If an advisor is able to withstand narcoleptic impulses when reviewing its investment advisory contract, I suggest taking a moment to focus on the section that addresses the advisor’s limitations of liability.
In regulatory-speak, this clause of the contract is known as a “hedge clause,” and is typically found near indemnification or arbitration clauses. The hedge clause is one of those contractual provisions that is monumentally unimportant until a dispute arises between the client and the advisor, at which point it can become one of the most important legal nuances in the entire contract.
To hedge is to limit or qualify by conditions or exceptions. Insert appropriate hedge fund joke here (e.g., our hedge fund will produce consistently exceptional returns, but hell may not in fact freeze over). In other words, a hedge clause is a means by which an advisor limits its liability with respect to its clients.
On one extreme, a hedge clause could read, “Client agrees that advisor is not liable for anything, even if advisor commits fraud and uses client’s investable assets to make his monthly yacht payment.” Clearly this would not pass regulatory scrutiny.
On the other extreme, an advisory contract may not include any hedge clause whatsoever and the advisor could open itself up to any and all liabilities. While certainly noble and legally permissible, it is not legally advisable. So what is an appropriate middle ground?
The SEC addressed this very issue in a 2007 no-action letter provided to Heitman Capital Management, LLC and its affiliates. In the no-action letter, the SEC basically said that hedge clauses may be permissible if appropriately drafted and with the right set of facts and circumstances. The SEC grounded its rationale in Sections 206(1) and 206(2) of the Investment Advisers Act of 1940, the general antifraud provisions of the Act: “Those antifraud provisions may be violated by the use of a hedge clause or other exculpatory provision in an investment advisory agreement which is likely to lead an investment advisory client to believe that he or she has waived non-waivable rights of action against the adviser that are provided by federal or state law.”
In a previous SEC no-action letter from 1974 (Auchinloss & Lawrence Inc.), the SEC went so far as to suggest that hedge clauses limiting an advisor’s liability to gross negligence or willful malfeasance are likely per se misleading and therefore prohibited.
In the more recent Heitman no-action letter, however, the SEC stated that this is no longer the case. Instead, whether a hedge clause violates the antifraud provisions of the Act is fact-specific. Such a facts-and-circumstances analysis should consider:
- The form, content, and accuracy of the hedge clause
- Oral and written communications with the client about the hedge clause
- The sophistication of the client
- For unsophisticated clients,
- Plain English drafting of the hedge clause
- In-person highlighting or explanation of the hedge clause
- Enhanced disclosure regarding rights of action that still exist
- The presence and sophistication of an intermediary assisting the client
The SEC did not and will not opine on any specific hedge clause, but advisors should review their existing hedge clauses and the process by which investment advisory agreements in general are reviewed with and explained to clients—especially unsophisticated ones. In particular, an advisor will want to ensure that a hedge clause is followed by a “non-waiver disclosure,” which reminds clients that they are not waiving any rights that cannot be waived under state and federal securities laws.
Investment advisory contracts will almost certainly be reviewed in any SEC exam, and examiners will certainly make note of any egregious hedge clauses. An advisor has a right to contractually protect itself from spurious claims, but it can’t go so far as to take advantage of clients and deprive them of rights to which they are entitled.