Investment Adviser Hedge Clauses: A Suitable Tool to Limit Liability or an SEC Enforcement Red Flag?

A “hedge clause,” when incorporated into an investment advisory agreement, is designed to limit an adviser’s liability to its advisory client. Even carefully worded hedge clauses, however, can attract unwanted SEC enforcement attention.

For example, a recently settled SEC enforcement action involved hedge clauses that a registered investment adviser and fund manager, ClearPath Capital Partners LLC, included in investment advisory agreements and in documents of investment funds that were principally distributed to retail investors. The SEC found that these hedge clauses violated the Investment Advisers Act’s negligence-based anti-fraud provision because they were “misleading statements” about the scope of ClearPath’s “unwaivable fiduciary duty” under the act.

The SEC discussed in detail the nature of this federal law fiduciary duty in its 2019 final interpretive release regarding the standard of conduct for investment advisers, which was published as a companion to the adopting release for what is commonly referred to as the SEC’s Regulation Best Interest for broker-dealers. The SEC’s settled order with ClearPath purportedly relied on the guidance set forth in the interpretive release, including the following quoted language: “[T]here are few (if any) circumstances in which a hedge clause in an agreement with a retail client would be consistent with [the Advisers Act] 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 … [and] [s]uch a hedge clause generally is likely to mislead those retail clients into not exercising their legal rights, in violation of the antifraud provisions.” Notwithstanding the fact that the SEC’s order articulated that its determination was based on a “facts and circumstances” test, the order could be read as virtually foreclosing such an individualized factual analysis in favor of a rigid bright-line test where retail investors are concerned. Even if the SEC indeed intends such a restrictive application of the interpretive release, however, it is not certain that (in a litigation posture) a federal court would agree with that view. Among other reasons, a court now may accord less weight to the SEC’s views on the subject than it would have prior to the recent Loper Bright decision in which the U.S. Supreme Court overturned its Chevron deference doctrine.

With respect to institutional clients, however, the interpretive release’s view of what constitutes full and fair disclosure clearly was less restrictive and more flexible in that such disclosure “can differ, in some cases significantly, from full and fair disclosure for a retail client because institutional clients generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications.” The SEC added that whether “a hedge clause in an agreement with an institutional client [violates the] antifraud provisions will be determined based on the particular facts and circumstances.” Nonetheless, regardless of whether a hedge clause is tailored for an intended retail or institutional audience, the SEC’s order stated that “even if there is a disclaimer (sometimes known as a ‘savings clause’ or ‘non-waiver’ disclosure) stating that compliance with the state or federal securities laws is not waivable,” such a disclaimer would not necessarily shield an adviser from a potential enforcement action.

In the case of ClearPath, the firm used two different hedge clauses in its advisory agreements, which stated, among other things, that it was “not liable to its clients for ‘any action or inaction,’ with exceptions for ‘gross negligence’ or ‘willful malfeasance’ and violations of ‘applicable law.’” Each agreement also included a “savings clause” stating, among other things, that the “indemnification provided for herein shall be available only as and to the extent that it is not prohibited by applicable law governing rights of indemnification” and “nothing herein shall in any way constitute a waiver or limitation of any rights which Client may have under any federal or state securities laws.” Despite this arguably balanced and transparent language used by ClearPath in its hedge clauses (including the savings statements), the SEC still concluded that each hedge clause “when read in its entirety, is inconsistent with an adviser’s fiduciary duty because it may mislead ClearPath’s retail clients into not exercising their non-waivable legal rights.”

The takeaway: although the SEC’s findings in the ClearPath enforcement order in some respects seem to go beyond what the interpretive release provides and may be subject to challenge, advisers should thoroughly analyze whether the regulatory risks associated with any hedge clauses they are using — especially in the context of retail investors — outweigh their benefits. This is particularly prudent in the current SEC regulatory environment, in which the SEC’s then-acting chair delivered public remarks on February 24, 2025, emphasizing that “breaches of fiduciary duty by investment advisers” are among the enforcement priorities that the agency will be pursuing.