National Securities Markets Improvement Act of 1996

January 23, 1997

On October 11, 1996, President Clinton signed into law the National Securities Markets Improvement Act of 1996, H.R. 3005 (the "Improvement Act"). Among other changes, the law amends the Investment Company Act of 1940, as amended (the "Investment Company Act") and the Investment Advisers Act of 1940, as amended (the "Advisers Act"). Changes of significance to hedge funds and their investment managers that will be effected by the Improvement Act include:

Creation of a new type of private fund which may be sold to an unlimited number of "qualified purchasers;"
Simplification of the "look through" provisions for counting beneficial owners of limited offerings;
Allowing investment advisers to charge performance fees without restriction to the new type of private fund and to non-U.S. clients; and
Preemption of "blue sky" registration for federally registered investment advisers.

Private Investment Companies

Unless otherwise indicated, the following provisions will become effective on the earlier of 180 days after enactment of the Improvement Act (i.e., April 9, 1997) or the date on which the Securities and Exchange Commission ("SEC") adopts a rule defining the term "investments" for purposes of the definition of "qualified purchaser" (described below):

Private Funds

Under the Improvement Act, a new type of fund will be excluded from the definition of an "investment company" under the Investment Company Act. The Improvement Act adds a new Section 3(c)(7) to the Investment Company Act which excludes from the definition of "investment company" any issuer:

(a) which is privately offered, and

(b) the outstanding securities of which are owned solely by qualified purchasers. Securities owned by a person who received such securities from a qualified purchaser by gift, bequest, legal separation, divorce, death or other involuntary event shall be deemed to be owned by a qualified purchaser.

The Improvement Act also permits funds currently relying on the exclusion in Investment Company Act Section 3(c)(1) ("Section 3(c)(1) Funds" - i.e., privately offered investment companies with 100 or fewer beneficial owners) to convert into funds relying on new Section 3(c)(7) ("Section 3(c)(7) Funds"). In order to convert a Section 3(c)(1) Fund into a Section 3(c)(7) Fund, the fund must:

(a) Disclose to each beneficial owner prior to conversion that future participation will be limited to qualified purchasers and that beneficial ownership will no longer be limited to 100 investors;

(b) Give each beneficial owner an opportunity to redeem all or part of his interests in the fund for a "proportionate share" of the fund's net assets. The proceeds of such a redemption must be paid in cash unless the fund offers its beneficial owners an option to take their proceeds "in kind" and a beneficial owner elects to do so.

"Restricted" and other illiquid investments in a fund's portfolio may present obstacles to in-kind distributions, which could cause adverse tax consequences. Unless a redemption offer is made at year end 1996 (despite the unlikelihood that the Improvement Act's provisions will be effective by then), funds seeking to convert to Section 3(c)(7) Funds that ordinarily have only annual redemptions may have to incur at least one extra redemption "opening" in 1997.

Non-qualified beneficial owners of Section 3(c)(1) Funds that convert to Section 3(c)(7) Funds may continue to participate in the fund (and presumably increase their investments) pursuant to a "grandfather clause" provided that all such non-qualified owners (I) acquired the securities on or before September 1, 1996, and (ii) the fund was a Section 3(c)(1) Fund at the time of acquisition.

No other Section 3(c)(7) Funds may have any non-qualified purchasers.

The Improvement Act also provides that a Section 3(c)(1) Fund will not be "integrated" with a Section 3(c)(7) Fund and, thus, will never be required to count the beneficial owners of a Section 3(c)(7) Fund together with its own beneficial owners for purposes of its 100 investor limit. Similarly, a Section 3(c)(7) Fund will never be required to look to the beneficial owners of an affiliated Section 3(c)(1) Fund for purposes of determining whether all of the owners of the Section 3(c)(7) Fund are qualified purchasers. Investment managers may, therefore, manage parallel Section 3(c)(1) and Section 3(c)(7) Funds without fear of integration despite similarities between them as to investment objectives and risk characteristics (e.g., portfolio composition).

Qualified Purchasers

There are four categories of qualified purchasers:

Natural persons (including holders of joint or community property) owning "investments" of at least $5 million;
Family owned companies (i.e., those owned directly or indirectly by or for two or more persons related as siblings, spouses or direct lineal descendants, or estates or trusts of such persons) owning not less than $5 million in "investments";
Trusts not formed for the specific purpose of acquiring the securities offered, whose trustees or equivalent decision makers and whose settlors or other asset contributors are all qualified purchasers described above; and
Any other person, acting for its own account or for other qualified purchasers, who owns and invests on a discretionary basis "investments" of at least $25 million.

It is currently unclear whether existing fund investors who meet the above tests will be deemed to be qualified purchasers because the Improvement Act states that investors must be qualified purchasers at the time they acquire securities of the fund. Hopefully, the rules to be adopted by the SEC will clarify this point.

Section 3(c)(1) and Section 3(c)(7) Funds are not "qualified purchasers" unless all their beneficial owners who were owners on or before April 30, 1996, have consented to the fund's treatment as a qualified purchaser. If one of a fund's pre-April 30, 1996 investors is another Section 3(c)(1) or Section 3(c)(7) Fund, the consents of all of the beneficial owners of that investor are also required unless it is a family owned company or a trust (in which case, the consents of all directors, general partners or trustees are required).

State regulations are preempted with respect to securities offered or sold to qualified purchasers. Blue sky compliance is, therefore, not required with respect to such offers and sales. Sales to qualified purchasers will qualify for preemption without regard to whether offers and sales are made to non-qualified purchasers in the same offering.

Look-Through Provisions for Counting Beneficial Owners

The Improvement Act also amended the tests used to count beneficial owners for purposes of Section 3(c)(1) of the Investment Company Act. Of the two changes to the "look-through" provisions applicable to companies that invest in Section 3(c)(1) Funds, one may be deemed to be favorable to Section 3(c)(1) Funds and one may be deemed to be unfavorable to them.

Under existing law, if any company (whether or not it is engaged primarily in investing) owns more than ten percent (10%) of the outstanding voting securities of a Section 3(c)(1) Fund, that company is not counted as a single beneficial owner of the fund; rather all of its beneficial owners must be counted against the Section 3(c)(1) Fund's 100 beneficial owner limit unless that company has not invested more than 10% of its assets in Section 3(c)(1) Funds. In that latter case the company is still entitled to be counted as a single investor.

Under the Improvement Act, a company investing in a Section 3(c)(1) Fund will be treated as a single beneficial owner of the fund unless that company (i) owns more than ten percent (10%) of the outstanding voting securities of the fund and (ii) is an investment company, a Section 3(c)(1) Fund or a Section 3(c)(7) Fund (i.e., a fund of funds). Thus, a Section 3(c)(1) Fund will no longer be required to count the beneficial owners of its 10% owners unless they are themselves investment companies, Section 3(c)(1) Funds or Section 3(c)(7) Funds.

However, if a company that owns more than ten percent (10%) of the outstanding voting securities of a Section 3(c)(1) Fund is an investment company, a Section 3(c)(1) Fund or a Section 3(c)(7) Fund, the beneficial owners of that investor will have to be counted as beneficial owners of the Section 3(c)(1) Fund even if the company has not invested more than 10% of its assets in Section 3(c)(1) Funds. These changes may, therefore, require existing Section 3(c)(1) Funds to recount the number of their beneficial owners.

SEC Rulemaking

Within 180 days from the enactment of the Improvement Act, the SEC is to prescribe rules defining the terms "investment" and "beneficial owner" for the purpose of identifying Section 3(c)(7) Funds.

Within one year from enactment, the SEC is to promulgate rules permitting "knowledgeable employees" (as defined by rule) of Section 3(c)(1) and Section 3(c)(7) Funds and their affiliates to invest in those funds without causing the funds to lose their ability to rely on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.

Investment Adviser Registration

Unless otherwise indicated, the following provisions will become effective 180 days after enactment of the Improvement Act (i.e., April 9, 1997):

Performance Fees

Registered investment advisers may now be paid a performance fee by Section 3(c)(7) Funds, non-U.S. persons or entities and any other classes of customers or transactions as the SEC shall determine by rule without compliance with the eligibility (i.e., $500,000 under management or $1 million net worth) and one year minimum performance requirements of Rule 205-3 under the Advisers Act. This provision will become effective on the earlier of 180 days after enactment of the Improvement Act or the date on which the SEC's specified rulemaking regarding certain revisions applicable to registered investment companies is completed. The Improvement Act is silent as to whether these categories of clients include converted Section 3(c)(1) Funds that have participants who are not eligible investors.

Unsettled at this point is whether an offshore fund that includes U.S. persons as investors will be treated as a U.S. or a non-U.S. person.¹

Preemption of State "Blue Sky" Regulation in Certain Cases

Under the Improvement Act, an investment adviser already registered with the state in which it maintains its principal office need not register with the SEC unless it either (i) has more than $25 million (or such higher amount established by the SEC) in client "assets under management," or (ii) advises registered investment companies, in either of which cases, such advisers must register exclusively with the SEC. Supervised persons will also be regulated exclusively by the SEC, except that a state may license, register or qualify an investment adviser representative who has a place of business within the state. (The SEC may, at its discretion, allow the federal registration of other persons consistent with the purposes of the Improvement Act.)

The SEC may, under the Improvement Act, deny or withdraw the registration of any investment adviser who has been convicted of a felony (i.e., a crime punishable by imprisonment for one year or more, or similar crime in a foreign jurisdiction) within the ten years preceding filing of the application for registration or at any time thereafter.

States may not require the registration of an investment adviser (i) who is exempt from the definition of an investment adviser under the Investment Advisers Act of 1940; or (ii) who is registered with the SEC; or (iii) who does not have a place of business in the state and who has had fewer than six (6) clients who are residents of the state during the preceding twelve (12) month period.

States may not impose requirements related to minimum net capital, bonding or maintenance of books or records in addition to those mandated by the state in which the adviser maintains its principal place of business. States will, however, retain the authority to investigate and bring enforcement actions for fraud and deceit against an investment adviser and associated persons. States will also retain the authority to require filings for notice purposes and the payment of fees by investment advisers. Until October 11, 1999, states may require the registration of investment advisers that fail or refuse to pay fees required by the state.

Registered Investment Companies

Federal Regulation

The Improvement Act codifies the regulatory exemption that permits certain mutual funds and other investment companies to purchase securities of certain other mutual funds and investment companies that are part of the same "group of investment companies."

Upon registration, mutual funds and certain other investment companies are deemed to have registered an indefinite amount of securities. Fees for indefinite registration are no longer due six months from the date of sale in an amount three times that which would otherwise have been payable. Registration fees will now be due within 90 days of the end of the company's fiscal year and will be based upon aggregate sales during the fiscal year (less redemptions and repurchases). This amendment will become effective on the earlier of one year from enactment of the Improvement Act or the effective date of rules issued by the SEC to implement this amendment.

The Improvement Act allows the SEC, by rule, to remove limitations on advertising prospectuses to content "the substance of which" is contained in a fund's statutory prospectus.

The Improvement Act affords the SEC greater control over reporting, allowing it to require additional filings rather than just quarterly or semi-annual filings, and requiring additional information as it deems necessary in reports to shareholders. The SEC may also examine records that relate to the operations of, or transactions with the investment company, rather than just those records required by SEC rules. In promulgating such rules and requirements, the SEC is required to take steps to avoid unnecessary recordkeeping by and minimize the compliance burden upon persons required to maintain records.

State Regulation

Under the Improvement Act, states are preempted from regulating securities issued by investment companies registered with the SEC under the Investment Company Act.

Our Analysis

Until the SEC clarifies the definitions required by, and questions arising under, the new law, it may be premature to plan to convert a Section 3(c)(1) into a Section 3(c)(7) Fund or, alternatively, to establish a brand new fund under Section 3(c)(7). Clearly, however, the new legislation (1) impacts a fund's ability to sell interests to more than 100 investors; (2) changes the requirements to comply with state blue sky laws regarding registration as an investment adviser and offering and selling fund interests to "qualified purchasers"; (3) enhances a registered adviser's ability to charge performance based fees and (4) to the extent a fund may invest in other funds, limits the ability to invest in Section 3(c)(7) Funds without the prior consent of all equity owners.

For these reasons, it is prudent that you consider the impact of the new legislation on each fund's goals.

¹ In a recent discussion with the Staff of the SEC, we learned that the Staff has recently adopted the informal position that a hedge fund will be treated as "one client" for purposes of determining when an incentive fee may be charged. This new position has not been codified and clearly runs counter to previous authority (such as the Hellmold Associates no action letter) which treats the individual partner or shareholder as the "client" when an incentive fee is calculated at the individual sub-account level. It appears, therefore, that the SEC may no longer be interested in pursuing advisers who charge an incentive fee to partners who are in a fund for less than one year, as long as the fund has been in operation for at least one full year. As a consequence, even if an offshore fund with U.S. persons is not treated as a non-U.S. person for purposes of Rule 205-3, the one year restriction on withdrawals by U.S. Persons may only need to be imposed during the first year of an offshore fund's operations.

To learn more about the new law or to discuss other issues relating to hedge funds and their investment managers, contact Howard Neuman at: 212-818-9200.