In the second full week of the new year, the US Securities and Exchange Commission (SEC) settled an administrative action against Comprehensive Capital Management (CCM), a registered investment adviser, for, among other violations, the improper limitation of liability in an investment advisory agreement (i.e., the use of a hedge clause). The settlement sheds new light on the SEC’s views on the use of hedge clauses in investment advisory agreements and should encourage investment advisers to review existing hedge clauses in their investment advisory agreements.

Historically, the SEC frowned upon advisers’ use of hedge clauses in retail advisory agreements. Specifically, hedge clauses, which the SEC describes as the use of “[l]anguage purporting to limit an adviser’s liability in an advisory agreement,”[1] have been discouraged due to the SEC’s concerns that they could mislead a retail advisory client into thinking that it has waived non-waivable rights of action against the adviser that are provided under federal and/or state laws, including the Investment Advisers Act of 1940 (Advisers Act). More specifically, the SEC took the position in the 1970s that “hedge clauses that purport to limit an investment adviser’s liability to acts involving gross negligence or willful malfeasance are likely to mislead a client who is unsophisticated in the law into believing that he or she has waived non-waivable rights, even if the hedge clause explicitly provides that rights under federal or state law cannot be relinquished.”[2]

Heitman Capital Management

However, the staff slightly altered its position more than 30 years later to a less absolute prohibition of hedge clauses with the issuance of the Heitman Capital Management, LLC (Heitman) no-action letter.[3] The staff stated that “whether an investment adviser that uses hedge clauses in investment advisory agreements that purport to limit that adviser’s liability to acts of gross negligence or willful malfeasance violates [S]ections 206(1) and 206(2) of the Advisers Act would depend on all of the surrounding facts and circumstances.” The staff noted that it would consider “the form and content of the particular hedge clause (e.g., its accuracy), any oral or written communications between the investment adviser and the client about the hedge clause, and the particular circumstances of the client” in determining whether a violation has occurred.[4] The staff also outlined four factors that it would consider when a hedge clause is used in an investment advisory agreement with a client who is not well-versed with legal concepts: (i) whether the hedge clause was written in plain English; (ii) whether the hedge clause was individually highlighted and explained during an in-person meeting with the client; (iii) whether enhanced disclosure was provided to explain the instances in which such client may still have a right of action; and (iv) the presence and sophistication of any intermediary assisting a client in dealings with the investment adviser, as well as the nature and extent of the intermediary’s assistance.

The SEC’s Fiduciary Interpretation and Withdrawal of Heitman Capital Letter

In June 2019, the SEC revisited the use of hedge clauses in investment advisory agreements, while withdrawing the Heitman no-action letter.[5] In particular, the SEC clarified that an adviser’s fiduciary duty provided by the Advisers Act may not be waived. The SEC also noted that “[a] contract provision purporting to waive the adviser’s federal fiduciary duty generally, such as . . . a waiver of any specific obligation under the Advisers Act, would be inconsistent with the Advisers Act, regardless of the sophistication of the client.”[6] Finally, the SEC spent considerable time explaining its withdrawal of the Heitman letter, as well as its position going forward. The SEC concluded that “whether a hedge clause violates the Advisers Act’s antifraud provisions depends on all of the surrounding facts and circumstances, including the particular circumstances of the client (e.g., sophistication).”[7] However, for retail clients, the SEC stated that, in its view, “there are few (if any) circumstances in which a hedge clause in an agreement would be consistent with [the] antifraud provisions [under the Advisers Act], 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.”[8] The SEC would reach this conclusion even if the advisory agreement includes a non-waiver disclosure that specifies that the client would continue to retain its non-waivable rights. For institutional clients, the SEC believes that facts and circumstances would determine whether a hedge clause in an agreement would be consistent with the antifraud provisions under the Advisers Act.

The SEC’s Enforcement Action against Comprehensive Capital Management

The SEC’s most recent guidance may be gleaned from its settlement order with CCM. This settlement is particularly noteworthy for several reasons. First, prior to the SEC’s publication of the Fiduciary Interpretation, CCM received SEC staff examination findings that its hedge clause was too broad due to the client’s waiver of “all claims” and “any acts,” which the SEC concluded would include the adviser’s gross negligence, willful misconduct and fraud. The staff noted that there was no evidence CCM’s non-waiver disclosure would be comprehended by retail clients because (i) CCM did not have policies and procedures to assess a client’s sophistication in the law or to explain the meaning of the non-waiver disclosure and (ii) there was no evidence that CCM highlighted and explained the hedge clause during in-person meetings with each client and provided enhanced disclosure regarding when a client would retain a right of action.

Based on these findings, CCM informed the examination staff that it would not enforce the clauses and would revise its advisory agreements. However, the staff’s order suggests that CCM should have also notified clients that it would not enforce the hedge clause going forward. Second, following the SEC’s publication of the Fiduciary Interpretation, CCM revised the hedge clause in its advisory agreement to state that: (i) CCM and its IARs would be liable only for their own acts of gross negligence or willful misconduct; (ii) CCM and its investment adviser representatives would not be liable for any act or omission, or the failure or inability to perform any obligation, of any broker-dealer, investment adviser, sub-custodian or other agents or affiliates, whom CCM selected with reasonable care; and (iii) CCM would not be liable for any incidental, indirect, special, punitive or consequential damages. In addition, the hedge clause was followed by a non-waiver disclosure, which provided that nothing in the agreement would waive or limit any rights a client would have under federal or state securities laws.

The SEC concluded that the new hedge clause was misleading and an inaccurate statement of an investment adviser’s liability under the Advisers Act for three reasons: (i) the hedge clause purported to relieve CCM from liability for conduct as to which the client has a non-waivable cause of action against CCM provided by federal or state law (i.e., CCM and its financial professionals would be liable only for their own acts of gross negligence or willful misconduct); (ii) the hedge clause may have misled CCM’s retail clients into not exercising their legal rights; and (iii) the hedge clause included an inaccurate statement of the liability standards under the federal securities laws as they apply to investment advisers (i.e., by stating that “CCM and its [investment adviser representatives] will be liable only for their own acts of gross negligence or willful misconduct”).

Conclusion

This enforcement action is a reminder that small and large advisers alike should consider the nuances of the SEC’s position on the use of hedge clauses in advisory agreements:

• the SEC disfavors the use of hedge clauses in advisory agreements with retail clients, even if the agreement otherwise specifies that the client retains its non-waivable rights
• a hedge clause in an investment advisory agreement that purports to waive liability for claims that are available under federal or state securities laws violates the antifraud provisions of the Advisers Act
• a hedge clause in an investment advisory agreement that purports to waive liability for certain types of acts (e.g., gross negligence, willful misconduct, fraud), in the SEC’s view, likely violates the antifraud provisions of the Advisers Act and
• declining to enforce a hedge clause against retail clients is not, in itself, enough – for the clause to no longer be deemed misleading,  clients must be notified that the adviser will no longer enforce the clause.

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