Hedge Clauses and the SEC’s Position

Hedge clauses are provisions in investment advisory agreements that aim to limit an adviser’s liability for certain actions or outcomes. The U.S. Securities and Exchange Commission (the “SEC”) has expressed the position that such clauses can mislead clients into thinking they cannot exercise their legal rights and improperly infer or suggest that clients have waived non-waivable causes of action. Thus, the SEC reasons, such hedge clauses may be seen as misleading statements that discourage clients from taking legal actions against an adviser when such action may be appropriate. The SEC has stated previously that:

there are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with [] 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, in violation of the antifraud provisions, even where the agreement otherwise specifies that the client may continue to retain its non-waivable rights. 

In the same 2019 interpretation, the SEC acknowledged briefly that facts and circumstances should determine that whether a particular hedge clause is misleading. Consistent with this approach, the SEC often distinguishes between retail clients and more sophisticated or institutional clients, both generally and, in the past, even in this specific context. However, the SEC’s 2019 interpretation went further, stating that a “contract provision purporting to waive the adviser’s federal fiduciary duty generally . . . would be inconsistent with the Advisers Act, regardless of the sophistication of the client (emphasis added).” Although the SEC’s position was not met with universal agreement, many investment advisers subsequently took steps to limit the use of hedge clauses. 

ClearPath Enforcement Action and Settlement

The SEC has recently taken the opportunity to remind investment advisers of its position on hedge clauses. On September 3, 2024, the SEC entered an order accepting an Offer of Settlement from ClearPath Capital Partners LLC (“ClearPath”), a registered investment adviser to retail investors and private funds. In the order, the SEC found that ClearPath violated Section 206(2) of the Investment Advisers Act of 1940 (the “Advisers Act”) because of its improper use of liability disclaimers in both advisory agreements with retail clients and in governing documents of its private fund clients. Without admitting or denying the SEC’s findings, ClearPath agreed to a censure, to cease and desist from further violations of the charged provisions, and to pay a $65,000 civil penalty.

ClearPath’s Use with Retail Investor Clients

ClearPath used two advisory agreements containing hedge clauses with retail investors. These hedge clauses purported that ClearPath is not liable to its clients for “any action or inaction,” unless due to “gross negligence,” “willful malfeasance,” and violations of “applicable law.” The SEC reasoned that, when read in its entirety, this language may mislead ClearPath’s retail clients, causing them to not exercise their non-waivable legal rights, resulting in a violation of Section 206(2) of the Advisers Act.

ClearPath’s Use with Private Funds

ClearPath used hedge clauses in a limited partnership agreement of a private fund that ClearPath advised and served as general partner. The private fund’s provisions included a limitation on ClearPath’s liability to the private fund for “mistakes of judgment, or for action or inaction” and explicitly required investors to “waive any and all current and future claims (and right to assert such claims) against [ClearPath] and the other Indemnified Parties for any breach of fiduciary duty.” The operating agreement of another private fund for which ClearPath is the manager provided that ClearPath is not liable for “any loss or damage” unless the result of “fraud, deceit, gross negligence, willful misconduct or a wrongful taking.” These governing documents also contained other language purporting to limit fiduciary duties, a permissible concept under certain state laws but not in the context of the federal fiduciary duty of investment advisers. 

The SEC found that, when read in its entirety, the language used by ClearPath is inconsistent with an adviser’s fiduciary duty and stated that the language may mislead ClearPath’s client into not exercising its non-waivable rights, thus constituting a violation of Section 206(2) of the Advisers Act.

Why Does This Matter?

The use of hedge clauses by investment advisers in the exculpation and indemnification provisions in their advisory agreements and private fund governing documents is common. Such clauses may have been considered standard and in use for some time. However, in light of the SEC’s renewed focus on the topic and enforcement actions and settlements such as ClearPath, investment managers should once again review their use of hedge clauses with informed legal counsel. Hedge clauses should be tailored to the sophistication of the clients and amended where needed (with appropriate communication to clients) to avoid an interpretation that, when an agreement is read in its entirety, such clauses waive (or appear to waive) any non-waivable rights of the client.