The Hedge Fund Law Report

The definitive source of actionable intelligence on hedge fund law and regulation

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By Topic: Knowledgeable Employees

  • From Vol. 7 No.8 (Feb. 28, 2014)

    SEC Clarifies Scope of the “Knowledgeable Employee” Exception for Section 3(c)(1) and 3(c)(7) Funds

    Hedge funds and other private funds typically rely on the exemptions from registration set forth in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (Act).  Section 3(c)(1) exempts from registration funds that are not planning a public offering and whose securities are owned by fewer than 100 beneficial owners.  Section 3(c)(7) exempts funds that are not planning a public offering and whose securities are owned exclusively by “qualified purchasers” (generally, persons or entities that own more than $5 million in investments).  Rule 3c-5 under the Act provides that “knowledgeable employees” of private funds (Covered Funds) or of affiliated managers of Covered Funds are not counted towards the 100 owner limit under Section 3(c)(1).  In addition, they may invest in Section 3(c)(7) funds even if they are not qualified purchasers.  The knowledgeable employee exemption is important for hedge fund managers who want to use employee participation in their funds for compensation and other purposes.  See “Conflicts and Opportunities Offered by Concurrent Management of Employee-Owned Hedge Funds and Outside-Investor Hedge Funds,” The Hedge Fund Law Report, Vol. 2, No. 32 (Aug. 12, 2009).  The Managed Funds Association (MFA) recently asked the SEC for a no-action letter with regard to several of the definitions and concepts used in Rule 3c-5.  In response, the SEC has issued a no-action letter that clarifies the concepts of “principal business unit, division or function”; “policy-making function”; and participation in “investment activities”; and makes clear that the rule may apply to knowledgeable employees of separately managed accounts and of certain related advisers.  In that regard, the SEC has provided valuable guidance on some of the open questions concerning Rule 3c-5.  See “Are the General Counsel and Chief Compliance Officer of a Hedge Fund Manager Considered ‘Knowledgeable Employees’ of the Manager?,” The Hedge Fund Law Report, Vol. 5, No. 35 (Sep. 13, 2012).  This article summarizes the SEC’s letter and the relevant portions of the MFA’s request.

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  • From Vol. 5 No.35 (Sep. 13, 2012)

    Are the General Counsel and Chief Compliance Officer of a Hedge Fund Manager Considered “Knowledgeable Employees” of the Manager?

    Allowing employees to invest in a hedge fund manager’s funds can have both direct and indirect benefits for the manager and the employees, including aligning the interests of the employees with those of the manager and fund investors.  However, because most hedge funds elect not to register as investment companies pursuant to the Investment Company Act of 1940 (Company Act), they typically must comply with the requirements of the exclusions from investment company registration found in Section 3(c)(1) (which basically prohibits more than 100 beneficial owners in the fund) and Section 3(c)(7) (which limits investors in the fund to “qualified purchasers”) of the Company Act.  These exclusions can restrict employee investments in the manager’s funds.  However, Rule 3c-5 under the Company Act permits “knowledgeable employees” of a fund and certain of its affiliates to acquire securities issued by the fund without being counted towards the 100-beneficial owner threshold for Section 3(c)(1) funds and without having to qualify as qualified purchasers with respect to Section 3(c)(7) funds.  Investment and business personnel – portfolio managers, directors, officers and other senior business employees – typically fall squarely within the definition of knowledgeable employee, and in any case are often qualified purchasers as well.  However, a recurring question at hedge fund managers – particularly in the so-called “back office” – is whether the general counsel (GC) and chief compliance officer (CCO) of the manager constitute knowledgeable employees of the manager.  This question arises for at least three reasons.  First, GCs and CCOs – at least those who believe in what they are doing and where they are doing it – often want to invest in the funds of their manager-employers.  Second, investments by GCs and CCOs are good for the manager – they align employee incentives and fund investment goals.  (Some argue that fund investments by the GC and CCO can result in lax compliance, for example, that a GC or CCO invested in the fund would be more inclined to permit insider trading to increase fund returns.  We do not find that argument credible.  Smart GCs and CCOs know that lax compliance diminishes long-term returns.)  Third, many GCs and CCOs are close to being qualified purchasers, but are not quite there.  Such GCs and CCOs would not be able to invest in 3(c)(7) funds unless they fit within the knowledgeable employee definition.  In short, hedge fund investments by GCs and CCOs are usually a win-win.  But do the federal securities laws and rules permit such investments?  That is the fundamental question that this article seeks to answer.  More specifically, this article discusses: the benefits to a hedge fund manager of employee investments in manager funds; the interaction between Sections 3(c)(1) and 3(c)(7) of the Company Act and the knowledgeable employee definition; the operation of Rule 3c-5 of the Company Act and who generally qualifies as a knowledgeable employee; categories of hedge fund manager employees that are typically considered knowledgeable employees; consequences of making an incorrect knowledgeable employee determination; whether in-house counsel and compliance staff constitute knowledgeable employees; whether “dual-hatted” GCs/CCOs constitute knowledgeable employees; factors bearing on the analysis; and how the size of the firm impacts the knowledgeable employee calculus.

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