investment-adviser-client-agreements/ or - Available for an a la carte purchase through our Online Store at https://www.ria-compliance-consultants.com/product/reviewing-and-updating-investment-adviser-client-agreements/
SEC Enforcement Action: In the Matter of Comprehensive Capital Management, Inc. (1/11/2022)
SEC Release No. IA-5248: Commission Interpretation Regarding Standard of Conduct for Investment Advisers (6/5/2019) at pages 10 – 11
Understanding the Provisions Required for Registered Investment Adviser Client Contracts (5/16/2013)
Common Investment Advisor Exam Deficiencies (3/12/2013)
Section 215(a) of Investment Advisers Act of 1940 as amended
Disclosures
The information contained in this blog post is general in nature intended for educational purposes only and is not intended to be a comprehensive analysis of this topic. This is merely a summary and does not necessarily include all material facts from the proceeding or order. RIA Compliance Consultants, Inc. has not verified the accuracy of the securities regulator’s order and is not offering any opinion whether the allegations made by the securities regulator in the administrative proceeding referenced above are accurate. This post is not intended to constitute compliance consulting advice or apply to any particular investment adviser firm’s specific situation. Please consult the applicable securities regulator’s order, rules and published guidance for more details about the topics referenced above. RIA Compliance Consultants, Inc. is not a law firm and does not provide legal services. This blog post should not be considered legal advice. RIA Compliance Consultants, Inc. recommends that an investment adviser discuss the use of liability hedge clauses in client agreements with its legal counsel. For more information about the limitations of this blog post and information on our website, please see our Disclosures webpage.
Posted by Bryan Hill
Labels: Client Contracts, Fiduciary, SEC
Tagged: Fiduciary Duty, SEC
