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SEC Fines Investment Adviser Over the Use of Hedge Clause in Advisory Agreement

Last month, the SEC commenced an administrative enforcement action that highlights the significance of its change in guidance over the use of “hedge clauses” in investment advisory agreements. Recall that in IA-5248, the SEC’s 2019 interpretive release that addressed the standard of conduct for investment advisers, the Commission withdrew the 2007 No-Action Letter previously issued in Heitman Capital Management, LLC (Feb. 12, 2007) (“Heitman Letter”). Prior to IA-5248, the Heitman Letter had frequently been relied upon by investment advisers to permit the use of hedge clauses, or clauses purporting to limit an adviser’s liability, as long as the clause contained an affirmative statement that it should not be construed to waive unwaivable claims under federal and state securities laws. Because the SEC concluded that the Heitman Letter had been often misconstrued, IA-5248 expressly withdrew it.

Prior to the issuance of the Heitman Letter in 2007, the SEC had rather consistently prohibited the use of hedge clauses. The Heitman Letter, however, constituted a departure from that previous near-blanket prohibition. In Heitman, the SEC staff stated that the use of a hedge clause that limits the adviser’s liability except for gross negligence or willfulness may under some circumstances be permitted, depending on “all the surrounding facts and circumstances.” Among the circumstances to be considered were whether it was written in plain English, whether it had been highlighted and explained to the client personally, whether there was a heightened explanation of the types of claims that were not waived, and whether impacted clients had access to other professional “intermediaries” upon whom they relied. After the Heitman Letter, the use of hedge clauses by investment advisers proliferated, not always consistently with the Heitman guidance.

After emphasizing that the Heitman Letter had been issued to clarify when an adviser may use a hedge clause without violating the antifraud provision of the Investment Advisers Act, the Commission clarified in IA-5248 that, “[i]n our view . . . 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. Such a hedge clause generally is likely to mislead those retail clients into not exercising their legal rights . . . .”

The recent enforcement case, which was settled upon filing, was brought against Comprehensive Capital Management (CCM), a registered investment adviser, and listed several alleged violations including the improper inclusion of hedge clauses in its advisory agreements. In an examination that pre-dated the issuance of IA-5248, the SEC had taken issue with CCM’s hedge clause, determining it to be so broad as to waive even claims based on fraud or willfulness. Furthermore, the SEC noted that CCM lacked policies or procedures regarding highlighting or explaining the provision to retail clients, among other things. CCM represented that it would refrain from enforcing the clauses and would remove the clause from its advisory agreements.

After the issuance of IA-5248, CCM revised its hedge clause to provide that CCM and its advisers would be liable for their own gross negligence or willful misconduct, would not be liable for any act or obligation of any broker-dealer or other third party, and that CCM would not be responsible for any punitive, consequential or indirect damages. The SEC determined that the revised hedge clause was misleading for a number of reasons. Among other things, the SEC found that the clause purported to waive conduct as to which the client has a non-waivable cause of action, i.e., claims arising under federal and state law based on negligence. Second, the SEC staff determined that the clause may have misled clients into refraining from exercising their rights because they may have concluded that claims other than those based on willfulness or gross negligence were waived. The SEC ordered CCM to take a number of remedial steps to address the violation, and to pay disgorgement and civil penalties exceeding $75,000.

As the CCM enforcement action demonstrates, the SEC strongly disfavors the use of hedge clauses in advisory agreements and expressly prohibits it as fraudulent or misleading conduct whenever it appears in an agreement for a retail client. Advisers should carefully review their agreements and make any changes necessary to conform them to the SEC’s 2019 guidance.


Parker MacIntyre provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds, and issuers of securities, among others. Our Investment Adviser Group assists financial service providers with complex issues that arise in the course of their business, including complying with federal and state laws and rules. Please visit our Investment Adviser Practice Group page for more information.

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