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.”