September 17, 2024
What happened?
On September 3, 2024, the SEC announced charges against ClearPath Capital Partners, LLC, for failing to comply with rules governing the safekeeping of client assets and for its use of impermissible liability disclaimers in its advisory and private fund agreements.
Failure to Distribute Required Audited Financial Statements
The Custody Rule includes requirements for notification, account statements and an independent, surprise examinations for advisers that have custody of client assets, unless the rule is otherwise satisfied. For firms that manage pooled investment vehicles and do not want a surprise examination, an alternate way of satisfying the rule is to arrange for audited financial statements to be completed annually by an independent public accountant that is registered with the Public Company Accounting Oversight Board (“PCAOB”), in accordance with generally accepted accounting principles (“GAAP”), and to be distributed to all limited partners within 120 days of the end of the pooled investment vehicle’s fiscal year.
From 2018 to 2022, ClearPath claimed it was relying on audited financial statements to comply with the Custody Rule, but in seven different instances it failed to deliver audited financial statements to the investors of a fund. ClearPath could not demonstrate that these financial statements were delivered to investors, even in years when the audit was completed. Audited financial statements were delivered 333 to 1,064 days after the relevant fiscal year-end, in violation of the rule. Additionally, a particular fund was liquidated, but no final audit was ever performed – meaning audits were neither prepared nor delivered to investors. These failures around audited financial statements, and the choice not to follow the surprise examination path to compliance, meant a complete failure to comply with the Custody Rule.
Improper Limitation of Liability in Advisory Agreements and Private Fund Agreements
Investment advisers owe a fiduciary duty to clients and the funds they manage under the Advisers Act. While an advisory agreement or private fund agreement can shape the relationship with an adviser, this fiduciary duty cannot be waived. Misrepresenting the scope of an adviser’s duty, or including misleading references that could lead a client to incorrectly believe the client has waived an unwaivable right under state or federal law, is a violation of both the Adviser’s Act and the antifraud provisions of federal law.
Language purporting to limit the firm’s liability in an agreement is known as a “hedge clause.” Whether a hedge clause is misleading is a facts-and-circumstances test. ClearPath’s agreements claimed to broadly limit its own liability. The hedge clauses in their limited partnership agreements waived the fiduciary duty and stated that the firm was not liable to its private fund client for “mistakes of judgment, or for action or inaction” and explicitly required investors to “waive any and all current and future claims (and right to assert such claims) against [the firm] and the other Indemnified Parties for any breach of fiduciary duty.” The terms of the operating agreements claimed that the firm was not liable for “any loss or damage” unless the result of “fraud, deceit, gross negligence, willful misconduct or a wrongful taking.” The SEC looked at the facts and circumstances, reading this language in its entirety, and found the agreements to be inconsistent with an adviser’s fiduciary duty because it could mislead clients into not exercising non-waivable legal rights.
What Does This Mean For Me?
If you are making use of audited financial statements to meet the Custody Rule requirements for your pooled investment vehicles, double check your proof of investor delivery. If you cannot demonstrate delivery of the audit, then the clock is still running. Every year, you must work with your independent account to prepare and deliver the audits within the 120-day deadline. The SEC has discovered violations during examinations and by tracking ADV filing responses to question 23(h) of Form ADV Part 1. If your ADV says “not yet received,” that is a clear indication that you are still waiting on the audit and may be outside the 120-day deadline. Work to make sure these are ready to be delivered each year within that 120-day period. If your firm relies on this method of Custody Rule compliance, you must see to this recurring obligation.
The SEC has consistently included misleading hedge clauses on its list of priorities. Investment advisers have a fiduciary duty, and any appearance of waiving that duty in an advisory agreement or private fund agreement will violate the Advisers Act and threaten SEC charges. The SEC indicated that this was true for all client types in its June 5, 2019 publication (Commission Interpretation Regarding Standard of Conduct for Investment Advisers, IA Rel. No. 5248, here) where the SEC noted that a “contract provision purporting to waive the adviser’s federal fiduciary duty generally … would be inconsistent with the Advisers Act, regardless of the sophistication of the client.” When you work with legal counsel, share this enforcement order for ClearPath, share the 2019 publication, and make sure that an attorney’s effort to protect the firm under contract law does not go so far as attempting to waive your firms unwaivable fiduciary duties.
