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News October 18, 2004 Issue

SEC Regions Issuing Deficiencies On Hedge Clauses

In recent weeks, at least two SEC regional offices, Atlanta and Chicago (which, perhaps coincidentally, was singled out by one panelist at last weekís NRS conference as being "totally irrational"), have taken what appear to be new positions about hedge clauses. In deficiency letter comments, each has taken the position that itís a fraudulent practice for advisory contracts to contain liability-limiting hedge clauses ó even if the hedge clause contains language that explicitly states that the client is not giving up rights under the federal securities laws.

IM Insight reviewed the comments delivered by the two offices, which are nearly identical. The comment of the Atlanta office reads, in part: "Advisory contracts should contain no language that implies that the client has given up legal rights. Such provisions in advisory contracts can be misleading and in violation of Section 206, the anti-fraud provision of the Advisers Act, and are rendered void by Section 215 of the Advisers Act, which governs the validity of advisory contracts. Such clauses may lead a client to believe that he or she is foreclosed from a remedy he or she might otherwise have under common law or federal securities laws."

The examination staff went on to take the position that explanatory language along the lines that "Nothing in the hedge clause will be deemed to waive the clientís rights under the federal securities law" no longer "cures" the hedge clause. As in: "[Registrantís disclaimer at the end of the advisory contractís Liability section] fails to mitigate the exculpatory hedge clause that is the essence of the paragraph. We have taken the view that a misleading effect may be present despite such a disclaimer since, if the hedge clause purports to limit liability to acts of gross negligence, acts done in bad faith, or to willful misfeasance, it is unlikely that a client who is unsophisticated in the law would realize that he may have a right of action under federal or state law even where his adviser has acted in good faith."