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Regulation and Compliance > Federal Regulation > SEC

Confusion and Misinformation

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One of the things I hope to do through these Expert’s Corner articles is to clear up some of the subjects about which many advisors have been misinformed over the years. This month I will address confusion regarding hedge clauses. In a follow-up column we’ll look at the use of arbitration clauses.

Primarily as a result of misinformation and uneven regulatory compliance enforcement, advisors have long been confused about whether the use of advisory contract provisions which seek to limit the scope of a client’s legal remedies against the advisor are prohibited under the Advisers Act. The SEC refers to these types of liability limitation provisions as “hedge clauses.” Examples of such liability limitation provisions we have seen are:

“The Adviser, acting in good faith, shall not be liable for any action, omission, investment recommendation/decision, or loss in connection with this Agreement;” or “The Adviser shall not be liable for any action, omission, investment recommendation/decision, or loss in connection with this Agreement unless caused by Adviser’s gross negligence or willful malfeasance.”

The Commission has long maintained that advisory contacts should not contain language which implies that a client has given up legal rights. Beginning with the 1951 opinion of its then General Counsel as set forth in Advisers Act Release No. 58, the SEC has taken the position that such clauses may lead a client to believe that she is foreclosed from a remedy she might otherwise have under common law or federal securities statutes.

The SEC’s General Counsel, in Release No. 58, specifically indicated, in pertinent part, as follows: “The question arises, therefore, whether the result, if not the purpose, of such a legend is to create in the mind of the investor a belief that he has given up legal rights and is foreclosed from a remedy which he might otherwise have either under common law or under the Securities and Exchange Commission statutes…In my opinion, the anti-fraud provisions of the Securities and Exchange Commission statutes are violated by the employment of any legend, hedge clause or other provision which is likely to lead an investor to believe that he has in any way waived any right to action he may have…”

Beginning with 1951 Opinion of SEC General Counsel, it has been the Commission’s position that hedge clauses are prohibited by the antifraud provisions of Section 206 of the Advisers Act, and correspondingly rendered null and void by Section 215 of the Advisers Act. Section 215(a) declares void any contract term binding a person to waive compliance with any provision of the Advisers Act. This means that a contract provision which seeks to hold an adviser to a standard of care lower than that required by the Advisers Act is invalid.

Does that mean that contractual provisions that seek to limit the scope of an adviser’s liability are prohibited? No. Follow the subsequent guidance provided by the SEC in its 1974 Auchincloss & Lawrence Incorporated no-action letter.

In Auchincloss, upon review of a hedge clause seeking to limit the advisor’s liability to gross negligence or willful malfeasance, the SEC indicated that:

“…the use of adjectives ‘gross’ and ‘willful’ in the second paragraph of your contract to define the degree of negligence or malfeasance required to give rise to a client’s right of action appears to violate Section 206 of the Act, since there may be situations where applicable law requires a greater degree of care by a fiduciary. For the same reason, the express denial of liability in the second paragraph for specified conduct may mislead a client into believing that he has waived certain rights of action, and therefore violates Section 206.”

The SEC indicated that it would not object to the advisor’s continued use of the liability limitation paragraph if the qualifiers, gross and willful, were deleted, the words “or violation of applicable law” were added, and the advisor added a sentence indicating to the client that it continued to maintain remedies available under federal securities laws, as follow: “…Except for negligence or malfeasance, or violation of applicable law, neither you nor any of your officers, directors or employees shall be liable hereunder for any action performed or omitted to be performed or for any errors of judgment in managing the account. The federal securities laws impose liabilities under certain circumstances on persons who act in good faith, and therefore nothing herein shall in any way constitute a waiver or limitation of any rights which the client may have under any federal securities laws.”

By following Auchincloss, the advisor is not asking the client to relinquish rights or remedies that he may have under federal or state law. However, the Commission has sometimes been uneven in its interpretation and/or enforcement of hedge clauses. In some examinations, the Commission has pressed advisers on the use of hedge clauses, even with the Auchincloss language. For this reason, advisors must be knowledgeable about Auchincloss, and be prepared to defend such clauses. In addition, in order to capture the court’s concern about the investor not waiving rights he/she may have under “applicable law”–not just federal law, we recommend that advisors add “state law” to the qualifying Auchincloss paragraph as follows:

“The federal and state securities laws impose liabilities under certain circumstances on persons who act in good faith, and therefore nothing herein shall in any way constitute a waiver or limitation of any rights which the client may have under any federal or state securities laws.”

The general purpose of hedge clauses is to protect advisors from claims for investment losses that are not attributable to any negligent act or omission by the advisor, such as market corrections. However, these clauses have not stopped clients from bringing claims for investment losses by alleging negligence, breach of fiduciary duty, or breach of contract. Both the SEC and the courts have generally held that claims against an investment advisor can not be based solely on poor investment decisions alone. Specifically, in the 1997 case of Okley vs. Hyperion, involving a claim against a fund investment advisor’s failure to adequately balance investment risks of the fund’s underlying interest-rate sensitive securities, the court, while conceding that the advisor’s management may have been imperfect, indicated that a claim could not be based solely upon a poorly implemented investment strategy:

“To the extent that the complaint may suggest that the Defendants made no attempt whatsoever to balance, such an Allegation is put to rest by the prospectuses themselves. They fully disclosed the actual initial investments with a percentage breakdown and a description of different likely responses to interest changes. The plaintiffs do not dispute these percentages but contend that the percentages chosen did not permit a balanced portfolio when interest rates fell. The balancing may have been imperfect, but this is a matter of opinion and judgment–not the basis for a securities fraud claim, which requires a material misrepresentation or omission and is not sustained merely by a claim of poorly implemented investment strategy.”

Experience has shown us that the presence of hedge clauses will not guarantee that a client will not bring a cause of action against the advisor. For this reason, when drafting liability limitation provisions in advisory contracts, we tend to be much more specific about the scope and types of claims and/or situations that we seek to protect advisors from, rather than just indicating “any and all claims.” By so doing, the client is put on notice of these specific situations in the advisory contract.

Thomas D. Giachetti is chairman of the Securities Practice Group of Stark & Stark, a law firm with offices in Princeton, New York, and Philadelphia that represents investment advisors, financial planners, broker/dealers, CPA firms, registered reps, and investment companies. He can be reached at [email protected].


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