Q&A: Formation and management of hedge funds in USA (2024)

Formation and management

Forms of vehicle

What legal form of vehicle is typically used for hedge funds formed in your jurisdiction? Does such a vehicle have a separate legal personality or existence under the law of your jurisdiction? In either case, what are the legal consequences for investors and the manager?

The form of legal vehicle for a typical US-based hedge fund is either a limited partnership or limited liability company formed in the state of Delaware and operating under exemptions to the US federal securities laws. Limited partners and members are typically passive investors with limited or no voting rights. The form of legal entities limit liability for investors to the amount of their investment in the fund. These fund vehicles are typically organised as fiscally transparent entities for US federal income tax purposes, which means that the fund itself generally does not pay US federal income taxes. The selection of a limited partnership or limited liability company may in some circ*mstances depend on non-US tax considerations.

Formation process

What is the process for forming a hedge fund vehicle in your jurisdiction?

Hedge fund vehicles are generally formed in the state of Delaware by filing a certificate of limited partnership (for a limited partnership) or certificate of formation (for a limited liability company) with the Delaware Division of Corporations. After the entities are formed, the sponsor or manager will draft the governing and offering documents, including the private placement offering memorandum, subscription documents, investment advisory agreement and the limited partnership agreement or limited liability company operating agreement as applicable. Prior to commencing operations, hedge funds and their sponsors typically engage a number of third-party service providers, including attorneys, fund administrators, placement agents and accountants, and enter into trading agreements with one or more prime brokers and other trading counterparties. The costs and timeline for formation and launch of a hedge fund varies based on the size and complexity of the fund structure and its underlying investment strategy and objectives.

Custodianship and administration

Is a hedge fund vehicle formed in your jurisdiction required to maintain locally a custodian or administrator, a registered office, books and records, or a corporate secretary? If so, how is that requirement typically satisfied?

For hedge funds formed in Delaware, the entity must comply with local law, including maintaining a local registered agent with a street address at the fund’s registered office located in Delaware that is open during normal business hours to accept service of process. Local resident agents act as the point of contact between the Delaware Division of Corporations and the fund entity. Hedge funds typically engage local third-party service providers to act as registered agents. Hedge funds and their sponsors must also maintain books and records in accordance with local law, including complying with local inspection rights for fund investors pursuant to the fund’s governing documents.

A typical hedge fund manager that has custody of client assets, even briefly, is subject to extensive regulation pursuant to Rule 206(4)-2 under the Investment Advisers Act of 1940, commonly referred to as the 'Custody Rule'. When a manager has custody of client securities or funds, it must maintain the client assets with a 'qualified custodian' in a separate account for each client (ie,each fund) under the client’s name or in accounts that contain only the adviser’s clients’ assets in the name of the adviser as agent or trustee for the clients. Qualified custodians are defined in the Custody Rule to include banks, broker-dealers, futures commission merchants and certain foreign financial institutions.

Public access to information

What access to information about a hedge fund formed in your jurisdiction is the public granted by law? How is it accessed? If applicable, what are the consequences of failing to make such information available?

Hedge funds generally are not subject to regular public disclosure requirements. Hedge funds are generally structured to operate pursuant to exemptions to the Investment Company Act of 1940, the Securities Exchange Act of 1934 and the Securities Act of 1933. These exemptions typically require the fund to be structured as a limited private offering only to qualifying sophisticated investors. Hedge funds typically provide tax reporting and audited financial statements to investors on an annual basis and some funds may also provide additional information about their investments to investors on a periodic basis, however these reports are not publicly available.

Third-party investor liability

In what circ*mstances would the limited liability of third-party investors in a hedge fund formed in your jurisdiction not be respected as a matter of local law?

For hedge funds formed in Delaware, investors generally benefit from limited liability as limited partners (if the fund is structured as a limited partnership), or as members (if the fund is organised as a limited liability company). The state of Delaware has a robust body of case law safeguarding the liability of third-party investor limited partners and members. A limited partner’s or member’s liability is generally limited to the balance of the investor’s total investment in the fund. The general partner of a limited partnership has unlimited liability for any unsatisfied obligations of the partnership, however the managing member of a limited liability company does not.

Fund manager’s fiduciary duties

What are the fiduciary duties owed to a hedge fund formed in your jurisdiction and its third-party investors by that fund’s manager (or other similar control party or fiduciary) under the laws of your jurisdiction? To what extent can those fiduciary duties be modified by agreement of the parties?

Hedge fund managers have a fiduciary duty to act in the best interests of their clients. All hedge fund managers, regardless of whether they are registered under federal or state securities laws, are subject to the prohibition against fraudulent, deceptive or manipulative conduct as set forth in section 206 of the Investment Advisers Act of 1940 (referred to as the anti-fraud provisions). The United States Supreme Court held that section 206 imposes a fiduciary duty on investment managers by operation of law. This fiduciary duty comprises a duty of care and a duty of loyalty and is viewed in the context of the agreed-upon scope of the relationship between the manager and the client.

While a hedge fund manager’s fiduciary duty under the Investment Advisers Act of 1940 cannot be disclaimed or waived in its entirety and a manager cannot issue a blanket waiver of all conflicts of interest, the scope of the relationship can be defined and limited by the terms of the contract as long as there is full and fair disclosure and informed consent.

Management liability and negligence

What standard of liability applies to the management of a hedge fund formed in your jurisdiction? Does your jurisdiction recognise ‘gross negligence’ (as opposed to ‘ordinary negligence’) in this regard?

The gross negligence standard is recognised in Delaware as a heightened degree of negligence and is the typical standard in a hedge fund manager’s or sponsor’s investment advisory contract with a hedge fund.

Governance and other special issues or requirements

Are there any governance or other special issues or requirements particular to hedge fund vehicles formed in your jurisdiction? Does your jurisdiction impose any environmental, social and governance (ESG) obligations on hedge funds or their managers?

There are no such governance or other special issues or requirements particular to hedge funds but ESG is an area of steadily increasing regulatory focus in the United States. The US Securities and Exchange Commission's (SEC) Division of Examinations has included ESG as an area of interest for its exams, noting that it was particularly interested in the accuracy and adequacy of disclosures provided by fund managers. The SEC has been focused on ‘greenwashing’ where investment products are labelled as ESG without providing any metrics on the impact outcomes. The SEC has been focused on questions relating to, among other things, the definition of ESG used by the manager, ESG factors used, ESG scoring systems used, ESG policies and procedures, relationships with service providers that provide due diligence, screening information or other services relating to the selection or recommendation of ESG investments, marketing materials discussing ESG and ESG performance questions.

Fund sponsor insolvency or change of control

With respect to institutional sponsors of hedge funds organised in your jurisdiction, what are some of the primary legal and regulatory consequences and other key issues for the hedge fund and its general partner and investment adviser arising out of a bankruptcy, insolvency, change of control, restructuring or similar transaction of the hedge fund's sponsor?

Under section 205(a)(2) of the Investment Advisers Act of 1940, a manager cannot assign a client’s (a hedge fund in this case) investment advisory contract to another manager without the consent of the client. An ‘assignment’ is defined broadly under the Investment Advisers Act of 1940 to include any transfer of an investment advisory contract by the manager or any direct or indirect transfer of a controlling block of the manager’s stock or other equity interests resulting in a change in control of the management of an investment manager. However, the Investment Advisers Act of 1940 excludes from the definition of ‘assignment’ transactions that do not result in a change of actual control or management of the manager. For example, a transaction where the manager reincorporates to another local jurisdiction. A ‘negative’ consent may be sufficient to approve an assignment if the hedge fund’s advisory agreement does not specifically provide for written consent and if certain procedures, as disclosed in the hedge fund's governing documents, are followed.