Compliance Lessons from an SEC Enforcement Case: Advisory Agreements, Custody, and Policies and Procedures.

A case from earlier this year provides insight into key areas that registered investment advisory firms should review to help identify and address potential gaps in their compliance programs.  Reviewing SEC enforcement cases can help firms identify regulatory priorities, test portions of their own compliance programs, and discuss potential concerns with their internal and external compliance resources.

This case details the following violations:

·       Hedge clause and liability disclaimer language in advisory agreements.

·       Assignment language in advisory agreements that failed to require client consent before assignment.

·       Failure to obtain annual surprise examinations by an independent public accountant where required under the custody rule.

·       Failure to implement policies and procedures reasonably designed to prevent Advisers Act violations related to hedge clauses and assignment provisions.

SEC Interpretation of the Standard of Conduct for Investment Advisers

The SEC published its interpretation of the 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, 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 against the adviser provided by state or federal law. Such a hedge clause generally is likely to mislead those retail clients into not exercising their legal rights, in violation of the antifraud provisions, even where the agreement otherwise specifies that the client may continue to retain its non-waivable rights”.

Hedge Clause Issue

In this case, the adviser used the following clauses:

“R. Limited Liability: [Respondents] shall not be liable to Client, its agents or representatives thereof, for any act, omission, or determination made in connection with this Agreement except for its willful misconduct or gross negligence. . .”

T. Liability [Respondents] shall not be subject to liability for any act or omission in the course of, or connected with, its performance of this Agreement, except in the case of willful misfeasance, bad faith or gross negligence on the part of [Respondents], or the reckless disregard by the [Respondents] of its obligations and duties under this Agreement, but nothing herein shall in any way constitute a waiver or limitation of any rights which Client may have under any federal or state securities law or the Employee Retirement Income Security Act of 1974 (“ERISA”), if applicable…

Schedule A, T. Indemnification: Notwithstanding any provision of this Agreement, Client shall defend, indemnify and hold harmless [Respondents]… against any and all losses, claims, damages, liabilities, actions, costs or expenses to which such indemnified party may become subject to the extent such losses, claims, damages, liabilities, actions, costs or expenses arise out of or are based upon . . . (b) any violation of federal or state securities, trust or insurance laws by [Respondents], its officers, its agents, or its employees arising out of the purchase, sale, offer to purchase or offer to sell any security; (c) any breach, default or violation of, under or with respect to any of [Respondents’] duties, obligations, representations, warranties or covenants contained in this Agreement; or (d) any negligence, gross negligence, recklessness or willful or intentional misconduct of, or violation of any law by [Respondents] or any { } employee or agent.”

These provisions are problematic because they appear to limit the adviser’s liability to only the most serious forms of misconduct, such as willful misconduct, bad faith, gross negligence, or reckless disregard, which may mislead a retail client into believing the client has waived legal rights that cannot be waived under federal or state securities laws. The indemnification language is even more concerning because it appears to require the client to defend and indemnify the adviser for losses arising from the adviser’s own violations of law, breaches of duty, negligence, recklessness, or intentional misconduct. Taken together, this type of language is inconsistent with an investment adviser’s fiduciary duty and may discourage clients from exercising their legal rights.

Actionable Steps:

Firms should review any limitation of liability, indemnification, hedge clause, and assignment provisions in their existing advisory agreements with qualified legal counsel. If revisions are needed, firms should update their advisory agreement templates and consider whether existing client agreements should be repapered to ensure the firm’s contracts are consistent with current regulatory expectations.

Custody Rule Failures

The case is a reminder that custody can arise not only from physically holding client assets, but also from contractual authority over client funds or securities.

• The custody rule applies when a registered investment adviser has custody of client funds or securities.

• Custody may exist if the adviser directly or indirectly holds client assets or has the ability to obtain possession of them.

• Custody can also arise when an adviser is authorized to withdraw or direct the disbursement of client funds or securities held with a custodian.

• Advisers with custody generally must maintain client assets with a qualified custodian, provide required client notices, have a reasonable basis to believe clients receive quarterly account statements, and obtain an annual surprise examination by an independent public accountant, unless an exception applies.

In this case, the advisory agreement stated:

“H. Trading Authorizations: [Respondents] may give instructions to Custodians selected by [Respondents] with respect to such assets, and such Custodians may rely on [Respondents’] instructions without obtaining Client’s approval, counter-signature, or co-signature. [Respondents’] authority will include, without limitation, the authority: … (e) to withdraw or direct the disbursements of assets held in any account maintained on behalf of Client; . . . (h) generally to do and take all actions considered necessary or desirable by [Respondents] with respect to any account maintained on behalf of Client or the assets held therein.”

The language was later revised as follows:

“H. Trading Authorization: [Respondents are] authorized to give instructions to the custodian with respect to all investment decisions regarding the Assets and the Custodian is hereby authorized and directed to effect transactions, deliver securities, make payments and otherwise take such actions as [Respondents] shall direct in connection with the performance of [Respondents’] obligations in respect of the Assets.”

Both provisions in the advisory agreement provided the advisory firm with custody and required, among other things, an annual surprise examination by an independent public accountant.

The advisory firm failed to obtain verification of client funds and securities by annual actual examination by an independent public accountant for several years, which was a direct violation of Section 206(4) of the Advisers Act and Rule 206(4)-2 thereunder.

Actionable Steps:

Investment advisers should review their advisory agreements, custodial forms, standing letters of authorization, fee deduction authorizations, and any other client or custodian documents to confirm what authority the firm actually has over client funds and securities. This review should focus on whether the firm has authority to withdraw, disburse, transfer, deliver securities, make payments, or otherwise direct the movement of client assets beyond the firm’s intended scope of authority. If the documents create custody or are inconsistent with the firm’s Form ADV, compliance manual, custody practices, or intended custody status, the firm should work with legal counsel and compliance professionals to revise its templates, update disclosures, assess whether existing client agreements need to be repapered, and determine whether any custody rule requirements or exceptions apply.

If the agreement or custodial documents provide the firm with custody authority, the firm should promptly revise the language in both its templates and existing client agreements, assess the period during which custody existed, and engage an independent public accountant to conduct the required annual surprise examination or other appropriate remedial review. Addressing the issue proactively is likely to be significantly less costly than responding to a custody rule deficiency, enforcement referral, or formal enforcement action.

Policies and Procedures Failures

The advisory firm’s policies and procedures stated:

“[n]o { } Investment Management Agreement will contain a provision that will cause a client to waive compliance with any provision, rule or order under the Investment Advisers Act of 1940 or any other applicable law. In addition, no { } Investment Management Agreement will contain a hedge clause or other provision, which disclaims { }’s liability for any violation of law. Such a provision would be deemed void by virtue of Section 215 of the Investment Advisers Act of 1940”; and

“[p]ursuant to Section 205(a)(2) of the Investment Advisers Act of 1940, the Investment Advisory Contract between { } and each client will contain a provision prohibiting the assignment of the contract without the consent of the client”.

The policies and procedures were later updated to state:

“{ }’s advisory agreements meet all appropriate regulatory requirements and . . . do not contain any hedge clauses”; and

{ }’s advisory agreements meet all appropriate regulatory requirements and . . . contain a non-assignment clause”.

The firms’ compliance manuals included policies and procedures addressing hedge clauses and assignment provisions. However, the advisory agreements still contained hedge clauses and improper assignment language during the relevant period. As a result, the firms failed to implement policies and procedures reasonably designed to prevent violations of the Advisers Act and Rule 206(4)-7.

Actionable Steps:

Firms should review their policies and procedures against their advisory agreements, custodial documents, Form ADV disclosures, client authorizations, and day-to-day operations to confirm that the written compliance program aligns with the firm’s actual practices. It is not enough for the compliance manual to state that agreements do not contain hedge clauses or improper assignment provisions if the executed client agreements have not been reviewed, updated, and tested against that policy. Firms should periodically confirm that agreement templates, legacy client agreements, disclosure documents, and operational practices are consistent, and document any reviews, remediations, repapering, or disclosure updates completed as part of that process.

Summary of Violations and Enforcement Cost

The matter involved two related SEC-registered investment advisers with combined reported regulatory assets under management of approximately $527.2 million as of December 31, 2024. The case involved multiple advisory agreement and compliance program failures, including improper hedge clause and liability disclaimer language, assignment provisions that did not require client consent, custody language that gave the firms authority over client assets, and failure to implement policies and procedures reasonably designed to prevent Advisers Act violations related to hedge and assignment provisions. The firms consented to a cease-and-desist order, were censured, and agreed to pay combined civil penalties of $150,000. These amounts do not include the additional internal costs, legal expenses, compliance remediation, agreement revisions, client repapering, and operational disruption that often accompany an enforcement matter.

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Coulter Strategic Services provides customized compliance and regulatory consulting for SEC-registered and state-registered investment advisers throughout the United States. Services are tailored to each firm’s structure, business model, client base, regulatory obligations, and risk profile to help support an effective, practical, and sustainable compliance program.

CSS assists investment advisory firms with customized compliance services and customized compliance education, including compliance program reviews, annual reviews, policies and procedures, Form ADV and Form CRS reviews, custody rule considerations, marketing rule reviews, regulatory filings, mock exam preparation, training, books and records, and ongoing compliance support.

For investment advisers seeking experienced compliance consulting support, Coulter Strategic Services can help identify practical steps to strengthen the firm’s compliance program and better align policies, disclosures, and practices with current regulatory expectations.

Contact Coulter Strategic Services to discuss your firm’s compliance needs or learn more at https://www.coulterstrategicservices.com/

This material is provided for educational and informational purposes only and should not be construed as legal, regulatory, or compliance advice specific to any investment adviser. The information does not reflect the views of any federal or state regulatory body, agency, or association. While efforts have been made to provide accurate information, the information may become outdated or materially inaccurate without notice. Third-party information and regulatory developments may not be fully verified or updated after publication. Coulter Strategic Services and its staff do not provide legal opinions, legal recommendations, or legal advice. Investment advisers should consult legal counsel as appropriate regarding their specific facts and circumstances.

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