What Is the Uniform Securities Act?
The Uniform Securities Act is a model law created as a starting point for state-level securities regulation. The purpose of the Uniform Securities Act is to deal with securities fraud at the state level and to assist the Securities and Exchange Commission (SEC) in enforcement and regulation.
Uniform Securities Act Explained
Because not all investments are covered federally and not all investment dealers are registered at the federal level, the SEC cannot protect all investors and pursue all security violations. This created the need for state-level regulations such as the Uniform Securities Act to further protect investors. Each state has its own security laws colloquially referred to as the “blue sky laws.”
How the Uniform Securities Act Is Applied
The Uniform Securities Act is a framework that guides states in the crafting of their own securities legislation. The act evolved through a series of amendments due to earlier regulations not being adopting consistently across the country. Some jurisdictions did not enact each securities act introduced by the Uniform Law Commissioners. Through subsequent revisions and replacements of prior regulations, the Uniform Securities Act brought more parity to the federal and state implementation of securities protections.
One of the issues with regulating securities from two different levels of government is the potential for duplication. The Uniform Securities Act outlines the authority and role of state and federal regulators in dealing with securities fraud. For example, many fraudulent acts occur at the local level with pyramid schemes and other scams. That means enforcement through state law is necessary to address such crimes.
The act provides more structure and consistency in enforcement authority across states as well as in coordination with federal authority regarding the prosecution of securities fraud.
The intent of securities regulations, whether at the state or federal levels, is to prevent the fraudulent sale of securities to investors. Regulatory efforts stem from three primary elements. Registration is required for initial public offerings. Those who deal in securities, specifically investment advisers, broker-dealers, and their representatives and agents, must also be registered. In order to prohibit and prevent securities fraud, regulatory agencies must also have enforcement authority to address such actions. That includes being granted the ability to establish regulations and rules on securities transactions and having the capacity to bring the prosecution of criminal and civil violations to court.
The Uniform Securities Act serves as structure that includes state-level authority to take action on these issues.
INVESTMENT ADVISERS CAUTIONED ON USE OF HEDGE CLAUSES
INTRODUCTION
During the preregistration period for investment advisers, the staff of the Securities and Business Investments Division (the "Division") routinely reviews advisory agreements for compliance with The Connecticut Uniform Securities Act ("CUSA") and corresponding regulations.
As part of this review, staff members will not only ensure that certain contractual provisions required by Section 36-473(b) [now Section 36b-5(b)] of CUSA are included (e.g. nonassignment clauses, descriptions of services and fees), but may also offer comments to applicants regarding language which may be considered potentially misleading or otherwise inconsistent with the antifraud provisions contained in Section 36-473(a) [now Section 36b-5(a)].1
In recent months, the staff has observed an increase in the attempted use by investment adviser applicants of contractual language that seeks to limit or entirely avoid their civil liability for various types of conduct or omissions arising from the advisory relationship. Although no law specifically precludes the use of such provisions, commonly referred to as "hedge clauses," CUSA's antifraud provisions may be violated if an advisory client is lead to believe that the client has either waived a right of action he or she may have under state or federal securities law or common law, or is misled as to the nature of those rights.
LEGAL ANALYSIS
Since no state or federal law addresses the permissibility of hedge clauses per se, such provisions must be examined on a case-by-case basis to determine whether the actual language might be considered false or misleading and, therefore, contrary to the antifraud provisions contained in Section 36b-5(a) of CUSA. Inasmuch as there appears to be no relevant Connecticut case law, it is appropriate to look to federal authorities since the antifraud provisions in Section 206 of the Investment Advisers Act of 1940 (the "1940 Act") and Section 36b-5(a) of CUSA are largely identical. See State of Connecticut v. Farrah, [1978-81 Transfer Binder] Blue Sky L. Rep. (CCH) (Conn. Sup. Ct. 1979).
The basic test for determining the legality of a particular hedge clause is contained in an early release of the Securities and Exchange Commission (the "SEC"). Release No. 40-58, (April 18, 1951), Fed. Sec. L. Rep. (CCH) para. 56,383-6. It is interesting to note that this release was written not only in the context of investment advisory agreements, but was also intended to address the use of hedge clauses by brokers and dealers. The release simply states that "the anti-fraud provisions of the Securities and Exchange Commission statutes are violated by the employment of any legend, hedge clause, or other provision which is likely to lead an investor to believe that he has in any way waived any right of action he may have ...." This test is consistent with Section 215(a) of the 1940 Act which states that "[a]ny condition, stipulation, or provision binding any person to waive compliance with any provision of this title or with any rule, regulation or order thereunder shall be void."
1 It should be kept in mind, however, that under Section 36b-24(a)(2) of CUSA, effective registration does not constitute a finding by the Commissioner that any document filed with him, including the investment advisory contract, is "true, complete and not misleading." (emphasis added). Similarly, Section 36b-29(i) of CUSA states that "[a]ny condition, stipulation or provision binding any person acquiring any security or receiving investment advice to waive compliance with any provision of [chapter 672a], inclusive, or any regulation or order thereunder is void." It may, therefore, also be misleading under Section 36b-5 for an adviser to hedge any liability under the state securities laws.
In determining whether a particular hedge clause does, in fact, mislead the client into believing that he has waived any state or federal right of action, it should be remembered that any breach of an adviser's fiduciary duty to his client may, ipso facto, give rise to a fraud action under the securities laws. Along these lines, the SEC has noted that "[a]n investment adviser is a fiduciary. As such he is required by the common law to serve the interest of his client with undivided loyalty ... [A] breach of this duty may constitute a fraud within the meaning of clauses (1) and (2) of Section 206 of the Investment Adviser Act (as well as the anti-fraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934)." Release No. 40-40 (Jan. 5, 1945), Fed. Sec. L. Rep. (CCH) para. 56,374. Thus, an adviser's hedging of liability may also contravene common law standards of fiduciary responsibility.
Both the SEC and the United States Supreme Court have held that the common law standards embodied in the antifraud statutes hold advisers to an affirmative duty of utmost good faith and full and fair disclosure when dealing with clients. Even a negligent misrepresentation or failure to disclose material facts (especially in the case of a conflict or potential conflict of interest) places the adviser in violation of the antifraud provision whether or not there is specific intent or gross negligence or malfeasance. SEC v. Capital Gains Research, Bureau, Inc., 375 U.S. 180 (1963) (negligence alone gives rise to fraud liability under Section 206(2) of the 1940 Act - no need to show scienter); cf. Steadman v. SEC, 602 F.2d 1126 (5th Cir. 1979) (scienter is required under Section 206(1), but not under Section 206(2) of the 1940 Act). Under CUSA, the fiduciary nature of the adviser's role carries even greater implications, since Section 36b-29(b)(1) expressly provides for civil damages against any person who violates Section 36b-5(a), regardless of scienter.2 This should be contrasted with the 1940 Act which fails to provide for any express civil liability (with the exception of rescissionary and restitutionary actions under Section 215(b)) or implied right of action under Section 206. Transamerica Mortgage Advisors v. Lewis, 44 U.S. 11 (1979); accord, Neilson v. Professional Financial Management Ltd., [1988-1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) para. 93,938 (D.Minn. April 15, 1987). Moreover, in addition to providing for civil fraud actions, Section 36b-29(b)(1) holds investment advisers strictly liable for violations of Sections 36b-5(b), 36b-5(c), 36b-6(c) and 36b-24(b) of CUSA.
In short, CUSA's prohibitions and standards relating to investment advisers constitute a codification of their absolute duties as common law fiduciaries. Thus, an hedge clause which seeks to avoid an adviser's liability for acts or omissions done in good faith or without intent may be inherently misleading.
2 Section 36b-29(b)(1) itself carries no scienter requirement. However, since Connecticut's advisory fraud provision is modeled after Section 206 of the 1940 Act, it is likely that pursuant to SEC v. Capital Gains Research Bureau, Inc. and Steadman v. SEC, only actions under clause (2) of Section 36b-5(a) can succeed without a showing of intent.
SEC EXAMPLES
In several advisory interpretations made publicly available, the SEC has applied the analytical framework discussed above in determining the legality of a particular hedge clause or waiver. For example, in a 1972 letter, the SEC opined that a hedge clause which attempted to waive liability for acts constituting "ordinary negligence" was misleading, notwithstanding further language in the advisory agreement which specifically disclaimed any waiver for "acts or omissions which constitute fraudulent representations under applicable State or Federal common law or statute, gross negligence, willful misconduct or violations of the Investment Advisers Act of 1940, [or] any other applicable State or Federal statute or regulation thereunder." [citations omitted]
Similarly, the SEC has found to be misleading another hedge clause which sought to limit liability to acts done in bad faith or pursuant to willful misconduct but also explicitly provided that rights under state or federal law cannot be relinquished. In reaching this conclusion it was noted that "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." First National Bank of Akron (available Feb. 27, 1976); See also Municipal Advisory Council of Texas (available Oct. 23, 1975); Omni Management Corporation (available July 15, 1974).
RECENT STATE FILINGS
Several recent investment adviser applications filed with he Division have contained advisory contracts with hedge clauses which the agency believed would be potentially misleading to clients. For example, one agreement stated that "[a]dviser shall not be liable for any loss or depreciation in the value of the account unless it shall have failed to act in good faith or with reasonable care." The staff advised the applicant that this clause could be construed as inconsistent with Section 36b-5(a) (formerly Section 36-473(a))of CUSA since under both state and federal law, an investment adviser is a fiduciary who may be subject to civil liability even when he or she acts in good faith and with reasonable care. Furthermore, under Section 36b-29(i) (formerly Section 36-498(h)), such a provision would most likely be unenforceable and void.
Another advisory contract contained the following provision: "While [Adviser] agrees to use its best efforts in the management of the portfolio, [Adviser] shall not be responsible for errors in judgment or losses incurred on investments made in good faith, and its liability shall be limited expressly to losses resulting from fraud or malfeasance, or from violation of applicable law."
Again, the department viewed this language as potentially misleading to clients, given the adviser's duties as a fiduciary. Moreover, the adviser's statement that it assumes liability for "violation of applicable law" only compounded the problem since it was unlikely that the client would realize that "applicable law" does, under several circumstances, provide a right of action for even good faith "errors in judgment." For similar reasons, the staff took issue with a contract which stated that: "It is understood that we will expend our best efforts in the supervision of the portfolio, but we assume no responsibility for action taken or omitted in good faith if negligence, willful or reckless misconduct, or violation of applicable law is not involved."
Although this hedge clause correctly excepts from its coverage acts involving "negligence, willful or reckless misconduct, or violation of applicable law," it is still misleading to waive liability for "action taken or omitted in good faith." As noted earlier, an investment adviser is a fiduciary subject, under certain circumstances, to liability even when he has acted in good faith and without evil intent. Moreover, since it is "applicable law" itself which holds that advisers are fiduciaries, such a provision is nonsensical and confusing.
CONCLUSION
When drafting agreements which seek to limit an adviser's civil liability, applicants and their counsel should bear in mind that as fiduciaries, investment advisers are held to an affirmative duty of utmost good faith and full and fair disclosure when dealing with clients. Moreover, under CUSA, advisers are held to a strict liability standard for certain violations of that Act. Thus, language that seeks to limit liability to negligence or fraud would be misleading and untrue, even when qualified by a statement which excepts violations of state and federal law.
The purpose of this discussion is not to prohibit the use of all hedge clauses. For example, the agency has not objected to clauses which limit the investment adviser's liability for losses caused by conditions and events beyond its control such as war, strikes, natural disasters, new government restrictions, market fluctuations, communications disruptions, etc. Such provisions are acceptable since they do not attempt to limit or misstate the adviser's fiduciary obligations to its clients.
Any questions regarding this issue are welcome and should be directed to the Securities and Business Investments Division or Legal Division of the Department of Banking.
Originally Issued May, 1991.
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