United States: SEC Updates Guidance On Definition Of "Knowledgeable Employee" Under The Investment Company Act

In a No-Action Letter issued to the Managed Funds Association on February 6, 2014 (the "MFA Letter"),1 the staff (the "Staff") of the Division of Investment Management of the Securities and Exchange Commission (the "SEC") expanded its interpretation of the definition of "Knowledgeable Employee" in Rule 3c-5 under the Investment Company Act of 1940, as amended (the "Investment Company Act").

Background

Many private funds rely on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act to be excluded from the definition of "investment company." These include hedge funds, private equity funds, and other types of pooled investment vehicles. Section 3(c)(1) excludes a fund (a "3(c)(1) Fund") whose outstanding securities (other than short-term paper) 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. Section 3(c)(7) excludes a fund (a "3(c)(7) Fund") whose outstanding securities are exclusively owned by persons who, at the time of acquisition, are "qualified purchasers," and that is not making and does not presently propose to make a public offering of its securities. Under Rule 3c-5, Knowledgeable Employees are not counted toward the 100-person limit with respect to a 3(c)(1) Fund and are not required to be qualified purchasers with respect to a 3(c)(7) Fund. We collectively refer to 3(c)(1) Funds and 3(c)(7) Funds as the "Covered Funds."

Knowledgeable Employees

Rule 3c-5 defines the term "Knowledgeable Employee" to cover two categories of employees. First, the term includes "Executive Officers," directors, trustees, general partners, advisory board members, and persons serving in similar capacities, of a Covered Fund or an affiliated person that manages the investment activities of a Covered Fund (an "Affiliated Management Person"). The rule defines "Executive Officers" to mean the president, vice president in charge of a principal business unit, division, or function (such as sales, administration, or finance), any other officer who performs a policy-making function, or any other person who performs similar policy-making functions, for a Covered Fund or for an Affiliated Management Person of a Covered Fund.

Second, the term includes employees of a Covered Fund or an Affiliated Management Person of a Covered Fund (other than an employee performing solely clerical, secretarial, or administrative functions) who, in connection with their regular functions or duties, participate in the investment activities of such Covered Fund, other Covered Funds, or investment companies managed by such Affiliated Management Person of such Covered Fund, provided that such employees have been performing such functions and duties for the Covered Fund or the Affiliated Management Person, or substantially similar functions or duties for or on behalf of another company, for at least 12 months.

In prior guidance, the Staff has said that the following types of employees generally would not be Knowledgeable Employees: (1) 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 who, from time to time, interface among the fund, the portfolio managers, and the fund's clients; (2) research analysts who investigate the potential investments for a fund (unless a research analyst researches all potential portfolio investments and provides recommendations to the portfolio manager); (3) attorneys who, as part of their duties, provide advice with respect to, or who participate in, the preparation of offering documents and the negotiation of related agreements, and who are familiar with investment company management issues and respond to questions or give advice concerning ongoing fund investments, operations, and compliance matters; (4) brokers and traders of a broker-dealer related to a fund who are Series 7 registered; and (5) financial, compliance, operational, and accounting officers of a fund who have management responsibilities for compliance, accounting, and auditing functions of a fund.2

While the Staff has narrowly construed the types of activities that must be performed to qualify as a Knowledgeable Employee, it has expanded the types of employing entities beyond those specified in the rule.3 In addition to Covered Funds and investment companies managed by an Affiliated Management Person, Knowledgeable Employees may also be employees of companies excluded from the definition of "investment company" by Section 3(c)(2)4, 3(c)(3)5, or 3(c)(11)6 of the Investment Company Act, provided that such employees have been participating in the investment activities of such companies for at least 12 months.7 In taking this position, the Staff has said that these employees are likely to be as financially knowledgeable and sophisticated as employees who participate in the investment activities of a Covered Fund or an investment company, and Rule 3c-5 is premised on the view that certain persons, because of their financial knowledge and sophistication and their relationship with a Covered Fund, do not need the protection of the Investment Company Act.8

In addition, the Staff has also indicated flexibility in the category of persons who may be considered "Affiliated Management Persons." In promulgating Rule 3c-5, the SEC intended that Knowledgeable Employees be limited to persons whose employer managed the Covered Fund in which the employees wanted to invest.9 The requirement was intended, in part, to ensure that Knowledgeable Employees have access to information about the management of the Covered Fund in which they wish to invest.10 The Staff has acknowledged, however, that in certain circumstances, a company that is under common control with the investment adviser to a Covered Fund may be considered an Affiliated Management Person of the Covered Fund because an employee of such an entity generally will have significant access to information about the Covered Fund.11 Accordingly, the determination of whether an affiliate is an Affiliated Management Person for purposes of determining whether its employees are Knowledgeable Employees depends on the particular facts and circumstances.12

New Interpretative Guidance

The Staff's updated guidance for determining who may be considered a "Knowledgeable Employee" is discussed below.

Executive Officers and Policy-Making Employees

As noted above, the first category of Knowledgeable Employees includes "Executive Officers," which term the rule defines to include vice presidents in charge of a principal business unit, division, or function, and employees who perform policy-making functions.

Principal Business Unit

The MFA Letter states that the definition of "Knowledgeable Employee" in Rule 3c-5 provides flexibility in determining whether an individual is in charge of a "principal business unit, division, or function," and that this determination should be made by an investment manager based on the relevant facts and circumstances regarding its business operations. The MFA Letter also states that while not all business units, divisions, or functions are necessarily principal business units, divisions, or functions, it is possible that several of them could each be a principal business unit, division, or function, and that a business unit, division, or function does not need to be part of the investment activities of a Covered Fund in order to be considered principal. 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.

In connection with the foregoing, the Staff agreed that an investment manager's information technology ("IT") and investment relations departments may be deemed principal business units under certain circumstances. Examples include: (i) the IT department of an investment manager that employs technologically driven trading models, whose IT professionals are charged with building the models and systems that translate certain quantitative signals into trade orders; (ii) the IT department of an investment manager that employs technology professionals to build performance and risk monitoring systems that interact with the investment program; and (iii) the investor relations department of an investment manager that relies on investor relations personnel to conduct substantive portfolio reviews with investors and to respond to substantive due-diligence inquiries from institutional investors and consultants.

Employees Who Make Policy

The MFA Letter clarifies that employees without senior manager titles may satisfy the definition of "Executive Officer" by serving as a member of a group or a committee that develops and adopts an investment manager's policies, even if such employees do not perform policy-making functions by themselves outside of participation on such group or committee. For example, employees that serve as active members of a valuation committee may qualify as Executive Officers under the rule.

Participation in Investment Activities

The second category of Knowledgeable Employees includes those employees of a Covered Fund or an Affiliated Management Person who regularly participate in the investment activities of such Covered Fund, other Covered Funds, or investment companies managed by such Affiliated Management Person, provided that they have been performing such functions and duties for or on behalf of such Covered Fund or Affiliated Management Person, or substantially similar functions or duties, for or on behalf of another company, for at least 12 months ("Participating Employees").

Research Analysts

As discussed above, previous guidance indicated that a research analyst must research all potential portfolio investments and provide recommendations to the portfolio manager in order to be deemed a Knowledgeable Employee.13 By contrast, the MFA Letter expands this category of Knowledgeable Employee to include a research analyst who researches a portion of a Covered Fund's portfolio and provides analysis or advice to the portfolio manager with respect to only that portion.

Participating Employees

The MFA Letter provides that Participating Employees are not limited to those individuals charged with overall responsibility for the investment activity of a Covered Fund, and that other non-executive employees could be considered Participating Employees if they regularly participate in the management of a Covered Fund's investments (or a portion thereof). While reiterating that the ultimate determination of whether an individual participates in the investment decisions of a Covered Fund is a factual determination that must be made on a case-by-case basis, the MFA Letter states that the following individuals could fall within the category of Participating Employees if they regularly perform such functions or duties and have been doing so for at least 12 months:

  1. a member of the analytical or risk team who regularly develops models and systems to implement a Covered Fund's trading strategies by translating quantitative signals into trade orders or providing analysis or advice that is material to the investment decisions of a portfolio manager (in contrast to someone who merely writes the code to a program used by the portfolio manager);
  2. a trader who regularly is consulted for analysis or advice by a portfolio manager during the investment process and whose analysis or advice is material to the portfolio manager's investment decisions based on the trader's market knowledge and expertise (in contrast to a trader that simply executes investment decisions made by the portfolio manager);
  3. a tax professional who is regularly consulted for analysis or advice by a portfolio manager, typically before the portfolio manager makes investment decisions, and whose analysis or advice is material to the portfolio manager's investment decisions, such as when a tax professional's analysis of whether income from an offshore fund's investment may be considered "effectively connected income," is material to a portfolio manager's decision to invest in certain debt instruments (in contrast to a tax professional who merely prepares the tax filings for a Covered Fund); and
  4. an attorney who regularly analyzes legal terms and provisions of investments and whose analysis or advice is material to the portfolio manager's investment decisions, such as where the attorney's legal analysis of tranches of a distressed debt investment is material to a portfolio manager's decision to invest in the loan (in contrast to an attorney who negotiates agreements that effectuate transactions evidencing the investment decisions of the portfolio manager, or an attorney or compliance officer who evaluates whether an investment is permitted under a Covered Fund's governing documents).

Separate Accounts

As noted above, the Staff has previously stated that an employee who participates in the investment activities of a company excluded from the definition of "investment company" by Section 3(c)(2), 3(c)(3), or 3(c)(11) of the Investment Company Act may also be deemed a Knowledgeable Employee because such employee is likely to be as financially knowledgeable and sophisticated as an employee who participates in the investment activities of a Covered Fund or an investment company. The MFA Letter expands this concept by permitting an employee of an Affiliated Management Person who participates in the investment activities of "Covered Separate Accounts" to be eligible for Knowledgeable Employee status. The MFA Letter notes that such an employee is also likely to be as financially knowledgeable and sophisticated as an employee who participates in the investment activities of a Covered Fund or investment company. For purposes of the MFA Letter, "Covered Separate Accounts" refer to separate accounts (or a portfolio (or portion thereof) of a separate account) for clients that are "qualified clients"14 and are otherwise eligible to invest in the Covered Funds advised by the Affiliated Management Person, and whose accounts pursue investment objectives and strategies that are substantially similar to those pursued by one or more of those Covered Funds.

Employees of Related Advisers in Control Relationships

The Staff recently issued a separate No-Action Letter (the "Relying Adviser Letter") in which it stated that it would not recommend enforcement action under the Advisers Act if a "filing adviser" filed a single Form ADV on behalf of itself and "relying advisers" that are affiliated with the filing adviser as part of a single advisory business, under certain circumstances.15 The MFA Letter states that if a filing adviser and its relying adviser(s) collectively conduct a single advisory business as described in the Relying Adviser Letter, then each of the filing adviser and relying adviser(s) may be an Affiliated Management Person of a Covered Fund. As a result, Knowledgeable Employees of a filing adviser or any of its relying advisers may be treated as Knowledgeable Employees with respect to any Covered Fund managed by the filing adviser or its relying advisers, provided that the employees meet the other conditions of the rule. As discussed above, determining whether an Affiliated Management Person includes each affiliated entity of a Covered Fund that participates in investment activities of the investment management company depends on the relevant facts and circumstances. In making this determination, the Staff has considered the ability of an employee of an affiliated entity to have access to information about the Covered Fund. Given the nature of the factors to be met in order to be considered a single advisory business under the Relying Adviser Letter, the Staff believes that employees of affiliated advisers that are deemed to conduct a single advisory business would generally have significant access to information about the Covered Funds managed by the other affiliated advisers within the single advisory business.

Conclusion

The MFA Letter represents a significant expansion of the Staff's interpretation of which types of employees constitute "Knowledgeable Employees" for purposes of the Investment Company Act. Although the analysis of who meets such criteria is based on a facts and circumstances test, the MFA Letter acknowledges that such analysis can be flexible. In addition, the MFA Letter identifies specific examples of the types of employees that may qualify as Knowledgeable Employees who may not have qualified under the Staff's prior guidance. In order to verify compliance with the current advice, an investment adviser should document the facts and circumstances that support its conclusion that any particular employee is a Knowledgeable Employee for these purposes.

Footnotes

1 The MFA Letter is available at http://www.sec.gov/divisions/investment/noaction/2014/managed-funds-association-020614.htm.

2 American Bar Association Section of Business Law, SEC No-Action Letter (Apr. 22, 1999) (the "ABA Letter").

3 See ABA Letter; see also PPM America Special Investments CBO II, L.P., SEC No-Action Letter (Apr. 16, 1998) (the "PPM America Letter").

4 Section 3(c)(2) excludes certain underwriters, distributers, and broker-dealers.

5 Section 3(c)(3) excludes banks, insurance companies, and certain other financial institutions.

6 Section 3(c)(11) generally excludes certain tax-qualified pension or profit-sharing plans, any collective trust fund maintained by a bank that consists solely of assets of these plans, and any insurance company separate account the assets of which are derived from contributions under certain tax-qualified plans.

7 See the Staff's response to Question 2 in the ABA Letter.

8 Id.

9 See Privately Offered Investment Companies, Investment Company Act Release No. 22597 (Apr. 3, 1997), 62 FR 17512 (Apr. 9, 1997) (the "Adopting Release"). See also the Staff's response to Question 3 in the ABA Letter.

10 Id.

11 See the Staff's response to Question 3 in the ABA Letter.

12 Id.

13 See ABA Letter.

14 See Rule 205-3 under the Investment Advisers Act of 1940, as amended (the "Advisers Act").

15 American Bar Association, Section of Business Law, SEC No-Action Letter (Jan. 18, 2012).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration
Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:
  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.
  • Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.
    If you do not want us to provide your name and email address you may opt out by clicking here
    If you do not wish to receive any future announcements of products and services offered by Mondaq you may opt out by clicking here

    Terms & Conditions and Privacy Statement

    Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

    Use of www.mondaq.com

    You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

    Disclaimer

    Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

    The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

    Registration

    Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

    • To allow you to personalize the Mondaq websites you are visiting.
    • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
    • To produce demographic feedback for our information providers who provide information free for your use.

    Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

    Information Collection and Use

    We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

    We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

    Mondaq News Alerts

    In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

    Cookies

    A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

    Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

    Log Files

    We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

    Links

    This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

    Surveys & Contests

    From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

    Mail-A-Friend

    If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

    Emails

    From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

    *** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

    Security

    This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

    Correcting/Updating Personal Information

    If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

    Notification of Changes

    If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

    How to contact Mondaq

    You can contact us with comments or queries at enquiries@mondaq.com.

    If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.

    By clicking Register you state you have read and agree to our Terms and Conditions