Confusion and Misinformation

“…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].