How to Launch a Hedge Fund: Legal Requirements

Learn About Some of the Key Legal Considerations Involved in Launching Hedge Funds in the United States

The hedge fund industry is heavily regulated at the state and federal levels. From assets under management to choosing whether to work with only accredited investors, several factors can affect individual hedge funds’ legal and regulatory obligations. Learn what you need to know about the legal aspects of forming a hedge fund and navigating the regulatory landscape going forward.

Hedge funds are subject to extensive statutory and regulatory requirements in the United States. Hedge funds (and hedge fund advisers and managers) can also face significant liability exposure in litigation with investors and other parties. As a result, a comprehensive approach to compliance and risk management is imperative, and new hedge funds must take a proactive approach to meeting their regulatory compliance and reporting requirements on an ongoing basis.

This guide provides an introduction to the legal requirements for hedge funds in the United States. After providing an introduction to the primary federal statutes that govern hedge funds’ operations, we discuss the major legal steps involved in forming a hedge fund from scratch. We then discuss the risks of noncompliance before answering several frequently asked questions (FAQs) about the differences between compliance for hedge funds and other investment funds (i.e., private funds, mutual funds, and venture capital funds), the SEC’s and CFTC’s oversight of hedge funds, and how fund managers can (and should) manage their risk on a day-to-day basis.

Federal Securities Laws that Apply to Hedge Funds

Several federal statutes apply to hedge funds formed and operating in the United States. While most hedge funds do a decent job of managing statutory compliance, many hedge funds still fall far short of doing what is necessary to satisfy their statutory obligations.

This can (and does) have serious consequences. Even if a hedge fund executes sound investment strategies and makes money for its clients, noncompliance can still lead to enforcement actions and civil (or, in some cases, criminal) penalties. The US Securities and Exchange Commission (SEC) and US Commodity Futures Trading Commission (CFTC) both have a hand in enforcing hedge fund compliance, and they both take an aggressive approach to holding funds (and their managers) accountable when warranted.

With this in mind, here is an overview of the primary federal securities laws that apply to hedge funds:

Investment Advisers Act of 1940

The Investment Advisers Act of 1940 applies to hedge funds and hedge fund managers. As the SEC explains, under the Investment Advisers Act, “firms or sole practitioners compensated for advising others about securities investments must register with the SEC and conform to regulations designed to protect investors.” In most states, the Investment Advisers Act applies to private fund advisors with at least $150 million in regulatory assets under management (this is commonly referred to as the private adviser exemption), though in New York it applies to investment advisors with at least $25 million in regulatory assets under management. These thresholds for registered investment advisers’ reporting obligations were increased under the Dodd-Frank Act.

Under the Investment Advisers Act, registered investment advisers must file Form ADV detailing their business practices annually. The Investment Advisers Act also serves as the source of advisers’ fiduciary duties to hedge fund clients.  

Investment Company Act of 1940

The Investment Company Act of 1940 can also apply to hedge funds, although hedge funds can generally qualify for exemptions from this federal statute’s registration requirements. There are two key exemptions that hedge funds can use to avoid Investment Company Act registration:

• Section 3(c)(1): This exemption is available to hedge funds that refrain from public offerings and have no more than 100 beneficial owners.
• Section 3(c)(7): This exemption is available to hedge funds that refrain from public offerings and limit ownership to “qualified purchasers,” including individual fund investors with investments of $5 million or more and institutional investors with investments of $25 million or more.

If a hedge fund does not take the steps necessary to qualify for one of these exemptions, it will be subject to the Investment Company Act’s requirements. Complying with these requirements is a substantial undertaking, so it will be worth taking a proactive approach to managing exemption compliance (most significantly, the obligation to refrain from public offerings).

Securities Act of 1933

The Securities Act of 1933 serves as the foundation for the overarching regulatory framework that applies to registered advisers and pooled investment vehicles. As the SEC explains, “[o]ften referred to as the ‘truth in securities’ law, the Securities Act of 1933 has two basic objectives: require that investors receive financial and other significant information concerning securities being offered for public sale; and prohibit deceit, misrepresentations, and other fraud in the sale of securities.”

As the SEC goes on to explain, the “primary means” of achieving these goals is through establishing registration and disclosure obligations. However, the SEC recognizes several exemptions to the Securities Act’s registration requirements, and hedge funds can often qualify for these exemptions—with the right approach—as well. Avoiding SEC registration under the Securities Act can also be a key step for mitigating the costs of compliance on an ongoing basis.

Securities Exchange Act of 1934

While the Security Exchange Act’s public reporting requirements generally do not apply to hedge funds, hedge funds and private fund advisers may need to comply with many of this statute’s other requirements. These include the requirements pertaining to market trading rules, anti-fraud standards, and large holding disclosures, among others.

The Securities Exchange Act is also the source of statutory authority for the SEC’s Rule 10b-5. This is one of the SEC’s most potent enforcement tools, and entities and individuals that manage private funds must carefully manage compliance. Among other things, Rule 10b-5 requires hedge funds to clearly disclose the fund’s investment strategy to investors, requires hedge funds to maintain transparency in all investor communications, and prevents managers from using private fund assets for personal and other improper purposes.

Commodity Exchange Act

The Commodity Exchange Act applies to hedge funds that invest in swaps, futures, and commodities. Hedge funds covered under the Commodity Exchange Act are required to register with the CFTC—unless an exemption applies. There are exemptions for Commodity Pool Operators (CPO) and Commodity Trading Advisors (CTA); and, here too, hedge fund founders can take proactive steps to qualify for a registration exemption (and document their qualification) if desired.

Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) also establishes compliance requirements for hedge funds that are designed to protect the investors involved. Hedge funds may need to make regulatory filings and meet other affirmative requirements in order to manage their regulatory risks under the Dodd-Frank Act; although, once again, a key strategy to mitigate risk will often be to qualify for an exemption from regulatory oversight.

While these are the primary federal statutes that apply to hedge funds in the United States, this list is not exhaustive. Many state statutes apply to hedge funds as well. Certain fund managers may need to register at the state level, and hedge funds and large hedge fund advisers may also have various state-level compliance obligations. Specific investment decisions, management fees, performance fees, and uses of a fund’s profits can all implicate varying compliance obligations—and this is one reason (among many) why a custom-tailored approach to compliance is essential.

7 Key Legal Steps for Launching a US Hedge Fund

Let’s say you are an experienced investment manager, and let’s say you are ready to use your experience to launch a hedge fund of your own. What do you need to do before you can start raising capital from wealthy investors?

Here are seven key legal steps for launching a hedge fund in the United States:

1. Business Entity Selection and Formation

Launching a hedge fund starts with forming a business entity. Before a hedge fund can address the compliance obligations discussed above, it first needs to exist. While hedge funds can exist as corporate entities, most hedge funds are formed as a limited partnership. With that said, all hedge fund founders should make informed decisions based on their specific goals and needs.

2. Assessment of Registration Requirements and Exemptions

After formation, the next key legal step is to assess the fund’s registration requirements. This includes assessing its eligibility for statutory exemptions—and structuring the fund to qualify for these exemptions as warranted.

3. SEC, CFTC, and State-Level Registration (as Necessary)

New hedge funds should address all applicable registration requirements promptly. Securing necessary registrations can take time; so, once the decision is made to file, it is generally best to start the process sooner rather than later.

4. Choosing the Fund’s Structure

Choosing the fund’s structure goes hand-in-hand with assessing its registration obligations and exemption eligibility. This will also determine many of the fund’s other compliance obligations—so this should be an early step in the formation process as well.

5. Preparing Necessary Legal Documents

Along with any registration filings, new hedge funds will also need to generate various other legal documents early on. For example, documents like the private placement memorandum (PPM) and other offering forms are crucial for conducting hedge fund offerings while maintaining federal registration exemptions. Contracts with prime brokers, banks, administrators, distributors, accounting firms, and other service providers are key legal documents as well.

6. Developing and Implementing a Compliance Program

All hedge funds need well-documented compliance programs. Their compliance programs should include policies and procedures that are custom-tailored to their statutory and regulatory obligations—and these obligations will be determined based on the fund’s structure and the unique aspects of its operations. With this in mind, some common areas that new hedge funds will need to address in their compliance programs include:

• Managing the fund’s fiduciary duties to investors (including the duties to avoid conflicts of interest and properly manage expense allocation)
• Maintaining accurate pricing and valuation policies for all securities and commodities traded
• Complying with SEC Rule 10b-5 and the SEC’s Custody Rule
• Complying with anti-money laundering (AML) and know-your-customer (KYC) requirements (this is another area of federal compliance that is vital for hedge funds)
• Maintaining records as required by law (i.e., investment advisers must generally maintain records for at least five years)

This is just a small sampling. Since hedge funds operate as private pools of capital and work with private investors, they must manage a wide range of compliance obligations that are not purely related to their oversight by the SEC and CFTC.

7. Preparing to Manage (and Document) Compliance On an Ongoing Basis

Managing hedge fund compliance is not a one-time event. After establishing their compliance programs, new hedge funds must be prepared to proactively manage compliance on an ongoing basis. All hedge funds should document their compliance efforts on an ongoing basis as well—as having this documentation on hand can be critical in the event of a lawsuit or investigation.

Understanding the Risks of Legal Oversights and Noncompliance

What are the risks of noncompliance? In short, there are many. Some examples of the legal and regulatory risks associated with forming and managing a hedge fund in the United States include:

• Personal Liability – Hedge fund founders must be careful to avoid oversights that could expose them to personal liability in civil litigation and governmental enforcement proceedings.
• Civil Lawsuits from Investors – Hedge funds can face lawsuits from investors on various grounds—and hedge funds’ liability in these lawsuits can be substantial.
• SEC and CFTC Enforcement Actions – Hedge funds can also face substantial liability in SEC and CFTC enforcement actions.
• DOJ Prosecution – In egregious cases, the US Department of Justice (DOJ) can pursue criminal prosecution for violations of federal investor protection laws.
• Injunctions and Other Penalties – Along with substantial fines, enforcement actions and criminal proceedings can also lead to injunctions (including bars from the securities industry), prison time, and other penalties.

Again, these are just examples. Hedge funds, their managers, their chief compliance officers, and other personnel can all face a variety of potential risks on a daily basis. The key is to take a proactive approach to managing these risks, and to make informed decisions with a long-term perspective.

FAQs: Legal Issues Related to Hedge Funds and Private Equity

Can I serve as my hedge fund’s manager, or do I need to appoint an independent hedge fund manager?

Yes, if you are launching a hedge fund, you have the option of serving as your hedge fund’s manager. With that said, hedge fund managers need to have significant investment experience, and they need to be prepared to play an active role in all aspects of the hedge fund’s strategy and compliance efforts. If you are not confident that you are prepared to manage your hedge fund yourself, it may make sense to recruit an independent hedge fund manager who can use his or her experience to provide insights and guidance during the early stages of your fund’s growth.

Can hedge fund managers face personal liability for investor losses?

Yes, hedge fund managers can face personal liability for investor losses—if they are not proactive about protecting themselves. While hedge fund managers can face exposure to personal liability, they can also effectively eliminate this exposure by observing the legal formalities of forming and managing a hedge fund. This is a critical aspect of the formation process—and this is one of several reasons why it is important to engage experienced legal counsel with a comprehensive understanding of the risks that need to be addressed.

Are hedge funds and private equity funds subject to different legal and regulatory requirements?

Yes, hedge funds and private equity funds (i.e., those that make venture capital investments) are subject to different legal and regulatory requirements. Hedge funds and other types of funds (i.e., mutual funds) are subject to different requirements as well. If you have experience managing one of these other types of funds, it will be important to ensure that you have a clear understanding of all pertinent statutes and regulations as you begin to navigate the hedge fund formation process.

When do the SEC and CFTC pursue enforcement actions against hedge funds?

The SEC and CFTC pursue enforcement actions against hedge funds in a wide range of circumstances. With that said, most of these enforcement actions involve statutory and regulatory violations that pose risks (or potential risks) to a fund’s investors. Many enforcement actions result from investor complaints, though the SEC’s and CFTC’s market surveillance can lead to investigations and enforcement actions as well.

What can I do to make sure my hedge fund is not at risk of facing an SEC or CFTC enforcement action?

While it is not possible to completely eliminate the risk of facing an SEC or CFTC enforcement action, new hedge funds can effectively mitigate their risk by taking an informed and proactive approach to compliance. Working with experienced legal counsel is essential; and, along with establishing effective compliance policies and procedures, hedge funds should document their compliance efforts so that they are prepared to respond to SEC or CFTC scrutiny if necessary.

Contact the Hedge Fund Lawyers at Oberheiden PC

If you need to know more about the legal requirements for launching a hedge fund in the United States, we invite you to get in touch. Call 888-680-1745 or contact us online to arrange a free and confidential consultation with the hedge fund lawyers at Oberheiden PC.