One of the things I hope to do through these Expert's Corner articles is to clear up some of the subjects about which many advisors have been misinformed over the years. This month I will address confusion regarding hedge clauses. In a follow-up column we'll look at the use of arbitration clauses.
Primarily as a result of misinformation and uneven regulatory compliance enforcement, advisors have long been confused about whether the use of advisory contract provisions which seek to limit the scope of a client's legal remedies against the advisor are prohibited under the Advisers Act. The SEC refers to these types of liability limitation provisions as "hedge clauses." Examples of such liability limitation provisions we have seen are:
"The Adviser, acting in good faith, shall not be liable for any action, omission, investment recommendation/decision, or loss in connection with this Agreement;" or "The Adviser shall not be liable for any action, omission, investment recommendation/decision, or loss in connection with this Agreement unless caused by Adviser's gross negligence or willful malfeasance."
The Commission has long maintained that advisory contacts should not contain language which implies that a client has given up legal rights. Beginning with the 1951 opinion of its then General Counsel as set forth in Advisers Act Release No. 58, the SEC has taken the position that such clauses may lead a client to believe that she is foreclosed from a remedy she might otherwise have under common law or federal securities statutes.
The SEC's General Counsel, in Release No. 58, specifically indicated, in pertinent part, as follows: "The question arises, therefore, whether the result, if not the purpose, of such a legend is to create in the mind of the investor a belief that he has given up legal rights and is foreclosed from a remedy which he might otherwise have either under common law or under the Securities and Exchange Commission statutes…In my opinion, the anti-fraud provisions of the Securities and Exchange Commission statutes are violated by the employment of any legend, hedge clause or other provision which is likely to lead an investor to believe that he has in any way waived any right to action he may have…"
Beginning with 1951 Opinion of SEC General Counsel, it has been the Commission's position that hedge clauses are prohibited by the antifraud provisions of Section 206 of the Advisers Act, and correspondingly rendered null and void by Section 215 of the Advisers Act. Section 215(a) declares void any contract term binding a person to waive compliance with any provision of the Advisers Act. This means that a contract provision which seeks to hold an adviser to a standard of care lower than that required by the Advisers Act is invalid.
Does that mean that contractual provisions that seek to limit the scope of an adviser's liability are prohibited? No. Follow the subsequent guidance provided by the SEC in its 1974 Auchincloss & Lawrence Incorporated no-action letter.
In Auchincloss, upon review of a hedge clause seeking to limit the advisor's liability to gross negligence or willful malfeasance, the SEC indicated that:
