Performance Guarantees
Building on the theme of what advisers cannot say, this section covers one of the clearest prohibitions in securities law: you can never guarantee results.
The Prohibition
- It is unlawful to guarantee a client against loss in any securities transaction
- This applies to investment advisers, investment adviser representatives, broker-dealers, and agents alike
- The prohibition is absolute: there are no exceptions based on client sophistication or wealth
Exam Tip: Gotchas
- "Risk-free" claims about securities. Any claim that a security is risk-free is treated as a guarantee violation.
What Counts as a Guarantee
| Prohibited Action | Why It's a Guarantee |
|---|---|
| Promising a specific rate of return | Implies no risk of loss |
| Guaranteeing the client will not lose money | Direct guarantee against loss |
| Sharing in client losses | Implies the adviser is backing the investment |
| Promising to "make the client whole" if an investment declines | Guarantee against loss |
| Stating "this investment is risk-free" (for securities) | Implies guaranteed outcome |
Sharing in Losses
- Sharing in client losses is prohibited because it functions as a guarantee
- If an adviser agrees to absorb a client's losses, the client effectively has downside protection (which is a guarantee)
- This is different from performance-based fees (covered in the next section), which involve sharing in gains under strict conditions
Exam Tip: Gotchas
- Sharing in losses vs. sharing in gains. These are often confused. Sharing in losses = prohibited guarantee. Sharing in gains = performance-based fee (allowed only for qualified clients with a fulcrum fee structure).
Hedge Clauses
- A hedge clause is language in an advisory contract that attempts to limit the adviser's liability
- Hedge clauses that limit liability for negligence may be misleading and potentially prohibited
- A clause saying "the adviser is not responsible for any losses" could discourage clients from exercising their legal rights
- The SEC views overly broad hedge clauses as potentially fraudulent because they may mislead clients about their rights
Exam Tip: Gotchas
- Hedge clauses and fiduciary duty. Hedge clauses that disclaim liability for negligence are suspect; advisers cannot contract away their fiduciary duty.