Since domestic hedge funds are typically formed in the state of Delaware, managers must qualify the fund to do business in the manager's state of operation. This is known as foreign qualifying. Foreign qualifying simply means registering to do business in a state other than the state of incorporation.
What is Foreign Qualification?
When starting a domestic hedge fund, the fund entity (limited partnership or LLC) is typically formed in state of Delaware while the investment management company and general partner are typically formed in the state where the primary activity of the fund takes place--usually the manager's home state. Since the fund manager is typically not located in Delaware, it typically must foreign qualify the Delaware fund in the manager's home state.
Qualifying a business means registering for a certificate showing authority in the state where the fund will do business and pay state fees. This provides notice to the fund manager's home state that the Delaware fund is conducting business there. The fund will be subject to ongoing reporting requirements, fees and taxes both in Delaware and in the manager's home state. If the fund has owners or employees working in multiple states, it may be required to qualify in more than one state. The requirements for and process of foreign qualification varies by state. Because foreign qualification is fairly inexpensive, a manager should err on the side of qualifying when in doubt.
Consequences for Failing to Foreign Qualify the Fund
A hedge fund that fails to qualify in a state in which it is doing business could potentially lose the right to bring a lawsuit in state court. However, in many cases, the company can foreign qualify and then bring the lawsuit, but it may lose valuable time.
Additionally, the fund could be subject to penalties, fines and back taxes for the time in which the fund conducted business within the state.
Additional Local Issues
In addition to foreign qualification, a fund manager must, in its operation of the fund, adhere to local laws, regulation and ordinances. States vary substantially with respect to tax, payroll and other obligations incident to doing business within the state.