SEC Adopts Final Rules for Privately Offered Funds

May 9, 1997 : Supplemented May 25, 1999

The National Securities Markets Improvement Act of 1996, H.R. 3005 (the “Improvement 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 investments managers and to hedge funds and other investment vehicles, which rely on the exclusion from registration contained in Section 3(c)(1) of the Investment Company Act [1] (“Section 3(c)(1) Funds”).  Changes effected by the Improvement Act include:

* Creating a new type of private fund (a “Section 3(c)(7) Fund”) which may be sold to an unlimited number of “qualified purchasers;[2] “

* Simplifying the “look-through” provisions for counting beneficial owners of Section 3(c)(1) Funds;

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

* Pre-emption of most state securities regulation of Section 3(c)(1) Funds and Section 3(c)(7) Funds (both of which are sometimes referred to in this Advisory as “Private Funds”); and

* The adoption of the Investment Advisers Supervision Coordination Act (“Coordination Act”) creating a new federal-state regime for the regulation and registration of investment advisers [3].

On April 3, 1997, the Securities and Exchange Commission (“SEC”) adopted six final rules implementing some of the provisions of the Improvement Act.  The new rules, which are discussed in detail below, become effective on June 9, 1997.

SECTION 3(c)(7) FUNDS

A Section 3(c)(7) Fund will be excluded from the definition of an “investment company” under the Investment Company Act and, accordingly, need not register under that Act.  A Section 3(c)(7) Fund is defined as an issuer:

(a) which is privately offered (i.e., does not make or propose to make a public offering of securities), and

(b) the outstanding securities of which are owned solely by “qualified purchasers.”

Of particular note is the absence of any limitation on the number of qualified purchasers that may invest in a Section 3(c)(7) Fund [4] and the fact that a sponsor (or its affiliate) who serves as the general partner of a Section 3(c)(7) Fund organized as a limited partnership generally does not need to be a qualified purchaser.

There are five categories of qualified purchasers:

(1) Natural persons owning “investments” of at least $5 million [5] (see “Investments” Defined, below);

(2) Family owned companies owning not less than $5 million in “investments”;

(3) Trusts whose trustees are qualified purchasers under (1) or (2) above at the time that trust assets are invested in the Section 3(c)(7) fund6 and whose settlors or other asset contributors were qualified purchasers under (1) or (2) or above at the time they contributed funds to the trust. [7]

(4) Institutional investors, acting for their own accounts or for other qualified purchasers, that own and invest on a discretionary basis “investments” of at least $25 million, including employee benefit plans that are not participant-directed; and

(5) Certain qualified institutional buyers (“QIBs”) [8] acting for their own accounts or for other QIBs or qualified purchasers.

An investor’s status as a qualified purchaser need not be reaffirmed when the investor makes additional capital contributions to the fund or reinvests earnings in the fund.

Specifically excluded from the definition of qualified purchasers are (i) participant-directed employee benefit plans and (ii) with respect to any particular Section 3(c)(7) Fund, any entity formed for the specific purpose of investing in that Fund unless all of the entity’s beneficial owners are themselves qualified purchasers.[9]

“Investments” Defined. For the purpose of determining who is to be treated as a “qualified purchaser,” each of the following is included in the term “investments”:

(a) Securities, except securities issued by companies with which the prospective qualified purchaser is in a control relationship [10];

(b) Investment real estate [11];

(c) “Swaps” and similar financial contracts, commodity futures contracts or options, and physical commodities (e.g., gold, silver) held for investment purposes[12]; and

(d) Cash and cash equivalents (i.e., bank deposits, certificates of deposit and similar bank instruments) held for investment purposes.[13]

Investments jointly held with a spouse may be included, 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 hold $3 million in investments and they own $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.  Nevertheless, a spouse who is not a qualified purchaser may hold a joint investment in a Section 3(c)(7) Fund with a spouse who is a qualified purchaser.

A parent company and its wholly-owned and majority owned subsidiaries may aggregate their investments, regardless of which company is the prospective qualified purchaser.

Valuation of Investments. Investments may be valued either at cost or at their fair market value on the most recent practicable date [14].  In all cases, outstanding indebtedness incurred to acquire investments must be deducted.  The methodology can be selected by the Section 3(c)(7) Fund or left to the discretion of the prospective qualified purchaser. 

Section 3(c)(7) Funds may rely upon independent appraisals, 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, the Section 3(c)(7) or its representative reasonably believes the person to be a qualified purchaser.

Performance Fees. Registered investment advisers may be paid a performance fee by a Section 3(c)(7) Fund, as well as by a non-U.S. person, without compliance with the financial eligibility requirements (which a qualified purchaser would satisfy in any event) and the one year minimum performance requirements of Rule 205-3 under the Advisers Act.  Thus, performance fees for less than one year periods are permitted.

CHANGES APPLICABLE TO SECTION 3(c)(1) FUNDS

Revised Look-Through Provisions for Counting Beneficial Owners. The Improvement Act amended the tests used to count beneficial owners of Section 3(c)(1) Funds.  Under prior law, if any company (whether or not it is engaged primarily in investing) met both conditions of the following two-part test (the “Old Look-Through Rule”), that company was not counted as a single beneficial owner; rather all of its beneficial owners had to be counted towards the Section 3(c)(1) Fund’s 100 beneficial owner limit:

(i) if it owned more than 10% of the outstanding voting securities of that Section 3(c)(1) Fund (the “first 10% test”); and

(ii) it had more than 10% of its assets invested in that and other Section 3(c)(1) Funds (the “second 10% test”).

If the company did not meet either or both of the two conditions, it was entitled to be counted as a single investor.

In order to simplify the look-through rule, the second 10% test has been eliminated.  Now, a company investing in a Section 3(c)(1) Fund will be treated as a single beneficial owner of the fund unless

(a) it meets the conditions of the first 10% test because it owns more than 10% of the outstanding voting securities of the Section 3(c)(1) Fund (it is a “10%+ Owner”), and

(b) it is an investment company or a Private Fund.

Because 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 or Private Funds, most institutional investors will not be subject to a “look-through.” If a 10%+ Owner is an investment company or a Private Fund, however, the beneficial owners of the 10%+ Owner will have to be counted as beneficial owners of the Section 3(c)(1) Fund, even if the company would have passed the no longer operative second 10% test (i.e., has not invested more than 10% of its assets in Section 3(c)(1) Funds). 

In addition, the SEC has expressed its belief that the 10%+ Owner determination only needs to be made at the time that a company makes an investment in a Private Fund.  Consequently, redemptions will not alone cause a company investor to become a 10%+ Owner under the look-through rule, even if its proportionate ownership of the Fund is increased above 10% following a redemption.  Subsequent investments by that company could, of course, change the result.

The changes to the look-through provisions would have required existing Section 3(c)(1) Funds to recount the number of their beneficial owners.  Rather than disrupt existing Section 3(c)(1) Funds that relied on the old law in counting their beneficial owners, the new look-through rule will not apply to companies that invested in the Section 3(c)(1) Fund on or before April 1, 1997, so long as they continue to invest no more than 10% of their assets in Private Funds.  Although this will permit many “old” investors to retain their status as single beneficial owners, that status will have to be redetermined whenever they make an additional investment in the Section 3(c)(1) Fund.

CONVERSIONS TO SECTION 3(c)(7) FUNDS

A Section 3(c)(1) Fund may convert into a Section 3(c)(7) Fund by notifying each of its “beneficial owners” 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 Fund for a “proportionate share” of the Fund’s net assets (the “Notice and Redemption Obligation”).  The proportionate share of net assets determination may be made in accordance with the Fund’s governing documents (e.g., the partnership agreement).  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.[15] Holdback provisions in governing documents (such as reserves for contingencies) may be given effect so long as they do not act as a penalty for exercising the redemption right.

Grandfather Provision. Beneficial owners of converted Section 3(c)(1) Funds who are not qualified purchasers may continue as investors in the converted fund pursuant to a “Grandfather Provision,” provided that all such non-qualified owners (i) initially invested in the Fund on or before September 1, 1996, and (ii) the fund was a Section 3(c)(1) Fund at the time of the initial investment.  The SEC has indicated that the Grandfather Provision is designed to permit Section 3(c)(1) Funds that convert into Section 3(c)(7) Funds to continue their “existing relationships with investors who are not qualified purchasers.” Accordingly, a grandfathered investor may continue to make new investments in the fund even after conversion - either individually or through an IRA or other investment entity which is the “alter ego” of the grandfathered investor.  Unfortunately, the September 1, 1996 cut-off date will prevent many Section 3(c)(1) Funds that accepted investments after September 1, 1996 from investors who are not qualified purchasers from taking advantage of the conversion privilege [16].

Modified Look-Through Provision for Notice and Redemption Obligation. In order to avoid problems with existing investors, Section 3(c)(1) Funds that choose to convert may rely on the Old Look-Through Rule for purposes of the Notice and Redemption Obligation.  Accordingly, they may treat as their beneficial owners all of their 10%+ Owners who satisfied the second 10% test on October 11, 1996, even if a 10%+ Owner is an investment company or Private Fund and is in a control relationship with the converted Section 3(c)(7) Fund.  Additional investments by that 10%+ Owner will not change the result.  Thus, Section 3(c)(1) Funds seeking to convert will, in most cases, not need to provide notices and redemption opportunities to the beneficial owners of their own fund-of-fund investors.

Integration Safe Harbor. 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.  This “safe harbor” allows 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 intend to allow Private Fund sponsors to convert their existing Section 3(c)(1) Funds into Section 3(c)(7) Funds for the sole purpose of acquiring an additional 100 “slots” for new investors, the SEC cautions sponsors that they will not be entitled to rely on the safe harbor unless their conversions of existing Section 3(c)(1) Funds are bona fide and made in good faith [17].  The SEC will employ a facts and circumstances test to determine whether a conversion satisfies this standard.  In the SEC’s view, the most important test of the bona fides of a converted Section 3(c)(7) Fund will be the legitimacy of its efforts to solicit new investments from qualified purchasers; what steps are taken to sell to qualified purchasers and whether the converted fund faces any obstacles that would prevent it from selling to qualified purchasers.  Sponsors must be careful that they are not engaging in a sham designed to create parallel Section 3(c)(1) Funds.

CHANGES AFFECTING ALL PRIVATE FUNDS

Effects of Transfers. Rule 3c-6 promulgated under the Investment Company Act provides that securities of a Section 3(c)(1) Fund received from a person other than the Section 3(c)(1) Fund itself will be deemed to be owned by the person from whom the transfer was made if the transferee (a) is the estate of the transferor, (b) receives the securities as a gift or bequest or as a result of a legal separation or divorce, or (c) is a company owned exclusively by, or created by the transferor exclusively for the benefit of, the transferor and the persons described in clauses (b) and (c) of this sentence.  The rule 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 do not involve sales by the transferors.

The rule similarly provides that the transferee of securities of a Section 3(c)(7) Fund will be deemed to be a “qualified purchaser transferee” (whose Section 3(c)(7) Fund securities will be deemed to be owned by a qualified purchaser even if the transferee is not a qualified purchaser) if the transferee receives the securities from a qualified purchaser or another qualified purchaser transferee other than the Section 3(c)(7) Fund itself if the transferee satisfies one of the conditions described in clauses (a), (b) and (c) of the previous paragraph.  Section 3(c)(7) of the Investment Company Act, itself, provides for similar treatment in other cases of involuntary transfers. [18] These provisions protect Section 3(c)(7) Funds against the possibility that they will lose their status as Section 3(c)(7) Funds as a result of beneficial ownership changes over which they have no control and which do not involve sales by the transferors. [19] The new Rule 3c-6 implements these provisions without imposing the limitations in the proposed version of the rules that would have restricted transfers to related parties or charities and required restrictions on subsequent transfers.

“Knowledgeable Employees” Defined.Directors, executive officers [20] and general partners of a Private Fund or its investment advisor, and other “knowledgeable employees” of Private Funds and their affiliates (collectively “Fund Personnel”) may invest in those Private Funds without causing them to lose their ability to rely on Section 3(c)(1) or 3(c)(7) of the Act.  Thus, Fund Personnel will not count towards a Section 3(c)(1) Fund’s 100 investor limit and may invest in a Section 3(c)(7) Fund even if they are not qualified purchasers.  The SEC defines the term knowledgeable employees to include employees who, in connection with their regular functions or duties, actively participate in the investment activities of either the Private Fund itself, or certain other funds which are managed by the investment adviser of the Private Fund or, in some cases, under common control with the Private Fund. [21] An individual must have participated in such investment activities for at least 12 months in order to qualify as a knowledgeable employee, although the performance of substantially similar functions or duties for another investment manager may be included in the calculation of the 12 month period.  A knowledgeable employee must be actively involved with managing fund investments; persons who obtain information for the fund or provide information to others about the fund - such as attorneys, research analysts, marketing professionals and brokers - do not qualify as knowledgeable employees.  A knowledgeable employee who invests in a Section 3(c)(1) Fund will not count toward the 100 investor limit even if the investment was made prior to the effective date of the Improvement Act, or the person ceases to qualify as a knowledgeable employee at a later date.  Moreover, a person who becomes a knowledgeable employee subsequent to investing in a Section 3(c)(1) Fund will no longer be counted toward the 100 investor limit. [22]

Private Fund securities transferred by Fund Personnel under one of the circumstances described in “Effects of Transfers” will be deemed to continue to be beneficially owned by Fund Personnel.

QUALIFIED PURCHASER FUNDS

A Private Fund that wishes to become a qualified purchasers itself (a “Fund-of-Funds”) in order to invest in other Section 3(c)(7) Funds must obtain the consent of all of its beneficial owners who were owners prior to April 30, 1996, including the consent of the beneficial owners of any Private Funds that directly or indirectly own interests in the Fund-of-Funds (the “Consent Provision”). [23] For this purpose, interests in the Fund-of-Funds 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 is a Private Fund,

(b) the owning company has a control relationship with either the Fund-of-Funds or the Section 3(c)(7) Fund in which the Fund-of-Funds wishes to invest (the “Target Fund”), and

(c) the equity owners of the owning company were deemed to be beneficial owners of the Fund-of-Funds on April 30, 1996 (because the owning company met both conditions of the Old Look-Through Rule on that date).

Thus, the consent of the beneficial owners of the owning company is not required unless the owning company directly or indirectly controls, is controlled by, or is under common control with, the Fund-of-Funds or the Target Fund.  Generally, an institutional investor (the owning company) will be able to provide the required consent itself, even if under the new look-through provision the security holders of the owning company are deemed to be beneficial owners of the Fund-of-Funds for other purposes.  If, however, the owning company meets all of conditions (a)-(c), its equity owners would be deemed to be beneficial owners of the Fund-of-Funds, each of whose consents would have to be obtained.

Similarly, Private Funds will not be considered to own the securities of a Fund-of-Funds indirectly unless they have a control relationship with either the Fund-of-Funds or the Target Fund.  Thus, a Fund-of-Funds can obtain blanket consents with respect to most transactions and will be able to limit the need to obtain consents to specific transactions to those unusual situations in which a control relationship exists.

BLUE SKY PREEMPTION

The Improvement Act also amended the Securities Act of 1933 (the “Securities Act”) to prohibit states from requiring registration or qualification of any securities that are offered or sold to a qualified purchaser or issued in connection with certain exempt transactions, including certain Regulation D private placements.  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.  Conventional blue sky compliance is, therefore, not required with respect to such offers and sales, although states will be permitted to require notification filings and to charge fees in connection with such filings (but only in the amounts in effect on October 10, 1996). [24] States may also continue to investigate and enforce their anti-fraud laws and regulations.  The effect of this preemption is to limit state supervision of private placements that comply with Regulation D, including, of course, sales of interests in hedge funds.  Many states are expected to require the filing of copies of the federal Form D and the payment of filing fees.

[1] The exclusion applies to privately offered investment companies with 100 or fewer beneficial owners.

[2] As a practical matter, there is a 499 person limit on the number of investors in most Section 3(c)(7) Funds.  The Securities Exchange of 1934 and Rule 12g-1 promulgated thereunder require the registration of any class of equity security of any company with more than $10 million in total assets that is held by 500 or more persons.  In order to avoid registration, a Section 3(c)(7) Fund with more than $10 million in total assets must limit itself to 499 investors.

[3] At the SEC’s request, Congress postponed the effective date of the Coordination Act until July 8, 1997.

[4] See, however, note 2, above.

[5] Investments held jointly with a spouse or as community property or held by an “alter ego” (such as a self-directed IRA or self-directed employee benefit plan account) may be included in an individual’s investments total.

[6] In a fund with more than one trustee, only the trustee who makes investment decisions for the trust must be a qualified purchaser.

[7] A trust is not a qualified purchaser simply because its beneficiaries are qualified purchasers.

[8] QIBs are institutions that own and invest on a discretionary basis $100 million of securities of issuers that are not affiliated with the institution (“QIB Securities”), except that QIBs that are registered dealers will be deemed to be qualified purchasers only if they own and invest on a discretionary basis either $25 million of QIB Securities or $25 million of “investments.”

[9] Whether a particular entity has been formed for the purpose of investing in a Section 3(c)(7) fund involves a fact-based determination, in which the percentage of the entity’s assets invested in the fund is relevant but not determinative. 

[10] The term “control relationship” refers to family-owned and other closely held businesses and controlled subsidiaries of operating companies, except that investments in the following types of companies will be included in total “investments” despite the existence of a control relationship:  (i) publicly owned companies that file periodic reports under the Securities Exchange Act of 1934, or whose securities are listed on a designated offshore securities market, (ii) investment companies, Private Funds and other issuers excepted from the definition of investment company by Sections 3(c)(1) through 3(c)(9) of the Investment Company Act, (iii) companies with shareholders’ equity of $50 million or more (whether or not they are publicly traded), and (iv) commodity pools.

[11] Real estate used by the prospective qualified purchaser or a member of his or her family for “personal purposes” (as defined in the Internal Revenue Code) or as a place of business or in connection with the conduct of a trade or business may not be included.

[12] Commodities used as part of a trade or business (e.g., grain held by a food processor as part of its inventory) may not be included.

[13] The net cash surrender value of a life insurance policy may be considered to be cash for this purpose, as may any unfunded capital commitments of Private Funds and commodity pools seeking to establish themselves as qualified purchasers.  Working capital and other cash used to meet day-to-day expenses may not be included.

[14] Commodity futures contracts and options are included as investments only to the extent of the initial margin and option premium deposited with a futures commission merchant.

[15] “Restricted” and other illiquid investments in a Section 3(c)(1) Fund’s portfolio may present obstacles to in-kind distributions, which could cause adverse tax consequences.  In addition, Section 3(c)(1) 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 the year of conversion.

[16] Tt a minimum, such a Section 3(c)(1) Fund would have to have all of such post-September 1, 1996 investments withdrawn in order to restore its eligibility to convert into a Section 3(c)(7) Fund.

[17] As proposed, the new rules would have prevented a converted Section 3(c)(1) Fund from relying on the safe harbor until 25% or more of the value of its securities were owned by new qualified purchasers who initially invested in the converted Fund after October 11, 1996.  The proposed rule, which would clearly have delayed a sponsor’s ability to launch a new Section 3(c)(1) Fund following the conversion of an existing Fund, was not adopted.

[18] Although the SEC has not provided a regulatory definition of the phrase “other involuntary event,” a distribution from a testamentary or inter vivos trust may qualify as an involuntary transfer for Rule 3c-6 purposes where facts and circumstances indicate that the decision to make the distribution was not made by the person who receives the distribution.

[19] Securities of a Section 3(c)(1) or 3(c)(7) fund may qualify for a Rule 3c-6 transfer even where the fund requires additional capital contributions from the investor, so long as the fund agrees not to hold the transferee liable for the additional contributions and either (i) the transferor agrees to pay the additional contributions; or (ii) the transferor provides the transferee with sufficient assets to pay additional contributions as they become due and “appropriate procedures” exist to ensure that the assets are used to pay the additional contributions. 

[20] The term “executive officer” means the president, any vice president in charge of a principal business function and any other person who performs a policy-making function.

[21] Such other funds may include additional Private Funds, investment companies, certain tax qualified pension or profit sharing plans, foreign or offshore investment companies and bank or insurance company funds.

[22] The following investments are deemed to be made by a knowledgeable employee: investments by an IRA or other entity which is the “alter ego” of the knowledgeable employee; investments by a family trust where the knowledgeable employee is the investment manager and source of the invested funds; and investments jointly owned by a knowledgeable employee and his or her spouse.  However joint investments of a knowledgeable employee and any other dependent are not deemed to be investments by a knowledgeable employee.

[23] If a pre-April 30, 1996 investor that is a Private Fund is a family owned company or a trust, only the consents of the directors, general partners or trustees are required.

[24] Until October 12, 1999, states may require the registration or qualification of securities issued by anyone who fails to pay the required fees.

For additional information on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.