Tag: Section 3(c)(1)

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.

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

Performance Fees for Private Investments Funds under the Investment Adviser Act

regulatory umbrella

As  more private investment funds will be pulled under the regulatory umbrella of the Investment Advisers Act,they will need to focus on the limitation on performance fees.

Section 205(a)(1) of the Advisers Act generally prohibits any investment adviser, unless exempt from registration pursuant to Section 203(b) of the Advisers Act, from entering into, extending, renewing, or performing under any investment advisory contract if the contract includes a performance fee. With the financial reform bill likely to pass any day, the 203(b) exemption will evaporate for many private investment funds.

Section 205(e) grants the SEC the power to create an exemption from the limitation “on the basis of such factors as financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, relationship with a registered investment adviser,” and other factors. The SEC created an exemption in Rule 205-3 for “qualified clients.”

A “qualified client”

1. has at least $750,000 under the management with the investment adviser

2. has a net worth of more than $1.5 million at the of the investment

3. is a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 [15 U.S.C. 80a-2(a)(51)(A)]

4. is an executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser

or

5. is an employee of the investment adviser who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser.

The rule requires a look -through from the fund to the investors in the fund. If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should all be qualified purchasers or knowledgeable employees and you won’t need to look much further.

If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

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The image is a black Tour de France umbrella available at the official store of Le Tour de France. (Yes, I’m a huge fan of the Tour de France.)

Private Fund Exemptions under the Investment Company Act

Private investment funds primarily use two exemptions to avoid being defined as an “investment company” under the Investment Company Act of 1940: Section 3(c)(1) or Section 3(c)(7).

Less than 100 Investors

Section 3(c)(1) of the Investment Company Act excludes from being an investment company any issuer whose outstanding securities are beneficially owned by not more than 100 persons and that is not making and does not presently propose to make a public offering of its securities. The benefit of Section 3(c)(1) is that there is no additional status requirement for the investor, such as net worth, total assets, or total investments owned beyond the “accredited investor” standard.

There are some catches in trying to count the number of investors. There are several types of investors that result in a look through their ownership.

More than 100 Investors

If your private fund will have more than 100 investors, either directly or because of a look-through, then the fund will need to fit under the Section 3(c)(7) exemption. As with Section 3(c)(1) you cannot anticipate making a public offering. Investors in 3(c)(1) fund need only be accredited investors, but investors in a 3(c)(7) fund must be “qualified purchasers.”

The higher standard of qualified purchaser limits potential investors to institutional investors, investment managers and high net worth individuals. (More on the “qualified purchaser” definition in my next post.)

Contacting lots of investors may be viewed as general solicitation so you need to pay attention to the prohibition on general solicitation or advertisement under .

You will also need to be careful in limiting future transfers of interest in the private investment funds. With more than 100 investors, you will no longer be in the safe harbor exemption from being a publicly traded partnership.

500 or more Investors

Once you have 500 or more investors and more than $10 million in assets you are subject to the reporting requirements of the Exchange Act. Effectively you are no longer a private fund.

I believe something analogous happened to Google. They had gotten so big and their shares ended up in the hands of more than 500 people. Since they would have to begin complying with the reporting requirements, they may as well let the shares trade publicly.

So if you are going to end up with more than 500 investors in a private fund, you are better off having several smaller funds to avoid the public reporting requirements under the Exchange Act.

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Image of the Twenty Dollar Bill is by Darren Hester under a Creative Commons License.