Things not to put in Advisory Contracts – Hedges

The Securities and Exchange Commission labels language purporting to limit an adviser’s liability in an advisory agreement as a “hedge clause.” In 2019, the SEC published the Commission Interpretation Regarding Standard of Conduct for Investment Advisers summarizing its position on an advisor’s fiduciary obligations. That statement stated:

“there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with [] antifraud provisions, where the hedge clause purports to relieve the adviser from liability for conduct as to which the client has a non-waivable cause of action against the adviser provided by state or federal law. Such a hedge clause generally is likely to mislead those retail clients into not exercising their legal rights, in violation of the antifraud provisions, even where the agreement otherwise specifies that the client may continue to retain its non-waivable rights. (footnote 11)”

During an exam, the SEC found these provisions in an advisor’s agreements with retail clients, which the SEC characterized as hedge clauses:

R. Limited Liability: [Respondents] shall not be liable to Client, its agents or representatives thereof, for any act, omission, or determination made in connection with this Agreement except for its willful misconduct or gross negligence. . .”
T. Liability [Respondents] shall not be subject to liability for any act or omission in the course of, or connected with, its performance of this Agreement, except in the case of willful misfeasance, bad faith or gross negligence on the part of [Respondents], or the reckless disregard by the [Respondents] of its obligations and duties under this Agreement, but nothing herein shall in any way constitute a waiver or limitation of any rights which Client may have under any federal or state securities law or the Employee Retirement Income Security Act of 1974 (“ERISA”), if applicable…
Schedule A, T. Indemnification: Notwithstanding any provision of this Agreement, Client shall defend, indemnify and hold harmless [Respondents]… against any and all losses, claims, damages, liabilities, actions, costs or expenses to which such indemnified party may become subject to the extent such losses, claims, damages, liabilities, actions, costs or expenses arise out of or are based upon . . . (b) any violation of federal or state securities, trust or insurance laws by [Respondents], its officers, its agents, or its employees arising out of the purchase, sale, offer to purchase or offer to sell any security; (c) any breach, default or violation of, under or with respect to any of [Respondents’] duties, obligations, representations, warranties or covenants contained in this Agreement; or (d) any negligence, gross negligence, recklessness or willful or intentional misconduct of, or violation of any law by [Respondents] or any FamilyWealth employee or agent.

The SEC concluded:

“The language, when read in its entirety, is inconsistent with an adviser’s fiduciary duty because it may mislead Respondents’ retail clients into not exercising their nonwaivable legal rights. Accordingly, the Respondents’ use of these hedge clauses violated Section 206(2) of the Advisers Act.”

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