Dispute resolution

Dispute resolution provisions create a clear roadmap for handling conflicts that might arise in hedge fund operations. These conflicts can occur between fund managers and investors, among different investors, or with outside parties. Think of these provisions as a predetermined set of rules that everyone agrees to follow if problems arise.

Hedge funds include these provisions in their main governing documents and in separate agreements called "side letters Side letter Side letters are separate agreements between a hedge fund and a specific investor that modify or supplement the standard fund terms, typically granting special rights or preferences to large or strategic investors. ." The goal is simple: provide certainty about how disputes will be resolved while keeping costs down and avoiding negative publicity that could harm the fund's reputation.

Investment managers must decide which state or country's laws will apply when disputes arise. This decision affects partnership agreements, employment contracts, and other key documents. However, selecting a particular jurisdiction's laws doesn't guarantee that those laws will actually govern the dispute—courts may sometimes apply different rules based on the specific circumstances.

The most straightforward approach involves two basic principles. For partnership-related disputes, managers typically choose the laws of the state where they formed the partnership. For employment disputes, they usually select the laws of the state where the employee primarily works. This approach reduces confusion and makes enforcement more predictable.

Investment managers need to be careful because different agreements within the same fund structure might reference different governing jurisdictions. This requires close coordination to ensure all documents work together smoothly.

When parties agree that disputes will be resolved in a specific location, courts generally respect these agreements. Most investment managers prefer to handle disputes where their main business operations are located, rather than in their formal incorporation state, which might be Delaware or another state chosen primarily for tax or legal advantages.

Fund managers face an important strategic choice between exclusive and permissive forum selection clausesContractual provisions that designate specific courts or jurisdictions where disputes must be resolved, either exclusively or permissively.. Exclusive clauses require all disputes to be resolved in one specific location, which generally works better for fund sponsors and is widely accepted by most investors.

However, some institutional investors—particularly state pension fundsRetirement benefit plans established by employers to provide income to employees after retirement, typically qualifying as tax-exempt organizations.—face legal restrictions that prevent them from agreeing to resolve disputes in other states' courts. These investors may require permissive language that allows disputes to be filed in multiple locations, giving them flexibility to choose the most appropriate forum.

Rather than changing the main fund documents to satisfy every investor's preferences, sponsors often handle special requests through targeted side letters. These are separate agreements between the fund and specific investors that modify certain terms without affecting other investors.

This approach allows sponsors to maintain their preferred dispute resolution structure with most investors while still accommodating institutional requirements through individual agreements. It's a practical compromise that keeps the main fund documents clean while providing necessary flexibility.

Arbitration offers an alternative to traditional court litigation where parties submit their disputes to neutral third parties or panels for binding decisions. This process works differently from court proceedings in several important ways.

Unlike judges who must follow strict legal rules, arbitrators have more flexibility in how they apply laws and procedures. Arbitration proceedings remain private—documents and evidence generally stay out of public view. While both sides can still request information from each other (a process called "discovery"), arbitrators typically control and limit this process more tightly than courts would.

Investment managers often prefer arbitration for several practical reasons. It can reduce the risk of extremely large monetary judgmentsCourt orders requiring one party to pay a specific amount of money to another party as compensation for damages or losses., lower the costs of gathering evidence, decrease overall legal expenses, and provide faster resolution than court cases. The selection process also allows parties to choose arbitrators who understand the investment industry. Additionally, the private nature of arbitration helps preserve confidentiality and prevents negative publicity that could damage business relationships.

Despite these advantages, arbitration has some significant drawbacks. Arbitration decisions receive very limited review on appeal, making it extremely difficult to overturn problematic awards even when arbitrators make clear errors. Arbitrators may base their decisions on what seems fair rather than on strict legal principles, and some may try to find middle-ground solutions that partially satisfy both parties rather than making definitive rulings.

The limited appeal rights in arbitration contrast sharply with the broader review available in court proceedings. While courts charge minimal fees to the parties, arbitrators charge substantial fees that the parties must pay directly. Some arbitration systems also restrict formal legal motions, reducing opportunities to resolve cases early in the process.

Arbitration provisions should explicitly exclude disputes that cannot be subject to mandatory arbitrationContractual requirements that force parties to resolve disputes through arbitration rather than allowing them to choose court litigation. under applicable laws. While arbitration offers streamlined procedures, it generally provides less formal motion practice compared to court proceedings, which affects how cases are managed and resolved.

Certain types of disputes—such as those involving securities law violations or employment discrimination—may have statutory protections that limit or prohibit mandatory arbitration. Investment managers must carefully craft their arbitration provisions to comply with these legal requirements while still achieving their dispute resolution objectives.

Hedge funds commonly use arbitration to resolve conflicts among their own management team members and ownership groups. Fund sponsors typically include arbitration requirements in general partner agreements and investment manager operating documents. The confidential nature of arbitration makes it especially attractive for sensitive internal business disputes that could damage the firm's reputation if made public.

These internal disputes might involve disagreements about profit distributionThe allocation and payment of earnings to partners, shareholders, or other stakeholders according to agreed-upon formulas., management decisions, or conflicts of interest among partners. Arbitration allows these sensitive matters to be resolved privately while maintaining professional relationships.

Arbitration provisions appear less frequently in agreements between fund sponsors and their investors, though specific situations may require arbitration. This area has attracted significant regulatory attention recently. The Securities and Exchange Commission (SEC) has studied the growing use of mandatory arbitration clauses by investment advisers and found that approximately 61% of registered investment advisers Registered investment adviser (RIA) A registered investment adviser (RIA) is a hedge fund manager or other investment adviser that has registered with the SEC or state securities regulators. These advisers must follow comprehensive rules including fiduciary duties, compliance requirements, and regular examinations. now require investor disputes to go through arbitration rather than court.

The SEC's Investor Advisory CommitteeSEC committee composed of institutional investors and other stakeholders that provides recommendations on investor protection and market structure issues. issued recommendations in 2025 calling for consistent arbitration standards between broker-dealersA person or firm engaged in the business of buying and selling securities for the account of others or for its own account. and investment advisers. This reflects growing concerns about investor protection when arbitration is mandatory rather than voluntary. In September 2025, the SEC clarified that mandatory arbitration provisions would not prevent securities registration statementsDetailed disclosure documents filed with the SEC that provide investors with material information about securities offerings. from becoming effective, marking an important policy development for the industry.

The Financial Industry Regulatory Authority (FINRA) requires its members—primarily broker-dealers—to submit disputes with other members or customers for arbitration when requested. However, customers retain the right to pursue their claims in court unless they have specifically agreed to mandatory arbitration in their account agreementsContracts between financial institutions and their customers that establish the terms and conditions for maintaining and operating investment accounts..

FINRA members typically include arbitration clauses in customer agreements to ensure both parties face similar dispute resolution requirements. This creates a more balanced system where neither side can simply choose the forum they believe will be most favorable.

This framework differs significantly from the investment adviser context, where no uniform arbitration systemA standardized dispute resolution framework that applies consistent rules and procedures across an entire industry or regulatory regime. exists and advisers may select their preferred dispute resolution mechanisms. This difference has led to ongoing regulatory discussions about appropriate investor protections and whether a more unified approach would better serve investors.

Funds with non-U.S. managers or significant international operations may designate non-U.S. forums for dispute resolution. Complex international fund structures sometimes require disputes to proceed before international arbitration tribunalsSpecialized panels that resolve cross-border disputes between parties from different countries, often operating under international arbitration rules., particularly when multiple countries have legitimate interests in the underlying issues.

These international considerations become especially important when funds have investors from different countries, each with their own legal systems and regulatory requirements. Managers must balance the desire for unified dispute resolution with the practical realities of international law and enforcement.