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.