(Article from Registered Funds Regulatory Update, April 2022)
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The SEC recently settled charges against Comprehensive Capital Management (“CCM”), a registered investment adviser, for, among other violations, improperly including a liability waiver, or “hedge clause,” in its advisory agreements. The SEC generally disfavors the use of hedge clauses in advisory agreements because they can mislead clients into incorrectly believing that they waived a cause of action against an adviser when such claims are non-waivable under federal or state laws.
In 2018, CCM was informed in connection with an SEC Staff examination that a hedge clause in its advisory agreement was overly broad due to the client’s waiver of “all claims” and “any act” against the adviser, which the SEC noted would include the adviser’s gross negligence, willful misconduct and fraud. Moreover, CCM did not have policies or procedures to assess a client’s sophistication on such matters or that required the adviser to explain the hedge clause at in-person meetings or provide enhanced disclosure as to when a client could bring a cause of action despite the hedge clause. As a result, the SEC found that the hedge clause violated the anti-fraud provisions of the Advisers Act. Thereafter, CCM agreed not to enforce the hedge clause but it never provided notice to that effect to its clients.
Then, in 2019, the SEC published the Commission Interpretation Regarding Standard of Conduct for Investment Advisers stating that there “are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with antifraud provisions . . . .” The guidance went on to note that questions of whether hedge clauses in agreements with institutional clients violate the anti-fraud provisions of the Advisers Act would be “determined based on the particular facts and circumstances” of each matter.
Following the SEC’s guidance, CCM revised its hedge clause in its advisory agreement to state that CCM would: (i) only be liable for its own acts of gross negligence or willful misconduct; and (ii) not be liable for any act or omission, or the failure or inability to perform any obligation, of any broker-dealer, investment adviser, sub-custodian or other agents or affiliates selected by CCM with reasonable care or for any incidental, indirect, special, punitive or consequential damages. The hedge clause was followed by a statement that nothing in the advisory agreement would waive or limit any rights a client would have under federal or state securities laws.
Upon review, the SEC determined that the new hedge clause violated the anti-fraud provisions of the Advisers Act because the hedge clause: (i) appears to relieve CCM from liability for acts the client has a non-waivable cause of action provided by federal or state law; (ii) could mislead retail clients into not enforcing their legal rights; and (iii) included a false statement of the liability standards applicable to investment advisers by stating that CCM would only be liable for its own acts of gross negligence or willful misconduct.
Without admitting or denying the findings, CCM agreed, among other things, to pay disgorgement of $66,635 plus interest, pay a civil monetary penalty of $300,000 and retain an independent compliance consultant.
In the Matter of Comprehensive Capital Management, Inc., SEC Admin. Proc. File No. 3-20700 (Jan. 11, 2022), available at: https://www.sec.gov/litigation/admin/2022/ia-5943.pdf.