SEC Issues No-Action Letter on the Use of “Hedge Clauses” in Investment Advisory Contracts
SEC Guidance Expands Scope of Exemptions Under Section 17(a) of the Investment Company Act
SEC Issues No-Action Letter on the Use of “Hedge Clauses” in Investment Advisory Contracts
By Cillian M. Lynch
On February 12, 2007, the Securities and Exchange Commission (SEC) issued a no-action letter (the Heitman Letter) to Heitman Capital Management, LLC, and certain of its affiliates (Heitman) addressing the use of “hedge clauses” and related client indemnification disclosure in investment advisory agreements. The issue was whether the use of such disclosure constitutes fraud under Sections 206(1) and 206(2) of the Investment Advisers Act of 1940 (Advisers Act).2
A “hedge clause” typically is used in an investment advisory contract to absolve the adviser of liability and might also function as indemnification of the adviser by the advisory client except in cases of the adviser’s gross negligence, reckless or willful misconduct, illegal acts, or acts outside the scope of the adviser’s authority. Hedge clauses are often followed by “nonwaiver disclosure” informing clients that they hold certain rights against the adviser, notwithstanding the hedge clause, typically under federal and state securities laws. The investment advisory agreement addressed in the Heitman Letter contained both a hedge clause and nonwaiver disclosure.
Sections 206(1) and 206(2) of the Advisers Act prohibit an investment adviser from employing any device, scheme or artifice to defraud, or to engage in any transaction, practice or course of business that operates as a fraud or deceit on clients or prospective clients. Hedge clauses or nonwaiver disclosure might violate these antifraud provisions if they are likely to lead an investment advisory client to believe that he or she has waived nonwaivable rights of action against the adviser that are provided by federal or state law.3 Cases interpreting the Advisers Act have determined that Sections 206(1) and 206(2) impose an affirmative duty on an investment adviser to explain a hedge clause if the investment adviser believes or has reason to believe that a particular client would likely be misled by it, as well as a duty to act solely in the best interests of its clients and to fully and fairly disclose all material facts.4
The SEC Staff (Staff) has previously taken the position that hedge clauses that ostensibly limit an investment adviser’s liability to acts involving gross negligence or willful malfeasance are likely to mislead an unsophisticated client into believing that he or she has waived nonwaivable rights, even if the hedge clause explicitly states that rights under federal or state law cannot be waived.5
Heitman’s letter requesting no-action assurance noted that its clients are sophisticated persons who have the resources and experience to understand the investment advisory contracts they are entering into, as well as the bargaining power to negotiate and even dictate the terms of the agreements. These clients include registered investment companies, large institutional investors who meet the definition of “qualified institutional buyer” under Rule 144A of the Securities Act of 1933 and “qualified purchaser” as defined in Section 2(a)(51) of the Investment Company Act of 1940.
The Staff agreed with Heitman’s argument that a bright-line prohibition against hedge clauses is improper, and found that whether hedge clauses and exculpatory language, as considered herein, violate Sections 206(1) and 206(2) of the Advisers Act depends on “all of the surrounding facts and circumstances.”6 The Staff went on to outline which factors it would consider in making this determination, including: the form and content of the particular hedge clause (e.g., its accuracy), any oral or written communications between the investment adviser and the client about the hedge clause, and the particular circumstances of the client. On this last point, the Staff noted that a hedge clause might be “misleading in its overall effect even though it might be argued that when narrowly and literally read, no single statement of material fact was false.”7
The Staff outlined additional factors it would consider in advisory contracts with clients “unsophisticated in the law,” including, but not limited to, whether: the hedge clause was written in plain English; the hedge clause was individually highlighted and explained during an in-person meeting with the client; enhanced disclosure was provided to explain the instances when such client may still have a right of action; and there was a sophisticated intermediary present to assist the client in dealings with the adviser, including the nature and extent of the intermediary’s assistance to the client.
The Staff determined that Heitman’s use of a hedge clause and nonwaiver disclosure, as described herein, does not per se violate Sections 206(1) and 206(2) of the Advisers Act. The Staff was careful to note that it took no position regarding whether the use of specific hedge clauses and nonwaiver disclosure by Heitman would mislead any particular client because of the fact-intensive nature of the inquiry, and that it would not, as a matter of policy, provide no-action or interpretive assurance regarding the permissible use of particular hedge clauses in advisory agreements. As such, advisers must rely on the guidance provided in the Heitman Letter and previous letters, and might wish to review the form and content of their own hedge clauses and/or non-waiver disclosure, giving particular consideration to the Staff’s enumerated factors for determining permissive use under Sections 206(1) and 206(2).
Advisers should clearly communicate with potential clients regarding hedge clauses while considering the particular circumstances and sophistication of each potential client. In dealing with “unsophisticated” clients, additional steps are recommended, such as the use of plain English, clear highlighting and explanation of the hedge clause, preferably in an in-person meeting, and additional disclosure explaining when a potential client might still have a right of action, notwithstanding the hedge clause and nonwaiver disclosure.
1 Cillian M. Lynch is an Associate in Stradley’s Washington, D.C., office.
2 15 U.S.C. 80b-6(1) and (2).
3 See Heitman Capital Management, LLC, et al., 2007 SEC No-Act. LEXIS 159 (Feb. 12, 2007), citing, e.g., In the Matter of William Lee Parks, Investment Advisers Act Release No. 736 (Oct. 27, 1980) and In the Matter of Olympian Financial Services, Inc., Investment Advisers Act Release No. 659 (Jan. 16, 1979). See also Opinion of General Counsel Roger S. Foster Relating to the Use of Hedge Clauses by Brokers, Dealers, Investment Advisers and Others, Investment Advisers Act Release No. 58 (Apr. 10, 1951).
4 See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963).
5 See Auchincloss & Lawrence Incorporated, 1974 SEC No-Act. LEXIS 1479 (Feb. 8, 1974), Omni Management Corporation, 1974 SEC No-Act. LEXIS 1119 (Dec. 13, 1974), and First National Bank of Akron, 1976 SEC No-Act. LEXIS 514 (Feb. 27, 1976).
6 See Acorn Financial Services, Inc., 1984 SEC No-Act. LEXIS 2528 (July 25, 1984).
7 See In the Matter of Spear & Staff, Inc., Investment Advisers Act Release No. 188 (March 25, 1965), citing SEC v. Capital Gains Research Bureau, Inc., supra Note 2.
SEC Guidance Expands Scope of Exemptions Under Section 17(a) of the Investment Company Act
By Ryan M. Orr
The Staff of the SEC recently issued two no-action letters providing guidance on the scope of the exemptions available under Section 17(a) of the Investment Company Act of 1940, as amended (the 1940 Act).1 Section 17(a)(1) of the 1940 Act prohibits any affiliate, acting as principal, from knowingly selling any security or other property to a fund. Section 17(a)(2) of the 1940 Act prohibits any affiliate, acting as principal, from knowingly purchasing any security or other property from a fund. Section 17(a) of the 1940 Act was designed to prohibit self-dealing and other forms of overreaching by a fund’s affiliates, especially where the affiliate has “both the ability and the pecuniary incentive to influence the actions of the investment company.”2
No-Action Relief Granted to Gartmore Variable Insurance Trust
On December 29, 2006, the Staff granted no-action relief to Gartmore Variable Insurance Trust (the VI Trust) with respect to a reorganization of its investments.3 The VI Trust proposed to conduct a transaction in which certain of its series funds would purchase shares of certain affiliated registered funds in-kind. The VI Trust sought to conduct the transaction in-kind, rather than through a cash sale and purchase of fund securities, in order to avoid significant brokerage costs. The in-kind transaction would also provide the VI Trust with greater flexibility in meeting the diversification requirements of the Internal Revenue Code of 1986, as amended.
The in-kind purchase transaction between the affiliated funds involved three transactions implicating the prohibitions of Section 17(a) of the 1940 Act:4
1. the sale of one fund’s shares to another fund may be viewed as a sale of securities by an affiliate to a fund under Section 17(a)(1) of the 1940 Act;
2. the purchase of the in-kind consideration by a fund may be viewed as a purchase of securities by an affiliate under Section 17(a)(2) of the 1940 Act; and
3. the sale of the in-kind consideration may be viewed as a sale of securities by an affiliate to a fund under Section 17(a)(1) of the 1940 Act.
Despite the apparent prohibition under Section 17(a), the Staff granted no-action relief to the VI Trust under the following conditions:
• An in-kind purchase would not dilute the interests of the shareholders of a fund.
• The in-kind consideration accepted by a fund would consist of securities that are appropriate, in type and amount, for investment by such fund in light of its investment objectives and policies and current holdings.
• The in-kind consideration would consist only of the redemption proceeds obtained through the redemption of shares of the fund.
• The funds would have the same procedures for determining their net asset values and would follow those procedures in determining the amount of redemption proceeds to be paid and the amount of shares to be sold.
• The in-kind redemptions and in-kind purchases would be effected simultaneously.
• The in-kind purchases would be conducted pursuant to procedures adopted by the board of trustees (Board) on behalf of each fund, including a majority of trustees who are not “interested persons” of the fund as defined in Section 2(a)(19) of the 1940 Act (Independent Trustees), that are reasonably designed to provide that the purchases in-kind are effected in a manner consistent with the above conditions.
• Within the seven days following the 30-day period immediately after completion of the in-kind purchases, the Board, including a majority of Independent Trustees, on behalf of each fund, would determine that all of the in-kind purchases involving the funds:
– were effected in accordance with the adopted procedures;
– did not favor one fund to the detriment of any other fund; and
– were in the best interests of each fund.
• The VI Trust would maintain and preserve for a period of not less than six years from the end of the fiscal year in which the purchase occurred, the first two years in an easily accessible place:
– a copy of the in-kind purchase procedures, as well as other records for the in-kind purchases, setting forth the identity of the funds involved;
– a description of the composition of the relevant funds’ investment portfolios (including each asset’s value) immediately prior to the in-kind purchases;
– a description of each security delivered in connection with the in-kind purchases;
– the terms of the in-kind purchases;
– the information or materials upon which the asset valuations were made; and
– a description of the composition of the relevant funds’ investment portfolios (including each asset’s value) 30 days after the in-kind purchases.
• The VI Trust’s investment adviser would, consistent with its fiduciary duties, disclose to the Independent Trustees of the Board of the funds the existence of, and all of the material facts relating to, any conflicts of interest between such adviser and the funds in a proposed in-kind purchase, to allow the Independent Trustees to approve the in-kind purchases.
No-Action Relief Granted to GuideStone
On Dec. 27, 2006, the Staff granted no-action relief to GuideStone Financial Resources of the Southern Baptist Convention (GuideStone Financial), GuideStone Capital Management (GuideStone Management) and the Real Estate Securities Fund and the Global Bond Fund (collectively, the Unregistered Funds) under Section 17(a)(1) of the 1940 Act if the Unregistered Funds sold portfolio securities to affiliated, newly created series of the GuideStone Funds (the Funds) in exchange for shares of the newly created series (the New Series).5
GuideStone Financial intended to engage in transactions whereby all of the assets of each Unregistered Fund would be transferred to a corresponding New Series in exchange for shares of a New Series, whereupon the Unregistered Fund would distribute the shares of the corresponding New Series pro rata to its holders and terminate (a Transaction). Each Transaction essentially entailed a merger (as defined in Rule 17a-8 under the 1940 Act) of an Unregistered Fund with a corresponding New Series whereby the New Series would be the surviving company. Without no-action relief, the Transactions would be prohibited by Section 17(a)(1) of the 1940 Act.
The Unregistered Funds could not rely on Rule 17a-8 under the 1940 Act, which exempts mergers between registered investment companies, as well as between registered investment companies and certain affiliated entities (namely, bank common and collective trust funds and insurance company separate accounts, collectively the Specified Entities). The Unregistered Funds were not Specified Entities. The SEC had previously addressed on a case-by-case basis through the exemptive process the mergers of registered investment companies with non-Specified Entities and had imposed conditions on those mergers to address the possibility of overreaching by the non-Specified Entities. Those conditions required compliance with all of the requirements of Rule 17a-8 under the 1940 Act (other than with respect to Specified Entities). In addition, the conditions required compliance with the requirements of Rule 17a-7 under the 1940 Act (except for Rule 17a-7(a)’s requirement that the transaction be for cash payment).6
The Staff granted no-action relief based on the following conditions:
• The Transactions would comply with the terms of paragraphs (b), (c), (d), (e), (f) and (g) of Rule 17a-7 under the 1940 Act and the provisions of Rule 17a-8 under the 1940 Act (as these
provisions apply to a merger between an unregistered fund that is eligible to rely on the Rule and a registered investment company).
• The in-kind consideration accepted by each New Series would consist of securities that are appropriate, in type and amount, for investment by the New Series in light of its investment objectives and policies.
• The Unregistered Funds and the New Series have the same procedures for determining their net asset values and will follow those procedures in determining the amount of shares; the Board of the Funds approved the procedures for the New Series; the approved procedures included the preparation of a report by an independent evaluator to be considered by the Board in assessing the value of any securities (or other assets) for which market quotations are not readily available, that sets forth the fair value of each such asset as of the date of the Transaction; and the independent evaluator would be a person who has expertise in the valuation of securities and other financial assets and who is not an interested person, as defined in Section 2(a)(19) of the 1940 Act, of the Unregistered Funds or any affiliated person of the Unregistered Funds (other than the New Series).
• The redemptions from the Unregistered Fund would be effected simultaneously with the purchases by each corresponding New Series.
• The New Series would effect the Transactions pursuant to procedures adopted by the Board, including a majority of the Independent Trustees, that are reasonably designed to provide that the Transactions are conducted in a manner consistent with the above conditions.
• The Funds would maintain and preserve for a period of not less than six years from the end of the fiscal year in which the Transactions occurred, the first two years in an easily accessible place, a copy of its in-kind purchase procedures as well as other records for the in-kind purchase setting forth a description of the composition of each Unregistered Fund’s investment portfolio (including each asset’s value) immediately prior to the in-kind purchase, a description of each portfolio security delivered in connection with the in-kind purchase, the terms of the in-kind purchases, the information or materials upon which the asset valuations were made, and a description of the composition of each New Series’ investment portfolio (including each asset’s value) one month after the in-kind purchase.
• GuideStone Management would, consistent with its fiduciary duties, disclose to the Independent Trustees the existence of, and all of the material facts relating to, any conflicts of interest between GuideStone Management and the New Series with regard to the Transactions, to facilitate the ability of the Independent Trustees to evaluate and approve the Transactions.
• GuideStone Management would bear the costs associated with the Transactions.
1 15 U.S.C. 80a-17.
2 See Investment Company Mergers, Investment Company Act Release No. 25259 (Nov. 15, 2001) (proposing amendments to Rule 17a-8 under the 1940 Act), citing, among other things, Investment Trusts and Investment Companies: Hearings on S.3580 before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong. 3d Sess., at 256-59 (1940).
3 Gartmore Variable Insurance Trust, 2006 SEC No-Act. Lexis 754 (Dec. 29, 2006).
4 The purchase of shares by the affiliated fund was exempted under Section 17(a)(2) because the transaction involved securities of which the seller was the issuer.
5 GuideStone Financial, et al., 2006 SEC No-Act. LEXIS 752 (Dec. 27, 2006).
6 Rule 17a-7 provides conditional relief from the prohibitions of Section 17(a) of the 1940 Act. Paragraph (a) of Rule 17a-7 provides that a transaction occurring in reliance on the Rule must be “a purchase or sale, for no consideration other than cash payment against prompt delivery of a security for which market quotations are readily available.” The Unregistered Funds could not conduct the Transactions in reliance on Rule 17a-7 because the Transactions would not entail “cash payment against prompt delivery of a security for which market quotations are readily available” (as required by Rule 17a-7(a)) but, rather, would entail the payment of in-kind consideration for fund shares.