The SEC alleged that each advisers’ advisory agreements:

• Included broad liability disclaimers (or “hedge clauses”) that, in the SEC’s view, could mislead clients regarding the advisers’ fiduciary duties in violation of the Investment Advisers Act of 1940’s (Advisers Act) antifraud provisions
• Improperly permitted assignment of the advisory agreement without consent, in contravention of Section 205(a)(2) of the Advisers Act
• Included trading authorization language that gave rise to custody obligations that the advisers allegedly failed to meet in violation of Rule 206(4)-2 under the Advisers Act

The hedge clause at issue stated that the advisory agreement did not waive or limit “any rights which Client may have under any federal or state securities law” and excluded from the waiver “willful misfeasance, bad faith or gross negligence” but not ordinary negligence. The order highlighted that the advisers’ clients were retail investors, pointing to a June 2019 Commission Interpretation criticizing the use of hedge clauses in that context. The SEC did not contend that any client was actually misled.

Although the advisers were given credit for introducing a revised agreement in response to an SEC examination, the SEC criticized the advisers’ decision not to have existing clients execute the updated agreement immediately. The SEC also found that the updated agreement did not respond adequately to the staff’s concern about the assignment provision or the trading authorization language giving rise to custody.

Lastly, and reminiscent of the prior US administration’s approach, the order found that due to the deficient clauses in the firms’ investment advisory agreements, both advisers failed to adopt adequate policies and procedures in violation of Rule 206(4)-7 under the Advisers Act. However, the order was careful to articulate the alleged disconnect between particular language in the advisers’ compliance manual and the specific conduct in question, which perhaps signals a more intentional approach by the SEC to allegations of Compliance Rule violations.

Without admitting or denying the SEC’s findings, the advisers agreed to orders requiring them to cease and desist from violations of Section 206(2) of the Advisers Act, which does not require a showing of intentional misconduct, and other rules, censures, and penalties of $85,000 and $65,000. No individuals were charged.

While the SEC’s focus on hedge clauses, especially in the context of agreements with retail investors, is nothing new, this case shows a focus on what is often considered boilerplate language. As SEC enforcement activity picks up, this case serves as an important reminder to investment advisers that contractual language in their advisory agreements should be carefully reviewed to ensure they align with statutory and fiduciary obligations. Advisers should consider whether their compliance testing adequately addresses investment advisory agreements.

Here, the SEC pointed to alleged gaps between specific compliance manual requirements for agreements and the agreements themselves, highlighting the importance of periodic reviews of an adviser’s compliance policies to ensure they align with actual practices. More broadly, it confirms that this SEC will continue to police regulatory violations by investment advisers and will not necessarily limit its enforcement agenda to overt fraud. For advisers involved in an SEC examination, the order also demonstrates the importance of resolving alleged deficiencies before any referral to the SEC’s Division of Enforcement.