Last month, two large, affiliated investment advisory groups reached a settlement with the Securities and Exchange Commission (SEC) over allegations that their form investment advisory agreements violated the Investment Advisers Act of 1940 (the Advisers Act). In particular, the allegations were that the advisers used improper “hedge clauses” in advisory agreements and impermissibly permitted contractual assignments. These alleged infirmities led in turn to alleged custody rule and failure to maintain adequate compliance systems violations. Without admitting the allegations, the two firms, FamilyWealth Advisers (FWA) and FamilyWealth Asset Management (together, FamilyWealth) agreed to a censure, to cease and desist illegal activity and for one firm to pay a fine. In settling the matter, the SEC acknowledged FamilyWealth’s remedial efforts, which may have contributed to the modest size of the fine.
Improper Hedging
The SEC objected to three clauses in FamilyWealth’s agreements that purported to limit the adviser’s liability to the client. First, the agreements disclaimed liability to clients unless FamilyWealth engaged in willful misconduct or gross negligence. Similarly, FamilyWealth used a clause disclaiming liability except for willful malfeasance, bad faith, gross negligence or reckless disregard of its duties. Finally, a clause required clients to defend, indemnify and hold harmless FamilyWealth against a broad category of liabilities.
The SEC strictly scrutinizes these hedge clauses, particularly when firms use them for retail clients. In fact, under a 2019 commission interpretation, “there are few (if any) circumstances in which a hedge clause . . . 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 . . . .” The interpretation clarifies that the problem is not merely that these clauses deprive clients of certain rights of action. Rather, the SEC found that FamilyWealth’s provisions “may mislead . . . retail clients into not exercising their nonwaivable legal rights.” According to the SEC, such conduct violated Section 206(2) of the Advisers Act.
Omitted Assignment Clause
FamilyWealth’s second violation involved assignment clauses. The Advisers Act generally requires agreements to prohibit advisers from assigning their side of the contract without the client’s consent. But FamilyWealth’s agreements provided the opposite: that FamilyWealth retained the right to assign the contract without client notice or consent. The SEC concluded that this violated Section 205(a)(2) of the Advisers Act.
Custody Rule Failures
Third, the SEC found that FamilyWealth had custody of its clients’ funds and failed to meet its obligations as custodian. The SEC considered FamilyWealth’s arrangements custodial because the advisory agreements allowed advisers to instruct custodians to take actions such as withdrawing and disbursing funds without client consent. Since the arrangement was custodial, FamilyWealth was required to subject client funds to inspection by independent accountants. It failed to do so, violating Rule 206(4)-2.
Compliance Failures
Based on all this, the SEC found that FamilyWealth failed to implement internal policies that would ensure compliance with federal law, as required by Rule 206(4)-7. The firm’s policy manuals had sections concerning hedge clauses and assignments. Despite the existence of these policies, FamilyWealth repeatedly entered into advisory agreements with clients that contained problematic clauses. Its policies were therefore not reasonably designed to ensure compliance.
The Aftermath
In the settlement, the firms agreed to SEC censure, to cease and desist illegal activity and for FWA to pay an $85,000 fine. FamilyWealth may have avoided a larger fine in part because of its remedial efforts, including 2024 revisions to its advisory agreements, which it distributed to clients and requested that clients sign and return.
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