By Les Abromovitz, Senior Director
On January 11, 2022, the SEC instituted public administrative and cease-and-desist proceedings pursuant to Sections 203(e) and 203(k) under the Investment Advisers Act of 1940 against a Registered Investment Advisor (“RIA”) in Rockaway, New Jersey. The RIA consented to the order that imposed remedial sanctions and agreed to cease and desist from engaging in the conduct that got the firm in the SEC’s crosshairs.
From 2017 through March 2021, the RIA allegedly misrepresented fee-related information and failed to disclose conflicts of interest in its Forms ADV Part 2A regarding commissions paid to an affiliated broker-dealer, as well as its associated persons. The SEC also found fault with the RIA’s advisory agreements, which included liability disclaimer language that is frequently referred to as a hedge clause.
Hedge clauses cause problems with the SEC
A hedge clause is a provision in an advisory contract that is intended to limit an advisor’s liability. Hedge clauses are frowned upon by the SEC, because they could lead clients to assume incorrectly that they have waived a cause of action against the RIA that is permitted under state or federal law. Generally, it is improper for an RIA to limit liability in its advisory agreements with retail clients.
The Investment Advisers Act is the source of the federal fiduciary duty owed by investment advisors. According to the SEC, an advisor’s fiduciary duty may not be waived, even though its application may be shaped by agreement. Advisory agreements may not misrepresent or contain misleading misstatements regarding the scope of an advisor’s fiduciary duty. Advisory agreements should not use language that would lead clients to believe mistakenly that they have waived a cause of action that is non-waivable.
Hedge clauses in advisory contracts can be viewed as misleading, even if there is additional language stating that compliance with state or federal securities laws cannot be waived. This disclaimer is sometimes referred to as a non-waiver disclosure or a savings clause. RIAs’ use of a hedge clause will still cause problems for the firm with the SEC, even if their contracts include a non-waiver disclosure.
Whether a specific hedge clause is misleading depends on facts and circumstances. In the action bought against the New Jersey advisor, the RIA’s advisory contracts imposed broad limits on the firm’s liability. The hedge clause stated that the client was waiving all claims, and the RIA would never be liable to the client for any act, including the advisor’s gross negligence, willful misconduct, and fraud.
The RIA’s policies and procedures stated that the firm’s advisory agreements met all appropriate regulatory requirements and did not contain any hedge clauses, which was not the case. Furthermore, the RIA had no policies and procedures to evaluate a client’s sophistication regarding legal matters or to explain the meaning of the non-waiver disclosure. There was no evidence offered to show that this non-waiver disclosure would be understood by retail clients.
There was also no evidence that the RIA highlighted and explained its hedge clause during in-person meetings with each client. In addition, the firm did not provide enhanced disclosure regarding when a client retains the right to bring an action.
The RIA assured examiners that the firm would not seek to enforce the hedge clause in any litigation or arbitrations with clients that might arise. The RIA did not, however, give this assurance to current or former clients.
The SEC concluded that the firm’s hedge clause violated Section 206(2) of the Investment Advisers Act. The SEC reached this conclusion, even though the RIA included a non-waiver disclosure in its contracts. The provision stated that nothing in the agreement constitutes a waiver or limitation of any rights which the client or the RIA may have under any federal securities laws. Clearly, the SEC believed that the advisor’s non-waiver disclosure did not undo the potential damage done by the RIA’s hedge clause.
The SEC found that the RIA’s hedge clause was inconsistent with an advisor’s fiduciary duty. The SEC also determined that this particular hedge clause would mislead advisory clients into not exercising their legal rights. Therefore, the original and revised hedge clause used by this RIA violated Section 206(2) of the Investment Advisers Act.
The SEC’s objections to this RIA’s hedge clause are not surprising in view of its previous guidance regarding investment advisor conduct. On June 5, 2019, the SEC published the Commission Interpretation Regarding Standard of Conduct for Investment Advisers, IA Rel. No. 5248 (June 5, 2019). In that release, the SEC said there are few if any circumstances in which a hedge clause in a contract with a retail client would be consistent with the antifraud provisions of the Investment Advisers Act. In conjunction with that release, the SEC withdrew the Heitman Capital Management, LLC, SEC Staff No-Action Letter (Feb. 12, 2007), which articulated the Commission staff’s guidance on hedge clauses.
Using an improper hedge clause was only one of several charges made by the SEC against the RIA. The firm was also charged with violating Section 204(a) of the Investment Advisers Act and Rule 204-2 thereunder, which require RIAs to keep true, accurate and current books and records pertaining to their investment advisory business. The RIA failed to keep true, accurate, and current records of accounts where it had discretionary authority.
In addition, although the RIA had established written policies and procedures, they were not implemented. The RIA was unable to produce accurate client information, advisory account information, and related firm records. Furthermore, the RIA failed to implement the results of its annual compliance review.
With regard to the use of hedge clauses in contracts with institutional clients, their validity will also depend upon the particular facts and circumstances. Advisors must address any conflicts of interest created by the hedge clause in a manner that is consistent with their duty of loyalty.
The SEC’s action is available at https://www.sec.gov/litigation/admin/2022/ia-5943.pdf.