SEC Proposes New Rules to Implement
Securities Markets Improvements Act

February 18, 1997


    The National Securities Markets Improvements Act of 1996, H.R. 3005 (the "Improvements Act") amended the Investment Company Act of 1940, as amended (the "Investment Company Act") and the Investment Advisers Act of 1940, as amended (the "Advisers Act") in several ways that are of significance to hedge funds and their investments managers; in particular, by: 

o Creating a new type of private fund (a "Section 3(c)(7) Fund") which may be sold to an unlimited number of "qualified purchasers;" 

o Simplifying the "look through" provisions for counting beneficial owners of limited offerings;

o Allowing investment advisers to charge performance fees without restriction to Section 3(c)(7) Funds and to non-U.S. clients; and

o Creating a new federal-state regime for the regulation and registration of investment advisers.

A description of the Improvement Act appeared in our Hedge Fund & Investment Managers Advisory entitled "National Securities Markets Improvements Act of 1996," which should be reviewed in conjunction with this Advisory.

    Generally the provisions of the Improvement Act will become effective on the earlier of 180 days after its enactment (i.e., April 9, 1997) or the date on which the SEC adopts a rule defining the term "investments" for purposes of the definition of "qualified purchaser." The SEC has now proposed a definition for the term "investments" and new rules to implement these provisions of the Improvement Act. Those proposed rules that are designed to implement the investment adviser regulation aspects of the Improvement Act were described in a Hedge Fund Investment Managers Advisory entitled "SEC Suspends Use of Form ADV-S and Proposes New Rule 203A-5 and Form ADV-T," dated January 23, 1997. The proposed rules intended to apply to Section 3(c)(7) Funds and other private investment companies are described below.


Background

    Under the Improvement Act, a Section 3(c)(7) Fund will be excluded from the definition of an "investment company" under the Investment Company Act. New Section 3(c)(7) of the Investment Company Act defines a Section 3(c)(7) Fund as an 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, or operation of law will be deemed to be owned by a qualified purchaser.

The Improvement Act creates four categories of qualified purchasers:

(1) Natural persons (including holders of joint or community property) owning "investments" of at least $5 million;

(2) 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";

(3) 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 in (1) and (2) above; and

(4) Any other person (i.e., institutional investor), acting for its own account or for other qualified purchasers, who owns and invests on a discretionary basis "investments" of at least $25 million.

The proposed rules would extend condition (3) above to all entities attempting to be treated as qualified purchasers; i.e., they must not be formed for the specific purpose of acquiring the securities offered, or they must have as beneficial owners only persons who are themselves qualified purchasers under conditions (1) and (2).

Special provisions govern the ability of hedge funds and other investment vehicles currently relying on the definitional exclusion in Investment Company Act Section 3(c)(1) ("Section 3(c)(1) Funds") and of Section 3(c)(7) Funds to be treated as qualified purchasers under condition (4). These rules are described below under the caption "'Beneficial Owner' Defined."

New Section 3(c)(7) of the Investment Company Act also provides that securities of a Section 3(c)(7) Fund owned by persons who receive them from a qualified purchaser as a gift or bequest, or by means of a legal separation, divorce, death or other involuntary event, will be deemed to be owned by a qualified purchaser. Proposed Rule 3c-6 would also permit transfers of securities of a Section 3(c)(7) Fund on essentially the same conditions as those proposed for transfers under Section 3(c)(1)(B) of the Investment Company Act. Those conditions are described below under the caption "Section 3(c)(1) Funds and Conversions to Section 3(c)(7) Funds."

"Investments" Defined

For the purposes of determining who is to be treated as a "qualified purchaser," proposed Rule 2a51-1 would include in the term "investments" each of the following:

(a) Securities, except securities issued by companies with which the prospective qualified purchaser is in a control relationship (e.g., family-owned and other closely held businesses and controlled subsidiaries of operating companies); provided, however, that controlling ownership interests in (i) listed companies that are not majority-owned subsidiaries of the prospective qualified purchaser and (ii) investment companies and other issuers excepted from the definition of investment company by Sections 3(c)(1) through 3(c)(9) of the Investment Company Act would be deemed to be "investments";

(b) Real estate held for investment purposes (i.e., not used by the prospective qualified purchaser or a member of his or her family for "personal purposes" (within the meaning of Section 280A(d) of the Internal Revenue Code, which addresses the deductibility of depreciation and other expenses with respect to "dwelling units") or as a place of business or in connection with the conduct of a trade or business);

(c) Commodity Interests (i.e., contracts for the purchase and sale of a commodity for future delivery) and physical commodities (e.g., gold, silver) held for investment purposes. Commodities used as part of a trade or business (e.g., grain held by a food processor as part of its inventory) are specifically excluded from the definition. Commodity interests would be included as investments to the extent of the initial margin and option premium deposited with a futures commission merchant; and

(d) Cash and cash equivalents held for investment purposes. Cash used to meet day-to-day expenses (i.e., working capital) is specifically excluded from the definition.


For the purposes of determining whether an individual is a qualified purchaser, investments include any individually held investments as well as any investments jointly held with a prospective qualified purchaser's spouse. However, investments held individually by one spouse may not be aggregated with investments held individually by the other spouse. Thus, if a husband and wife each individually held $3 million in investments and they owned $1 million in investments jointly, neither of them would be a qualified purchaser because each of them would be deemed the owner of only $4 million in investments.

In determining whether it is a qualified purchaser, a parent company may aggregate investments it owns with those owned by wholly-owned and majority owned subsidiaries, so long as the subsidiaries holdings are managed under the direction of the parent company.

Valuation of Investments

In order to determine whether an individual or a family owned company meets the $5 million threshold for qualified purchaser status, investments would be valued either at cost or at market value. The methodology could be selected by the Section 3(c)(7) Fund or left to the discretion of the prospective qualified purchasers. In all cases, certain deductions will have to be taken into account. Under proposed Rule 2a51-1(d), the value of "investments" would be reduced by the following:

(a) Outstanding indebtedness incurred to acquire investments;

(b) Indebtedness of natural persons secured by a mortgage on a personal residence or other non-investment real estate, unless the proceeds were used exclusively to finance the acquisition, of or improvements to, the property or to refinance an outstanding mortgage;

(c) Indebtedness incurred by any of a family owned company's owners to acquire the investments held by the company, as well as the amount of any real estate loans that any owner would have to deduct if the owner were the prospective qualified purchaser;

(d) Indebtedness incurred during the preceding 12 months (i) by a family owned company to the extent that the principal amount exceeds the fair market value of the company's assets that are not investments or (ii) by an owner of a family owned company or a member of his or her family if the indebtedness was guaranteed by the family owned company; and

(e) Other payments received by a natural person during the preceding 12 month period that could artificially inflate the amount of his or her investments, including payments (i) under an insurance policy, (ii) as a gift or bequest, (iii) pursuant to an agreement related to divorce or separation, or (iv) in connection with a lawsuit. 


In determining whether a person is a qualified purchaser, Section 3(c)(7) Funds may rely upon audited financial statements, brokerage account statements, and other appropriate information and certifications provided by the prospective qualified purchaser, as well as upon publicly available information as of a recent date, as long as such reliance is reasonable and, after reasonable inquiry, there is no basis to believe that any of the information relied upon is materially incorrect. 

Section 3(c)(1) Funds and Conversions to Section 3(c)(7) Funds

The Improvement Act permits Section 3(c)(1) Funds to convert into Section 3(c)(7) Funds by complying with the applicable requirements of the Improvement Act. Those requirements include notifying each beneficial owner of the proposed conversion and that beneficial ownership will no longer be limited to 100 investors and providing each beneficial owner an opportunity to redeem all or part of his interests in the fund. 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.

The Improvement Act amended the 10% test used to count beneficial owners for purposes of Section 3(c)(1) of the Investment Company Act. 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:

(a) owns more than ten percent (10%) of the outstanding voting securities of the Section 3(c)(1) Fund (the "first 10% test") and

(b) 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% equity 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 (the "second 10% test"). The second 10% test has been eliminated by the SEC in order to simplify the look-through rule. These changes may, therefore, require existing Section 3(c)(1) Funds to recount the number of their beneficial owners.


In order to avoid hardship, the SEC has proposed that the amended look-through provision will not apply in the case of an investor that held more than 10% of the outstanding voting securities of a Section 3(c)(1) Fund on October 11, 1996, provided that the investor continues to satisfy the second 10% test described above. Additional investments by that investor would not change the result.

In addition, Section 3(c)(1)(B) of the Investment Company Act also provides that securities of a Section 3(c)(1) Fund owned by persons who receive them as a result of a legal separation, divorce, death or other involuntary event, will be deemed to be owned by the person from whom the transfer was made. The provision protects Section 3(c)(1) Funds against exceeding the 100 investor limit as a result of increases in the number of their beneficial owners over which they have no control and which are involuntary on the part of the transferor. Proposed Rule 3c-6 is designed to implement Section 3(c)(1)(B) by expanding its scope to provide that securities of a Section 3(c)(1) Fund transferred pursuant to a gift, bequest or or an agreement relating to a legal separation or divorce or other involuntary event to:

(i) a family member,

(ii) a trust or similar vehicle established by the transferor for the exclusive benefit of family members, or

(iii) a charitable organization

will also be deemed to be beneficially owned by the person from whom the transfer was made; provided that the transferred securities are restricted from transfer (except for a transfer to the fund).

The Improvement Act provides that a Section 3(c)(1) Fund will not be "integrated" with a Section 3(c)(7) Fund and that a Section 3(c)(7) Fund will not be "integrated" with a Section 3(c)(1) Fund, thereby allowing investment managers to manage parallel Section 3(c)(1) and Section 3(c)(7) Funds despite similarities between them as to investment objectives and risk characteristics (e.g., portfolio composition). Expressing the view that Congress did not contemplate the treatment of converted Section 3(c)(1) Funds as Section 3(c)(7) Funds for this purpose, the SEC proposed the adoption of Rule 3c-7 under the Investment Company Act. The proposed rule would allow for such treatment of a converted Section 3(c)(1) Fund if, at the time the new Section 3(c)(1) Fund offers its securities, 25% or more of the value of the securities of the converted Section 3(c)(1) Fund are owned by qualified purchasers who acquired their interests after October 11, 1996. The SEC has asked for comment on, among other things, whether the percentage should be raised (e.g., to 50%). Proposed Rule 3c-7 will, in most cases, delay a manager's ability to launch a new Section 3(c)(1) Fund following the conversion of an existing Section 3(c)(1) Fund into a Section 3(c)(7) Fund.

"Beneficial Owner" Defined


The Improvement Act permits Section 3(c)(1) Funds to convert into Section 3(c)(7) Funds by disclosing to each "beneficial owner" of the Section 3(c)(1) Fund prior to conversion that future participation will be limited to qualified purchasers and that beneficial ownership will no longer be limited to 100 investors and giving each "beneficial owner" an opportunity to redeem all or part of his interests in the Section 3(c)(1) Fund for a "proportionate share" of the fund's net assets. Non-qualified beneficial owners of Section 3(c)(1) Funds that convert to Section 3(c)(7) Funds may continue to participate (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.

Proposed Rule 2a51-2 would generally determine "beneficial ownership" in accordance with Section 3(c)(1) of the Investment Company Act but would create a special rule for companies. An interest in a Section 3(c)(1) Fund that is owned by a company will be deemed to be beneficially owned by that company (the "owning company"), unless:

(i) on October 11, 1996, by reason of the application of the first and second 10% tests, the owning company's interest in the Section 3(c)(1) Fund was required to be treated as beneficially owned by the owning company's equity owners,

(ii) the owning company has a control relationship with the grandfathered Section 3(c)(1) Fund, and

(iii) the owning company is itself an investment company, a Section 3(c)(1) Fund or a Section 3(c)(7) Fund;

in which case the required notification and redemption opportunity would have to be provided to the owning company's equity owners as the "beneficial owners." Comment has been specifically requested by the SEC as to the application of the control relationship element of this definition.

Section 3(c)(1) Funds and Section 3(c)(7) Funds that wish to become qualified purchasers themselves ("purchasing funds") must obtain the consent of all of their beneficial owners who were owners prior to April 30, 1996, including the consent of the beneficial owners of any Section 3(c)(1) Funds and Section 3(c)(7) Funds that directly or indirectly own interests in the purchasing fund. For this purpose, interests in the purchasing fund that are beneficially owned by a company will be deemed to be beneficially owned by one person (i.e., the owning company) unless:

(a) the owning company has a control relationship with either the purchasing fund or the Section 3(c)(7) Fund in which the purchasing fund wishes to invest (the "target fund"), and 

(b) the conditions described in clauses (i) and (ii) above are met, 


in which case the owning company's equity owners would deemed to be the beneficial owners whose consent would have to be obtained. Section 3(c)(1) Funds and Section 3(c)(7) Funds would not be considered to own the securities of a purchasing fund indirectly unless they have a control relationship with either the purchasing fund or the target fund. Thus, a purchasing fund can obtain blanket consents with respect to most transactions and would be able to limit the need to obtain consents to specific transactions to those situations in which a control relationship exists.


"Knowledgeable Employees" Defined

Pursuant to the Improvement Act's requirement that the SEC propose rules permitting "knowledgeable employees" 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 3(c)(7) of the Act, the proposed rules provide a definition of knowledgeable employees. The definition would include directors, executive officers, and general partners of a fund or an affiliate of the fund that oversees the fund's investments. The definition would also include other employees who, in connection with their regular duties, participated in, or obtained information regarding, the investment activities of the fund or other investment companies managed by the affiliates for a period of at least 12 months.

Under the proposed rule, transfers of fund securities held by fund personnel would be allowed to family members as a gift, bequest or pursuant to an agreement related to divorce or separation, as well as pursuant to trusts and other family vehicles established by fund personnel for the exclusive benefit of family members and charitable organizations, provided the funds are otherwise subject to an arrangement prohibiting any other transfer of such shares. 

* * * * * * *

The SEC has requested public comment on many of the provisions of the proposed rules, clearly indicating that the proposed rules are subject to revision and further clarification. It is premature to place complete reliance on the rules as they have been proposed. As always, we will continue to apprise you as developments occur.

The SEC requests comments on these proposals. If you would like to consider commenting or would like further information about SEC reporting requirements or to discuss other issues relating to hedge funds and their investment managers, contact Howard Neuman or Carla Barone at (212) 818-9200.

The SEC requests comments on these proposals. If you would like to consider commenting or would like further information about SEC reporting requirements or to discuss other issues relating to hedge funds and their investment managers, contact Howard Neuman or Carla Barone at (212) 818-9200.

SATTERLEE STEPHENS BURKE & BURKE LLP

230 Park Avenue New York, N.Y. 10169 Phone: (212) 818-9200 Fax: (212) 818-960747 Maple Street Summit, N.J. 07901-2518 Phone: (908) 277-2221 Fax: (908) 277-2038
World Wide Web Site:http://www.ssbb.com





To take action on any of the information contained in this report, you should seek professional advice.