Hedge clauses in advisory contracts

Earlier this year, the Securities and Exchange Commission brought an enforcement case against a registered investment adviser that has shone a bright light on contracts between advisers and their retail clients. The case is important because it involved the firm’s use of misleading “hedge clauses” that were found to have violated anti-fraud provisions of the Investment Advisers Act of 1940 (IAA). These clauses, which have been fairly common in investment advisory agreements, are confusing to clients. They are problematic because they may cause clients to believe that they have waived a non-waivable cause of action against the adviser provided by state or federal law.

The Comprehensive Capital case

During an examination of Comprehensive Capital Management, Inc. (CCM), a New Jersey-based adviser, staff of the Commission found that CCM’s investment advisory agreements included a hedge clause that could not be readily understood by clients. The hedge clause stated, in part: “Client agrees to hold CCM, its officers, directors, employees, agents, independent contractors, and representatives, forever harmless from all claims, liabilities, losses, damages, attorney’s fees, costs and expenses which may arise from any act (on Client’s behalf or for Client’s account), omission, or insolvency of any broker-dealer, agency, professional, independent contractor or financial salesperson […].” The sentence that followed stated: “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 or CCM may have under the federal securities laws.” We think that the juxtaposition of these two clauses would be baffling to most investors.

This contractual language purported to broadly limit CCM’s liability. The hedge clause indicated that the client was waiving “all claims” and that CCM could never be liable to the client for “any act, “which would have included acts of gross negligence on the part of the investment adviser, willful misconduct, and fraud. The hedge clause was then paired with a “savings clause” which created an implication that the hedge clause would not waive or limit the client’s rights under federal or state securities laws. There was no explanation of what, if any rights, the client might have. We wonder whether clients of the firm may have asked questions about the apparent incongruities prior to signing the contract.

Noting that most, if not all, of CCM’s clients were retail investors, the Commission concluded that that there was no evidence that these disclosures would be comprehended by retail investors. It found that the hedge clause was inconsistent with CCM’s fiduciary duty to its clients under the IAA because it could be misleading to the firm’s retail clients, and could cause them to not exercise their legal rights. The Commission found that CCM had willfully violated the anti-fraud provisions of the IAA by including the hedge clause in its advisory contracts.

Investment advisers as fiduciaries

Investment advisers are fiduciaries under federal law. The standard of conduct to which investment advisers are subject includes both a duty of loyalty and a duty of care and requires that they act in the best interests of their clients at all times. The duty of care requires an investment adviser to provide investment advice in the best interest of its clients, based on the client’s objectives. The duty of loyalty requires an investment adviser to make full and fair disclosure of all conflicts of interest that might incline an investment adviser – consciously or unconsciously – to render advice which is not disinterested. This disclosure of conflicts is essential so that a client may provide informed consent. This fiduciary duty applies throughout the entire relationship between an investment adviser and its client.

The Commission’s current position on hedge clauses

Three years ago, the Commission published its “Interpretation Regarding the Standard of Conduct for Investment Advisers” (Interpretation) which clarified certain aspects of the fiduciary relationship between an investment adviser and its client. The Commission clearly stated that an adviser’s federal fiduciary duty cannot be waived and that contractual provisions purporting to waive the adviser’s federal fiduciary duty would be inconsistent with the IAA and, as such, are not likely to be enforceable. The publication of the Interpretation eliminated any ambiguity that might have existed as to the validity of a hedge clause in an advisory contract between an adviser and a retail investor. The Commission stated: “In our view…there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with those 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.” The Commission’s current position is that hedge clauses are 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.

Additional thoughts

Now that the Commission has clarified its stance on hedge clauses in advisory contracts with retail investors, it is clear that investment advisers cannot include in their contracts with retail clients any clause which is likely to lead a client to believe that he or she has waived any right of action that might be available under state or federal law. The CCM case illustrates that some investment advisers have not revised their contracts to eliminate these pesky hedge clauses. As a result of its failure to update its advisory agreements and other compliance failures, CCM was fined, censured and ordered to engage an independent compliance consultant to assist the firm with its compliance obligations. The contours of the relationship between an individual and his or her investment professional are shaped by an investment advisory agreement that defines the scope of services to be provided in return for a fee. We encourage readers to review their contracts with financial professionals carefully before signing them. Caveat Emptor!

Patricia Foster is a securities law attorney whose experience includes representation of clients in both registered and exempt securities offerings, as well as in various sectors of the financial services industry, including brokerdealers, investment advisers and investment companies.

This column is a collaborative work by Patricia Foster and David Peartree.

David Peartree is an adviser with Brighton Securities Capital Management, Inc., a registered investment adviser offering fee-only investment and financial planning advice. The information in this column is provided for educational purposes and does not constitute legal or investment advice. © 2022. Patricia C. Foster. All Rights Reserved.