Regulatory Framework and Formation Documents

The final installment of this series highlights the regulatory landscape and foundational documents required to structure and maintain a compliant hedge fund.

Regulatory Framework

Investment Company Act of 1940

Any entity primarily engaged in investing in securities may be classified as an investment company under the ICA, triggering burdensome registration and operational requirements. Hedge fund sponsors universally seek to avoid this classification.

The two exemptions most commonly relied on are:

• Section 3(c)(1): Available if the fund refrains from public offerings and has no more than 100 beneficial owners (15 U.S.C. § 80a-3(c)(1)).
• Section 3(c)(7): Available if the fund refrains from public offerings and limits ownership to "qualified purchasers" (generally natural persons or family entities with $5 million or more in investments, or institutional entities with $25 million or more (15 U.S.C. § 80a-3(c)(7))).

Both exemptions incorporate complex "look-through" rules that may require the fund to count the beneficial owners of investing entities rather than the entities themselves, particularly where an entity was formed for the purpose of investing in the fund.

Investment Advisers Act of 1940

The Advisers Act imposes registration and conduct requirements on persons providing investment advice for compensation. Following the Dodd-Frank Act's elimination of the former private adviser exemption, most U.S.-based hedge fund managers with $150 million or more in regulatory assets under management must register with the SEC. Registration brings ongoing compliance obligations, including books-and-records requirements, periodic examinations, Form ADV disclosure, and Form PF reporting for private fund advisers.

Advisers below the $150 million threshold may fall under state regulatory jurisdiction. The Dodd-Frank Act generally requires advisers with between $25 million and $100 million in assets under management to register with their home state, if that state maintains an adviser registration and examination program.

Regardless of registration status, all investment advisers owe fiduciary duties to their fund clients and are subject to the Advisers Act's antifraud provisions (15 U.S.C. § 80b-6).

Securities Act of 1933

Hedge fund interests are securities whose offer and sale must either be registered with the Securities and Exchange Commission (SEC) or conducted under an available exemption. In practice, hedge funds rely on private placement exemptions, principally Section 4(a)(2) and the Regulation D safe harbors, to avoid the cost and disclosure burden of registration.

Rule 506(b) of Regulation D provides a well-established safe harbor requiring, among other conditions, that the offering involve no general solicitation, that purchasers make investment-intent representations, and that no more than 35 non-accredited investors participate. The fund, its GP, and management company are also subject to "bad actor" disqualification screening.

Since the JOBS Act, Rule 506(c) additionally permits offerings using general solicitation and advertising, provided that all purchasers are accredited investors and the issuer takes reasonable steps to verify their status.

Securities Exchange Act of 1934

A fund with more than $10 million in assets must register its equity securities under the Exchange Act if held of record by 2,000 or more persons (or 500 or more non-accredited investors). Most hedge funds remain well below these thresholds.

The Exchange Act's antifraud provisions, particularly Rule 10b-5, apply to all statements made in connection with the offer or sale of fund interests, exposing the sponsor and its personnel to liability for material misrepresentations or omissions in offering materials or investor communications.

ERISA Considerations

When benefit plan investors (pension funds, 401(k) plans, and similar vehicles) invest in a hedge fund, the fund may become subject to ERISA's fiduciary, prohibited-transaction, and reporting requirements unless an exemption applies. The most widely used exemption for hedge funds is the "25 percent test," which requires that benefit plan investors (including investments through individual retirement accounts) hold less than 25 percent of any class of the fund's equity interests. The Venture Capital Operating Company (VCOC) and Real Estate Operating Company (REOC) exemptions available to certain private equity and real estate funds are generally inapplicable to hedge funds given their trading-oriented strategies.

Failure to qualify for an exemption subjects the adviser to ERISA fiduciary status with respect to plan assets, carrying exposure to personal liability, disgorgement, equitable remedies, and civil or criminal penalties for any breach. Additionally, prohibited-transaction rules restrict dealings between the fund and parties in interest, potentially limiting fee arrangements, affiliated transactions, and certain investment activities.

Principal Formation Documents

Private Placement Memorandum

The PPM serves as the fund's primary disclosure and marketing document. Although not legally mandated for offerings limited to qualified institutional buyers and accredited investors, market convention calls for its delivery to every prospective investor.

A hedge fund PPM typically addresses:

• The fund's investment program, including strategies, instruments, use of leverage, and target risk/return characteristics.
• Biographical and track-record information for the portfolio management team.
• A term sheet summarizing the fund's material legal and economic terms.
• Risk factors covering market, credit, liquidity, leverage, counterparty, operational, and regulatory risks.
• Disclosure of conflicts of interest, including those arising from multiple-account management, affiliated transactions, and soft-dollar arrangements.
• Tax considerations for U.S. taxable, U.S. tax-exempt, and non-U.S. investors.
• Compliance with the SEC Marketing Rule governing advertising and performance presentation by registered advisers.

Limited Partnership or LLC Agreement

The operating agreement constitutes the fund's constitutional document, establishing the legal relationship between the GP or managing member and the investors. For hedge funds, the agreement gives particular attention to:

• Investment mandate, guidelines, and restrictions.
• Management fee and incentive allocation mechanics, including high-water mark and crystallization provisions.
• Subscription and redemption procedures, lock-ups, gates, and suspension authority.
• Valuation methodology and NAV determination.
• Side-pocket establishment and operation.
• Allocation of expenses between the fund and the adviser.
• Transfer restrictions and anti-money-laundering compliance.
• Dissolution triggers and liquidation procedures.

Subscription Documents

Each investor executes a subscription agreement specifying its investment amount and incorporating representations regarding investor qualification, beneficial ownership, tax status, and compliance with applicable laws. Accompanying questionnaires collect the information necessary to confirm the investor's eligibility under ICA exemptions, Regulation D requirements, and ERISA thresholds.

Side Letters

Sponsors frequently negotiate supplemental agreements with individual investors, particularly institutional allocators, granting bespoke terms. Common accommodations include reduced fees, preferential liquidity (shorter lock-ups or waived gates), enhanced portfolio transparency, most-favored-nation protections, and regulatory representations.

Investment Management Agreement

A separate advisory contract formalizes the relationship between the fund and its investment adviser, specifying the scope of delegated authority, the fee arrangement, liability and indemnification provisions, and termination mechanics.

Prime Brokerage Agreement

Unique to hedge funds relative to most other private fund categories, the prime brokerage agreement governs the provision of integrated execution, financing, securities lending, and custody services. The selection of one or more prime brokers, and the allocation of assets among them, has direct implications for the fund's cost of leverage, short-selling capacity, operational resilience, and counterparty concentration risk.

Regulatory Filings

If the offering relies on the Regulation D safe harbor, an SEC Form D must be filed within 15 days of the first sale, disclosing basic information about the issuer, the offering, and the purchasers. In addition, Regulation D state notice filings generally must be made in the states from which the fund has investors. Registered advisers must additionally file and maintain a current Form ADV and, for advisers to private funds exceeding certain thresholds, periodic Form PF reports with the SEC.

Bad Actor Screening

Rule 506(d) disqualifies an offering from the Regulation D safe harbor if any "covered person" – including the issuer, its directors and officers, general partners, managing members, and compensated solicitors – has experienced specified disqualifying events such as criminal convictions, certain regulatory orders, or SEC disciplinary actions. Sponsors must conduct and document diligence on all covered persons before commencing an offering.

Hedge fund formation requires careful navigation of overlapping regulatory regimes alongside thoughtful structuring of the fund's governing documents and investor-facing materials. Sponsors that address these requirements at the outset are better positioned to mitigate risk, maintain compliance, and operate efficiently as their fund grows.

For More Information

Baker Donelson's Fund Formation and Investment Management attorneys regularly advise sponsors on all aspects of hedge fund structuring, formation, and ongoing compliance. If you have questions about launching a new fund or the regulatory requirements applicable to your investment management business, please contact Paul J. Foley, Cole Beaubouef, Kiki Scarff, John M. Faust, or another member of our Fund Formation and Investment Management team.