On September 3, 2024, the SEC announced that it had settled charges against a Registered Investment Adviser (RIA) that failed to comply with requirements pertaining to the safekeeping of client assets. The SEC also alleged that the RIA used impermissible liability disclaimers in the firm’s advisory and private fund agreements.
Custody Rule as its relates to private funds advised by an RIA
According to the SEC’s order, the RIA based in Menlo Park, California, failed to timely distribute annual audited financial statements to investors in certain private funds that the firm advised. In addition, the RIA did not fulfill its obligations regarding financial statement audits of private funds advised by the firm. Those financial statements must be prepared in accordance with Generally Accepted Accounting Principles (GAAP). The RIA’s failure to distribute annual audited financial statements in a timely manner violated Section 206(4) of the Investment Advisers Act and Rule 206(4)-2 thereunder.
Rule 206(4)-2, commonly referred to as the Custody Rule, provides an alternative method for complying with its requirements governing investment advisers to limited partnerships, limited liability companies, or other types of pooled investment vehicles. The Custody Rule stipulates that an investment adviser shall be deemed to have complied with the independent verification requirements, as well as the notification and account statements delivery obligations with respect to a fund if:
- It is subject to audit at least annually and distributes audited financial statements, prepared in accordance with GAAP, to all members within 120 days of the end of the fund’s fiscal year; and
- The audit must be performed by an independent public accountant registered with and subject to regular examination by the Public Company Accounting Oversight Board.
Hedge clauses have no place in private fund partnership and operating agreements
In the firm’s advisory agreements and certain private fund partnership and operating agreements, the RIA included liability disclaimers, often called hedge clauses. A hedge clause is a provision in an advisory contract that is intended to limit an investment adviser’s liability. Hedge clauses are viewed negatively by the SEC, because they could lead clients to assume incorrectly that they have waived a cause of action against the RIA, even though it is permitted under state or federal law.
As a general rule, it is improper for an RIA to limit liability in its advisory agreements with retail clients. Those hedge clauses could potentially cause clients to mistakenly believe that they had waived causes of action against the adviser. The SEC’s complaint alleged that certain liability disclaimers used by the firm contained misleading statements regarding the scope of the RIA’s unwaivable fiduciary duty. The firm’s hedge clauses stated that the RIA was not liable to its clients for any action or inaction except for gross negligence, willful malfeasance, and violations of applicable law. When read in its entirety, the language was inconsistent with the adviser’s fiduciary duty because it might dissuade clients from exercising legal rights that were unwaivable.
SEC almost always blames inadequate policies and procedures for compliance problems
Aside from violating the Custody Rule, the SEC determined that the RIA violated Section 206(2) of the Investment Advisers Act and Rule 206(4)-7 thereunder. Rule 206(4)-7 requires RIAs to adopt and implement written policies and procedures that are reasonably designed to prevent violations of the statute and its rules. These policies and procedures must be reviewed at least annually to ensure that they are thorough and effective. The RIA’s policies and procedures did not address how the firm would comply with the Custody Rule’s requirements related to private funds it advised. In addition, the RIA failed to implement written policies and procedures to ensure that the firm’s advisory contracts and private fund agreements were compliant.
Without admitting or denying the SEC’s findings, the RIA agreed to a censure, to cease and desist from further violations of the Investment Advisers Act and its rules, and to pay a $65,000 civil penalty.
Takeaways
Hedge clauses in advisory contracts can be viewed as misleading, even if there is additional language stating that compliance with state or federal securities laws cannot be waived. This disclaimer is sometimes referred to as a non-waiver or savings clause. RIAs’ use of a hedge clause will still cause problems with the SEC, even if their contracts include a non-waiver disclosure. The SEC takes the position that a non-waiver disclosure will not undo the potential damage caused by an RIA’s hedge clause.
The SEC’s objections to an RIA’s hedge clause are not surprising in view of its previous guidance regarding investment adviser conduct. On June 5, 2019, the SEC published the Commission Interpretation Regarding Standard of Conduct for Investment Advisers, IA Rel. No. 5248 (June 5, 2019). In that release, the SEC said there are few if any circumstances where a hedge clause in a contract with a retail client would be consistent with the antifraud provisions of the Investment Advisers Act.
The enforcement action can be found HERE.
About RIA Compliance Group: RIA Compliance Group is an investment adviser compliance consulting firm based in Delray Beach, Florida. The firm’s mission is to provide affordable, timely, practical, and cost-effective compliance advice. We help investment advisers to comply with the myriad of state and SEC regulations and compliance obligations facing their firms. RIA Compliance Group takes pride in giving personal service and real world compliance advice, not theoretical concepts and legalese. The firm interacts on a daily basis with SEC and state securities regulators.
RIA Compliance Group, LLC – 701 SE 6th Ave, Suite 201, Delray Beach, FL 33483 – Tel: 561-600-0564 – sales@ria-compliance.com
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