Category: Investment Company Act

The One With Buzz

If you can grab the trading symbol “BUZZ” you should be able to make some money with it. Right? A company that owns beehives? or sells honey? or sells honey products? Or social buzz? VanEck Associates wanted to ride the social media wave and created an ETF that would

“Track the performance of the 75 large cap U.S. stocks which exhibit the highest degree of positive investor sentiment and bullish perception based on content aggregated from online sources including social media, news articles, blog posts and other alternative datasets.”

The investment thesis is that “Investor sentiment has proven to be an important factor in stock performance”. Sure. Why not. The tracker is the BUZZ NextGen AI US Sentiment Leaders Index. That index targets the most mentioned stocks online, determines whether the mention is positive or negative and then takes the 75 large cap stocks that have the most positives.

The initial proposal was that VanEck would license the BUZZ index for the ETF in exchange for 20% of the management fee it earned from the ETF. Then the BUZZ index provider decided to partner with an “Influencer” who would promote the ETF.

The “Influencer” goes unnamed in the SEC complaint, but it was fairly easy to find out that it was Dave Portnoy, the founder of BarStool Sports and “bro-influencer-in-chief.”

Before the launch of the ETF, a new agreement was struck with Mr. Portnoy getting a sliding scale of the ETF fees depending on how big the ETF grew in AUM. It would go up to 60% if the ETF reached $1.25 billion in AUM in 18 months.

All of that seems fine, as long as its disclosed. That is where VanEck came up short according to the SEC order. VanEck didn’t fully disclose the terms of the license agreement with the Buzz index to the ETF board. Van Eck didn’t tell the ETF board about Mr. Portnoy involvement or the details about the planned fee structure of the fund.

Under the Investment Company Act, the adviser needs to provide the board information about the advisory contract, including the following (see Form N-1A, Item 27(d)(6)(i))

  • “the extent to which economies of scale would be realized as the [f]und grows,”
  • “whether fee levels reflect these economies of scale for the benefit of [f]und investors.”
  • “the costs of the services to be provided and profits to be realized by the investment adviser and its affiliates from the relationship with the [f]und.”

Under the Investment Advisers Act, VanEck was tagged with a failure to have adequate policies and procedures about furnishing the ETF board with accurate information reasonably necessary for the ETF board to evaluate the terms of the advisory contract, as well as material information related to a proposed ETF launch.

Sources:

SEC Proposes Updated Definition to Help Three Funds

The press release for changes to “qualifying venture capital fund” caught my attention. I didn’t recall that definition, so I took a closer look. It’s in Section 3(c)(1) of the Investment Company Act, which makes it part of the “private fund” definition.

Section 504 of the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (“EGRRCPA”) amended section 3(c)(1) of the Investment Company Act by adding “qualifying venture capital funds” into the exemptions from the investment company definition. Other companies can only have 100 people. Qualifying venture capital funds can have up to 250 people. EGRRCPA created the new definition of “qualifying venture capital fund” as:

“a venture capital fund that has not more than $10,000,000 in aggregate capital contributions and uncalled committed capital.”

That seems like an really small fund and I would think that a change to the definition if it added an extra zero would be very meaningful. Then I read that the SEC was only proposing to increase the amount from $10 million to $12 million.

Why bother? The statutory definition in EGRRCPA requires this $10,000,000 threshold “be indexed for inflation once every 5 years by the SEC. Here it is five years later.

I rarely read the economic analysis of a proposed rule, but I was really interested in the impact.

Based on the Form ADV filings there are at least 23,759 venture capital funds. Of those, there are 14,822 qualifying venture capital funds. Of those, 653 have more than 100 beneficial owners.

Ultimately, the SEC estimates that there are three (3!) venture capital funds that are not currently excluded from registration under section 3(c)(1) but that could be defined as a qualifying venture capital fund if the threshold were adjusted for inflation to $12,000,000 as proposed.

I was floored to read how many small venture capital fund are out there. I was not surprised that the rule only helped a handful of funds.

Sources:

Individuals as Qualified Purchasers

To pull the pieces together, private funds are exempt from the Investment Company Act under Section 3(c)(1) or Section 3(c)(7). Under (1) the fund is limited to 100 investors. Under (7), there is no limit on the number of investors, but the investors have to be “Qualified Purchasers.”

The definition of “qualified purchaser” in Section 2(51)(A) includes individuals as

(i) any natural person … who owns not less than $5,000,000 in investments, as defined by the Commission;

Which leads us to seeking out the definition of “investments” for purposes of the “qualified purchaser” definition. That was published by a SEC rule-making in 1997 and can be found in Section 270.2a51-1(b).

The first issue to tackle is marriage or spousal equivalent.

The rule provides that, in determining whether a natural person is a qualified purchaser, the person may include in the amount of his or her investments any investments held jointly with the person’s spouse (“Joint Investments”). Thus, a person who owns $3 million of investments individually and $2 million of Joint Investments would be a qualified purchaser. The spouse also would be a qualified purchaser if he or she owned, individually, an additional $3 million of investments.

A married couple investing jointly can include their joint assets. If only one spouse is investing, that spouse can use the assets in his or her own name and the joint assets to reach $5 million.

For individuals there are six items that can be considered investments.

  1. Securities, as defined in section 2(a)(1) of the Securities Act of 1933. Excluded are securities in a company controlled by the person, unless that company is (i) an investment company or one of the exclusions from the definition, (ii) a company with publicly traded securities, or (iii) showing at least $50 million in shareholders’ equity on its financial statements.
  2. Real estate held for investment purposes. That excludes your principal residence, your vacation home and the office you work in.
  3. Commodity interests held for investment purposes. That means you have to be primarily in the business of trading commodity interests.
  4. Physical commodities held for investment purposes. That means you have to be in business of trading commodities. Your Babe Ruth baseball card is not going to count unless your business is trading baseball cards.
  5. Financial contracts held for investment purposes that fall outside the definition of securities.
  6. Cash and cash equivalents held for investment purposes. That’s going to exclude your checking account, but you can probably include your savings account.

Add that stuff together if its in the person’s name or held jointly. If it adds up to $5 million. That person is a “qualified purchaser.” You just have to have a reasonable belief that the person is a qualified purchaser.

Sources:

Is Your Real Estate Fund Invested in Real Estate?

One of the challenges with real estate funds is staying within the various requirements of a real estate fund at the beginning of its life and at the end of its life. At start-up, the fund may be sitting on substantial non-real estate while it is starting to invest. Similarly at the end of its life, a fund may be sitting on substantial non-real estate while its real estate investments have been sold off. Then the fund has to run through the muddy area of whether any of its non-real estate holdings are “securities”. That analysis is key when addressing the definitions and exemptions under the Investment Company Act.

Landwin Partners Fund I ran into this problem and got hit with an action from the Securities and Exchange Commission. The action was against the fund manager and the principal of the fund manager.

The fund manager, like all of us, noticed that the fund’s cash holdings were producing little to no interest. The fund’s bank/financial company offered some short-term bank notes to earn some interest. That spread to bonds, preferred stock and common stock that were unrelated to real estate.

According to the SEC order, $2.4 million of the fund’s $20 million of capital was in these non-controlling, non-real estate interests. The first problem was that the fund’s offering documents didn’t authorize investments in anything other than real estate. That put beyond its organizational powers.

The second problem was that the high ownership level of true securities implicated the Investment Company Act. Section 3(a)(1)(C) of the Investment Company Act defines an “Investment Company” as

“engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis”

The Securities and Exchange Commission lumped the fund’s holdings in real estate-related limited partnership interests and mortgage loans together with the publicly traded securities to take the position that the fund had exceeded that 40% threshold in the definition of an “Investment Company.”

I was surprised to see real estate partnership interests and mortgage loans being included in the definition of “security” for the purposes of the definition of an “Investment Company.” The fund had over 300 investors so it could not use the 3(c)1 exemption which imposes a 100 investor cap. I would assume that the investor base did not qualify the fund for exemption under 3(c)7 which requires the investor base to be “Qualified Purchasers.”

That would leave the fund looking to use the 3(c)5 exemption for investments in real estate. I assume the SEC took the position that the investments were securities and not the type of investments that qualify for the 3(c)5 exemption.

The SEC order didn’t go into details about the failure of the fund to meet those exemptions. It merely states that the fund failed to meet any exemption.

Similarly, the SEC order didn’t provide any information on why the real estate limited partnership interests or mortgage loans should be considered “securities.”

Mortgage loans as securities? Maybe. Sure, bonds and participating interests are more likely to be considered securities. If the fund was the lender, I didn’t think the loan would be considered a security. The order doesn’t tell us anything about the nature of the mortgage loans that made them securities. I would think that a mortgage loan would be considered an asset that qualified under the 3(c)5 exemption as “…(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”

Similarly, real estate limited partnership interests could be considered a security. It should depend how much control the limited partner has over the partnership. I believe that having major decision rights and some control over management moves the interest out of the definition of a security. As with mortgage loans, I would think that real estate-related limited partnership interests would be considered an asset that qualified under the 3(c)5 exemption as “…(C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”

Real estate fund managers who are not registered as investment advisers should be concerned about this case. It sounds like the SEC is possibly taking an aggressive approach on what is a security and the availability of the 3(c)5 exemption for real estate fund managers.

Sources:

More Insight on 3(c)5

Dodd-Frank created a new legal definition for a “private fund” as pooled investment vehicles that are excluded from the definition of “investment company” under the Investment Company Act of 1940 by section 3(c)(1) or 3(c)(7) of that Act. Real estate funds managers have used these standards because they are bright-line tests. It also skirts around the issue of whether the fund is investing in “securities” and “what is a security”.

Real estate fund managers have also looked at 3(c)5 and wondered if they can rely it as an exclusion under the Investment Company Act:

(5) Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who
is primarily engaged in one or more of the following businesses:
… (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

In 2017, Redwood Trust obtained a no-action letter from the SEC that the credit risk transfer certificates that the firm held would be allowed under 3(c)5.

On August 15, 2019, Redwood Trust, Inc. obtained another no-action letter for their mortgage servicing rights (MSRs) and cash proceeds.

In reviewing eligibility for the Real Estate Exception, the SEC has

taken the position that the exclusion in Section 3(c)(5)(C) may be available to an issuer if: at least 55% of its assets consist of “mortgages and other liens on and interests in real estate” (called “qualifying interests”) and the remaining 45% of its assets consist primarily of “real estate-type interests;” at least 80% of its total assets consist of qualifying interests and real estate-type interests; and no more than 20% of its total assets consist of assets (“miscellaneous assets”) that have no relationship to real estate (these factors together, the “Asset Composition Test”). .

In a no-action letter issued to Great Ajax Funding, the SEC staff acknowledged that an issuer that acquires whole mortgage loans may acquire certain other assets as a direct result of being engaged in the business of acquiring whole mortgage loans and that those assets might also be indicative of the issuer being in the business of acquiring whole mortgage loans.

For Redwood, the SEC staff ruled that the MSRs could be qualifying interests for purposes of the Asset Composition Test in utilizing Section 3(c)(5)(C) because “such assets are acquired as a direct result of the issuer being engaged in the business of purchasing or otherwise acquiring whole mortgage loans. “

The other problem that Redwood asked for no-action on was cash proceeds from selling the real estate interests. The SEC state that:

“An entity may treat cash proceeds from asset dispositions as Qualifying Real Estate Assets or Real Estate-Related Assets if, prior to such dispositions, such assets were themselves Qualifying Real Estate Assets or Real Estate-Related Assets, respectively. “

The Staff did qualified the cash proceeds. The relief applies only if the company only holds it for less than 12 months from receipt. The company then needs to reinvest it or distribute it.

Sources:

Is Apple a Hedge Fund?

I don’t own any Apple stock, but their announcement about what they’re planning to do with their big stockpile of cash caught my attention. Not because I’m going to rush out and buy the stock, but because of Dodd-Frank.

My analysis of when fund managers need to register with the Securities and Exchange Commission has me focused on the composition of a company’s assets. I was skeptical that Apple had those billions sitting in stacks of $100 bills in a vault at the Apple headquarters. Some of it had to be invested in securities.

Under the Investment Advisers Act you need to register if you are providing investment advice about securities. Apple is in the business of making shiny gadgets and driving tech-boys into slather over its latest product. Is that still true when the company is sitting on an enormous pile of cash and securities?

I decided to take a look at the balance sheet in Apple’s last 10-Q and broke it out into assets and securities.

 Assets Securities
Cash and Cash equivalents          9,815
Short-term marketable securities        19,846
Accounts receivable, less allowances      8,930
Inventories      1,236
Deferred tax assets      1,937
Vendor non-trade receivables      7,554
Other current assets      4,958
Long-term marketable securities        67,445
Property, plant and equipment, net      7,816
Goodwill         896
Acquired intangible assets, net      3,472
Other assets      4,281
   41,080        97,106
     138,186
70%

About 70% of Apple’s assets are in securities. That made me think of my analysis of whether you are an investment adviser. Apple could be a hedge fund. They have more in securities than they do iPhones.

Under Dodd-Frank, the definition of private fund is taken from the definition of an investment company in the Investment Company Act. Part of that definition is that the issuer

owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Apple is above that 40% level, so I took a closer look at Apple’s breakdown of its securities:

Cash 3,956
Money market funds  3,495
Mutual funds  1,238
U.S. Treasury securities 14,685
U.S. agency securities 20,000
Non-U.S. government securities  5,251
Certificates of deposit and time deposits 3,837
Commercial paper  1,518
Corporate securities 38,914
Municipal securities  4,078
Asset-backed securities  549
Total  55,043

That $55,043 happens to represent 40% of 138,681. I would guess that Apple is very aware of that 40% threshold to be considered an investment company and is purposefully keeping its allocation among securities to not go above the 40% threshold.

Because Apple has kept itself below the 40% level you don’t need to address the second prong of the test: whether Apple “holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities.”

So, the answer is “no.” Not because Apple is technology company, but because the company is purposefully managing its portfolio of securities to stay outside the definition.

Failure to Adequately Oversee Service Providers

Citing what it called “wholly inadequate” oversight of a faraway subadviser, the Securities and Exchange Commission fined and ordered repayment of advisory fees by Morgan Stanley Investment Management. According to the settlement, Morgan Stanley will repay its client, the Malaysia Fund, $1.8 million for fees it paid from 1996-2007 for “research, intelligence, and advice” that  AMMB Consultant Sendirian Berhad of Malaysia, was to provide as subadviser.

AMMB served as a sub-adviser to the Fund from inception until it was terminated at the end of 2007. The Research and Advisory Agreement specified that AMMB would register with the SEC as an investment adviser under the Investment Advisers Act and furnish Morgan Stanley “such investment advice, research and assistance, as [Morgan Stanley] shall from time to time reasonably request.” AMMB did not exercise investment discretion or authority over any of the assets in the Fund. Morgan Stanley took responsibility for monitoring AMMB’s performance of services. The Fund would pay AMMB an escalating fee based on the fund’s assets. During the relevant time period, the Fund paid AMMB advisory fees totaling $1,845,000. As the fund administrator, Morgan Stanley facilitated the Fund’s payment of AMMB’s advisory fees.

Section 15(c) of the Investment Company Act requires an investment adviser of a registered investment company to furnish such information as may reasonably be necessary for such company’s directors to evaluate the terms of any contract whereby a person undertakes regularly to serve or act as investment adviser of the company.

It was an OCIE exam in 2008 that first questioned the arrangement between AMMB and Morgan Stanley. AMMB did not provide any of the services it and Morgan Stanley represented to the Fund’s Board. Instead, AMMB provided two monthly reports that Morgan Stanley neither requested nor used in its management of the Fund. The first was a two-page list of the market capitalization of the Kuala Lumpur Composite Index. The second was a two-page comparison of the monthly performance of the Fund against other Malaysian equity trusts. For twelve years, the fund’s Board relied on Morgan Stanley’s representations and submissions of information regarding AMMB’s services when it unanimously approved the continuation of AMMB’s advisory contracts. The SEC stated that even though Morgan Stanley took responsibility for monitoring AMMB’s services, its oversight and involvement with AMMB during the relevant time period were wholly inadequate.

The settlement calls on the RIA to devise written procedures, reimburse the fund and pay a fine of $1.5 million.

If you are charging a fund for services provided by a third, then there is an obligation to make sure the third party is providing those services.  The SEC stated a violation of Section 206(2) of the Investment Advisers Act that prohibits an investment adviser from engaging “in any transaction, practice or course of business which operates as a fraud or deceit upon any client or prospective client”. It also imposes on investment advisers a fiduciary duty to act in “utmost good faith,” to fully and fairly disclose all material facts, and to use reasonable care to avoid misleading clients. SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 191, 194 (1963). Morgan Stanley willfully violated Section 206(2) of the Investment Advisers Act by representing and providing information to the Fund’s Board that AMMB was providing advisory services for the benefit of the Fund, which it was not.

Sources:

Real Estate Funds and the Investment Company Act

Traditionally, private fund managers have looked at the section 3(c)(1) or section 3(c)(7) exemptions from the definition of “investment company” to avoid the restrictions of being regulated under the Investment Company Act. Dodd-Frank defined a “private fund” as being “issuer that would be an investment company as defined in Section 3 of the Investment Company Act, but for section 3(c)(1) and section 3(c)(7) of that Act.”

If you want to avoid being a “private fund” you need to look at the other exemptions under the Investment Company Act. Section 3(c)(5) is available for real estate funds:

Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: …  (C) purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.

The SEC has issued some guidance on what is meant by that exemption.

In a No Action Letter issued to Realex Capital Corporation in 1984, the Securities and Exchange Commission did not decline to take action. Realex was looking to invest as a limited partner in a limited partnership that would own and operate a building. The SEC took the position that the interests would be “investment contracts” and therefore securities, not real estate for purposes of section 3(c)(5). Realex would be relying on the efforts of the managing partners for the success of the enterprise. In this case, Reaex had only limited major decision rights. For example there was a limitation on sale, but Realex could only object if it did not receive net cash proceeds at least equal to its capital contributions.

In a pre-REMIC No Action Letter, the SEC agreed not to action against Premier Mortgage Corporation for a mortgage pooling fund. Premier would acquire whole mortgage loans secured by first liens on the property.

Getting closer to real estate funds, United States Property Investments NV asked for clarification from the SEC for their fund that would be investing in real estate and real estate interests. In 1989, the SEC said the fund’s investment strategy would allow it qualify for the exemption under 3(c)(5). The fund would invest only in fee interests in real estate, joint ventures formed to acquire real estate, mortgage loan secured by real estate, and interests in joint ventures formed to make mortgage loans secured by real estate. At least 55% of the investments would be exclusively backed by real estate. The remainder would mortgage loans secured primarily, but not exclusively, by real estate.  The fund’s joint venture interests would be exclusively general partnership interests and would be active in the management and operation, including consent for major decisions.

Following that letter, City Trust followed up with a similar investment fund that would established for buying commercial mortgage loans and equipment loans in the form of industrial development bonds. This letter request combined the real estate mortgages in clause (C) of 3(c)(5)  with the purchase money debt for merchandise, insurance, and services in clause (A).

The United States Property Investments NV letter is the most useful to real estate private equity funds looking for 3(c)(5) as an exemption to avoid being defined as a “private fund.” It’s not clear what lesser amounts of real estate would be acceptable. It’s also not clear whether a more complicated structure of ownership would change the analysis. Real estate funds often have lots of intervening entities to satisfy tax, ERISA, financing and management issues.

The other thing to keep in mind is that using the 3(c)(5) exemption may get you out from under the definition of a private fund, but does not necessarily mean that you are not an investment adviser. It just means that the management company is not an adviser to a private fund.

Sources:

Image of Royal Exchange London is from the Library of Congress

Are you an Investment Company?

Fund managers are dealing with Dodd-Frank and the requirements under the Investment Advisers Act made by the Securities and Exchange Commission. Of course, a fund manager needs to focus on other areas of financial regulation and enforcement by the Securities and Exchange Commission. Fund managers need to keep focused on how they comply with the Investment Company Act.

Section 3 of the Investment Company Act has this definition:

1. When used in this title, “investment company” means any issuer which–

A. is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities;

B. is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or

C. is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

This leaves you with the tricky analysis of whether your investments are securities. To avoid that mess, most private funds look to two exemptions from the definition of “investment company”: 3(c)1 and 3(c)7.

Under 3(c)(1), the main limitations are that you have one hundred or fewer holders of beneficial interest in the fund and that you do not propose to sell them in a public offering. Under 3(c)(7) you can go beyond the 100 owners, but they need to be “qualified purchasers.” That means they need to have a big wallet.

One challenge for private funds who do not want to register under the Investment Advisers Act is that private fund is defined as an “issuer that would be an investment company as defined in Section 3 of  the Investment Company Act, but for section 3(c)(1) and section 3(c)(7) of that Act.”

There are other exemption available, but they are harder to fit under. You may have a trail of paper work stating that you fall under the section 3(c)(1) or section 3(c)(7) exemption, even though you could claim to fit under one of the other exemptions.

For example, 3(c)(5) is available for real estate funds:

Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: …  (C) purchasing or otherwise acquiring mortgages and other liens on and interest in real estate.

There are some additional limitations that come with this based on some SEC No Action letters. I’ll put some information together on that later.

Sources:

Image is Exchange hall, Copenhagen, Denmark, between ca. 1890 and ca. 1900, published by The Library of Congress

The Knowledgeable Employee Exemption for Private Funds

UPDATE: See More Guidance on Knowledgeable Employee Exemption for Private Funds

When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employees.

Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.)

The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act.

You will still need to determine if the employee’s acquisition of the interest is exempt from the registration requirements of the Securities Act. Most likely that will mean that the knowledgeable employee will need to be an accredited investor. Meeting that $200,000 per year / $300,000 per year if married income (and a reasonable expectation of that income continuing) threshold may be the biggest impediment to offering equity interests further down the company ladder.

The first category of “knowledgeable employees” is the management of the covered company, which covers these positions:

  • director [see Section 2(a)(12)]
  • trustee
  • general partner
  • advisory board member [see Section 2(a)(1)]
  • “executive officer”

Executive Officer is defined in Rule 3C-5 as:

  • president
  • vice president in charge of a principal business unit, division or function
  • any other officer who performs a policy-making function
  • any other person who performs a similar policy-making function

The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:

  • Participate in the investment activities in connection with his or her regular functions or duties,
  • has been performing such functions and duties for at least 12 months, and
  • is not performing solely clerical, secretarial or administrative functions.

The 12 month limit is not limited to 12 months at the employee’s current company. The SEC concluded that it is not necessary to require that an employee work for the particular fund or management affiliate for the entire 12-month period as long as the employee has the requisite experience to appreciate the risks of investing in the fund and performed substantially similar functions or duties for another company during that 12 month period.

Whether an employee actively “participates in the investment activities” of a private fund will be a factual determination made on a case-by-case basis.  In a 1999 No Action letter sent to the ABA the SEC said the following would NOT be knowledge employees:

  • Marketing and investor relations professionals who explain potential and actual portfolio investments of a fund and the investment decision-making process and strategy being followed to clients and prospective investors and interface among the fund, the portfolio mangers and the fund’s clients.
  • Attorneys who
    • provide advice in the preparation of offering documents and the negotiation of related agreements,
    • who also are familiar with investment company management issues, and
    • respond to questions or give advice concerning ongoing fund investments, operations and compliance matters.
  • Brokers and traders of a broker-dealer related to the Fund who are Series 7 registered.
  • Financial, compliance, operational and accounting officers of a fund who have management responsibilities for compliance, accounting and auditing functions of funds.

The SEC also said that research analysts who investigate the potential investments for the fund may not be knowledgeable employees unless they research all potential portfolio investments and provide recommendations to the portfolio manager.

Sources:

Photo is of the Board of Directors and Officers of the Industrial Exhibition Association of Toronto 1930 used under Creative Commons License from the Toronto Public Library Special Collections