What Precisely Is “Fiduciary Duty” in the Hedge Fund Context, and To Whom is it Owed?

The concept of fiduciary duty is at the heart of the relationship among hedge fund managers, hedge funds and hedge fund investors.  But until recently, “fiduciary duty” was not defined by any bill or law.  Rather, it was the creature of caselaw, and much of that caselaw dealt with whether and to whom the fiduciary duty is owed, rather than the content of the duty.  That has changed with the Obama administration’s proposal on July 10, 2009 of the Investor Protection Act of 2009 (IPA).  While the IPA has received significant attention because it would impose a fiduciary duty on broker-dealers that provide investment advice (currently, broker-dealers are subject to a less stringent “suitability” standard), for the hedge fund community, the IPA is noteworthy as the first proposed codification of the substance of a fiduciary duty.  In addition, the IPA delegates to the SEC rulemaking authority to define the “client” to whom a fiduciary duty is owed.  This could empower the SEC to resolve an ambiguity that has existed since the D.C. Circuit’s 2006 decision in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), as to whether a hedge fund manager owes a fiduciary duty to the hedge fund itself, or its underlying investors.  That is, the IPA may enable the SEC to provide by rule that a hedge fund manager owes a fiduciary duty to each investor in a hedge fund, and not just to the hedge fund itself.  For practical purposes, if the IPA were to become law and if the SEC were to provide by rule that a hedge fund manager owes a fiduciary duty to hedge fund investors, it likely would become easier for hedge fund investors to sue managers based on a range of manager conduct.  This is because such a law and rule would more explicitly confer standing on hedge fund investors to challenge various manager actions.  In this article, we explain precisely what “fiduciary duty” means in the hedge fund context, and explore to whom the duty is owed (the answer is by no means straightforward).  We also explore: the practical consequences of identifying either the hedge fund or its investors as the manager’s “client”; Investment Advisers Act Rule 206(4)-8, the anti-fraud rule with a negligence standard; whether fiduciary duty can be waived; the definition of “client” in the Private Fund Investment Advisers Registration Act of 2009; and the executive compensation provisions of the IPA.

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