Hedge Clause Alarm
Main Contributor: Gretchen Sturdivan, CSCP, Compliance Manager & Creative Director
Background
Throughout the past few years, we have continually seen the SEC take issue with and issue deficiency letters for hedge clauses they find in Advisers’ Investment Management Agreements (“IMAs”) and other disclosure documents, such as the ADV Part 2A or Form CRS. In this article, we will discuss what the SEC is basing this deficiency on, what examples might look like, and the kind of preventative action you can take, should you decide to.
Legal Basis
The SEC has clearly outlined their argument for the removal of hedge clause language. They are primarily relying upon the Adviser’s federal fiduciary obligation, which is enforceable through section 206 of the Investment Advisers Act of 1940. The fiduciary duty imposed upon Investment Advisers includes both a duty of care and a duty of loyalty. Advisers have an obligation to act in the best interest of their clients at all times and to not place their own interests ahead of clients’ interests.
Section 206 also prohibits investment advisers from:
“employing any device, scheme, or artifice to defraud any client or prospective client, and from engaging in any transaction, practice, or course of business which operates as a fraud of deceit upon any client or prospective client.”
As such, the SEC is looking for statements in IMAs and other disclosure documents that may waive or breach the adviser’s federal fiduciary duty and violate section 206 of the Advisers Act. Hedge clauses fall into this category.
Withdrawal of Heitman Capital Management No-Action Letter
An important element to understanding the SEC’s reasoning behind the removal of hedge clauses is the SEC’s withdrawal of the Heitman Capital Management no-action letter on June 5, 2019. This letter had allowed advisors to include hedge clauses in their agreements, as long as the clause also stated that it did not waive claims under federal and state securities laws. The SEC had concluded that the Heitman Letter has been misinterpreted and was misleading to clients, particularly retail clients.
2019 Commission Interpretation
In deficiency letters, the SEC has also previously cited the Commission’s Interpretation Regarding Standard of Conduct for Investment Advisers from 2019, which states:
“A contract provision purporting to waive the adviser’s federal fiduciary duty generally, such as (i) a statement that the adviser will not act as a fiduciary, (ii) a blanket waiver of all conflicts of interest, or (iii) a waiver of any specific obligation under the Advisers Act, would be inconsistent with the Advisers Act, regardless of the sophistication of the client.”
Additionally:
“Because an adviser’s federal fiduciary obligations are enforceable through section 206 of the Advisers Act, we would view a waiver of enforcement of section 206 as implicating section 215(a) of the Advisers Act, which provides that “any condition, stipulation or provision binding any person to waive compliance with any provision of this title. . . shall be void”…Thus, an agreement that contains general or broad language purporting to release an agent in advance from the agent’s general fiduciary obligation to the principal is not likely to be enforceable. This is because a broadly sweeping release of an agent’s fiduciary duty may not reflect an adequately informed judgment on the part of the principal.
Some commenters mentioned a 2007 No-Action Letter (the Heitman No-Action Letter) in which staff indicated that whether a clause in an advisory agreement that purports to limit an adviser’s liability under that agreement (a so-called “hedge clause”) would violate sections 206(1) and 206(2) of the Advisers Act depends on all of the surrounding facts and circumstances.” [Emphasis added]
However, the SEC felt that the Commenters’ interpretation was incorrect and in actuality:
“The Heitman Letter does not address the scope or substance of an adviser’s federal fiduciary duty; rather, it addresses the extent to which hedge clauses may be misleading in violation of the Advisers Act’s antifraud provisions…we express below the Commission’s views about an adviser’s obligations under sections 206(1) and 206(2) of the Advisers Act with respect to the use of hedge clauses. Accordingly, because we are expressing our views in this Final Interpretation, the Heitman Letter is withdrawn. [Emphasis added]
This Final Interpretation makes clear that an adviser’s federal fiduciary duty may not be waived, though its application may be shaped by agreement. This Final Interpretation does not take a position on the scope or substance of any fiduciary duty that applies to an adviser under applicable state law. The question of 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).
In our view, however, there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with those antifraud provisions, 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 [Emphasis added]. Such a hedge clause generally is likely to mislead those retail clients into not exercising their legal rights, in violation of the antifraud provisions, even where the agreement otherwise specifies that the client may continue to retain its non-waivable rights.
Whether a hedge clause in an agreement with an institutional client would violate the Advisers Act’s antifraud provisions will be determined based on the particular facts and circumstances [Emphasis added]. To the extent that a hedge clause creates a conflict of interest between an adviser and its client, the adviser must address the conflict as required by its duty of loyalty.”
What A Hedge Clause Looks Like
A hedge clause is a claim to wave or limit the rights that clients have under the law and language around the Adviser not being held liable if they acted in good faith. We’ve provided two generic examples below of such language:
Example 1:
“Except as may otherwise be provided by law, XYZ will not be liable to client for:
any loss that a client may suffer by reason of any investment decision made or other action taken or omitted in good faith by XYZ with that degree of care, skill, prudence and diligence under the circumstances that a prudent person acting in a fiduciary capacity would use;
any loss arising from XYZ’s adherence to client’s instructions; or
any act or failure to act by a custodian of client’s account.”
Example 2:
“Manager shall not be liable for any error of judgment with respect to Manager’s investment decisions, provided Manager acts in good faith, and Manager shall not be liable for any other act or omission, provided Manager acts in good faith and exercises due care. Manager shall not be responsible for any loss incurred by reason of any act or omission of any broker, dealer, bank or the Custodian; provided, however, that Manager will make reasonable efforts to require that brokers, dealers and banks selected by Manager perform their obligations with respect to the Account.”
SCS Recommends Preventative Action
In reviewing your client agreements and disclosure brochures, consider removing the hedge clause language from agreements to be executed with retail clients. Additionally, consider providing an addendum to current retail clients who have hedge clauses in their agreements before the SEC reviews them during an examination. Institutional agreements will be reviewed in light of the facts and circumstances.
Ultimately, it is up to the Adviser, as to whether or not they want to heed this recommendation. Some Advisers do not want to remove their hedge clause. However, we want to provide you with the information available from the collective in order for you to make the right decision for your firm. Please take note that we are not attorneys, and this is not legal advice. Given that your agreement is a legal document, we recommend that you consult with your attorney if you have any further questions or concerns.