Compliance Building

A new no-action letter from the SEC’s Division of Investment Management should allow more employees of a fund manager to invest in their firm’s private funds under the Investment Company Act. Even better for the compliance department, compliance staff could fit the expanded definition of a “knowledgeable employee.”

When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue 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.) When operating under the Section 3(c)(1) exemption, you need to worry about employee taken up one of those valuable 100 spots.

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.

Rule 3C-5 creates two categories of “knowledgeable employees”. 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.

It’s a typically fuzzy definition. I expect most fund managers have people that clearly fit in the definition, some that are clearly outside the definition, and some that are in a gray area. It depends on how you define “principal business unit”, “policy-making function”, and “participates in the investment activities”. There was a 1999 American Bar Association SEC No Action Letter that provided some guidance. This no-action letter goes even further.

Your IT head is likely to be happy with the guidance on “principal business unit”:

“While the ultimate determination of whether any business unit, division, or function should be deemed principal is a factual determination that must be made on a case-by-case basis, we believe that an investment manager could determine that its IT and investor relations departments are principal business units, divisions, or functions under the circumstances described above and, accordingly, the individual in charge of each such department could be a knowledgeable employee.”

In particular, the guidance points out that unit need not be part of the investment activities to be considered principal.

The letter opens a bit wider the definition of “policy-making function”:

“Further, we agree that the rule does not require that the policy-making function be concentrated in one individual and that employees serving as active members of a group or committee that develop and adopt an investment manager’s policies, such as the valuation committee, could be executive officers under the rule. We do not believe that individuals who merely observe committee proceedings or merely provide information or analysis to the decision-makers of a committee or group would be engaged in making policy and, therefore, such individuals generally would not be executive officers under the rule.

On the “participate in investment activities” term, the SEC says each of these could fit in the definition, depending on the facts and circumstances:

• member of the analytical or risk team who regularly develops models and systems to implement the Covered Fund’s trading strategies
• trader who regularly is consulted for analysis or advice by a portfolio manager during the investment process
• tax professional who is regularly consulted for analysis or advice by a portfolio manager
• attorney who regularly analyzes legal terms and provisions of investments

The SEC steps away from creating a bright line and leaves it up to the private fund to address the particular facts and circumstances for each employee. But you will need to write down why you treated an employee as a “knowledgeable employee.”

“[I]nvestment managers should maintain in their books and records a written record of employees the investment manager has permitted to invest in a Covered Fund as knowledgeable employees and should be able to explain the basis in the rule pursuant to which the employee qualifies as a knowledgeable employee.”

References:

• SEC No Action Letter Investment Company Act of 1940 – Section 7 and Rule 3c-5 Managed Funds Association February 6, 2014
• American Bar Association SEC No Action Letter, April 22, 1999 (.pdf)
• The Knowledgeable Employee Exemption for Private Funds
• Compliance staff could be seen as ‘knowledgeable’ employees under new SEC letter by IA Watch (Subscription Required)