One of the problems with the securities laws in the United States is that there are two levels of rules to be cognizant of at any single time – the federal rules and the state level rules.
For hedge fund managers that are registered as investment advisors with the SEC, there is a simple rule regarding performance fees – performance based fees can only be charged to those investors in the hedge fund who are “qualified clients” (the $1.5 million net worth requirement). For hedge fund managers that are registered as investment advisors with the state, however, the manager may need to be aware of the performance fee rules of states other than their own state because each state has different securities laws. (HFLB note: we will be discussing the issue of different state securities laws in an upcoming article on the Uniform Securities Act.)
Issues
There are three issues for a state-registered investment advisor to be aware of with regard to a hedge fund:
1. Are performance fees allowed at the state level? If so, what are the state’s investor qualification requirements?
2. Does an investment advisor need to “look through” the hedge fund to the individual investors to determine if a performance fee can be charged?
3. In the situation where a hedge fund investor resides in a state other than the state where the manager is registered, and with regard to the performance fee and “look through” rules, does the manager need to adopt the laws of the investor’s state or the laws of the state in which it is registered?
Discussion
First, generally all states will allow performance fees, but each state has different investor qualification requirements. Some states track the federal rules and require that performance fees be charged only to qualified clients, some states require that the performance fees be charged only to accredited investors, and some states do not allow state-registered investment advisors to charge performance fees (whether a state can legally have such a requirement is another issue).
With regard to the second issue, most all of the states which allow performance fees will “look through” the hedge fund to the individual investor for the purpose of determining who can take the performance fees; this means that each investor in the hedge fund will need to meet the qualification requirements. However, some states interpret their securities laws to mean that the performance fee can be taken at the fund level and that there is no “look through.” In these cases, if the hedge fund itself meets the qualification standards (say $1.5 million dollar net worth), then presumably the performance fee can be taken on all of the hedge funds assets, even if no single investor in the hedge fund is a qualified client. The central reason that anomalies like this exist is poor drafting on the part of the state legislatures.
Finally, we come to the third issue which is essentially a conflict of laws question. There are a couple of situations where this would apply.
Situation 1: Manager is registered as an investment advisor in State X which allows performance fees to be charged only to “accredited investors” ($1 million net worth) and “look through” rules apply. Investor from State Y wishes to invest in the hedge fund, but State Y has laws which prohibit performance fees except to those people who are qualified clients.
Situation 2: Same facts as above, but State X provides that there is no “look through” at the fund level and only the fund needs to be an “accredited investor” in order to charge a performance fee at the fund level (which would ultimately be paid by the investor through a diminished capital account).
While we believe that in both situations above the manager should be able to charge performance fees based on its own state laws and without regard to the laws of other states, there have been some state securities commissions that have stated informally to me over the phone that they believe the manager should charge performance fees to investors from their state pursuant to their state rules. We have never heard of a state instituting a proceeding against a hedge fund manager in this situation, but it is one potential issue and it has not been clearly resolved.
To try to bring a little bit of resolution to this issue, we did a conflicts of law analysis and found that it would probably be ok for a hedge fund manager to charge performance fees to its investors pursuant to the manager’s state law and without regard to the state law of the investors. However, I do not think a law firm would provide any sort of legal opinion on this issue because it is definitely still within the grey area of the law (HFLB note: this discussion should not be taken as any sort of legal advice, pursuant to our standard website disclaimer).
Generally I would recommend that state registered hedge fund managers only charge performance fees to qualified clients even if the manager’s state had lower requirements. If the manager wanted to charge performance fees to non-qualified clients, then the manager should consider charging performance fees pursuant to the state laws of each investor in the fund. The issue with this of course is that it would present additional work for the administrator and create additional costs for the fund. Additionally, the subscription documents would need to be redrafted to address the state law issues.
In any event, if this situation applies to a state-registered investment advisor who manages a hedge fund, the hedge fund manager should discuss this issue with their legal counsel.
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