United States: US Securities And Exchange Commission Clarifies And Expands Its Interpretation Of "Knowledgeable Employee" Under The US Investment Company Act

Keywords: no-action letter, Managed Funds Association, SEC, Rule 3c-5, Investment Company Act

On February 6, 2014, the Staff of the Division of Investment Management of the Securities and Exchange Commission ("SEC") issued the Managed Funds Association (the "MFA) a no-action letter (the "MFA Letter") clarifying and expanding the SEC's interpretation of the defined term "Knowledgeable Employee" in Rule 3c-5 under the Investment Company Act of 1940 (as amended, the "Investment Company Act").

Many hedge funds, private equity funds, and other types of pooled investment vehicles rely on exclusions from the definition of "investment company" provided under Sections 3(c)(1) or 3(c)(7) (each, a "Covered Fund") of the Investment Company Act. Rule 3c-5 under the Investment Company Act permits a knowledgeable employee of such Covered Funds, and a knowledgeable employee of certain Affiliated Management Persons,1 to invest in a Covered Fund that relies on Section 3(c)(1) without being counted toward the 100-person limit imposed upon a Section 3(c)(1) fund. The rule also permits such employees to invest in a Covered Fund that relies on Section 3(c)(7) without having to be a qualified purchaser with respect to a Section 3(c)(7) Fund and without being counted for purposes of determining whether a Section 3(c)(7) fund is owned exclusively by qualified purchasers.

Rule 3c-5 defines the term "knowledgeable employee" to include two categories:

  • "Executive officers," which term includes the "president, any vice president in charge of a principal business unit, division or function (such as sales, administration, or finance), and other officers who performs a policy making function, or any person who performs similar policy making functions" for a Covered Fund or an Affiliated Management Person of the Covered Fund; and
  • Non-executive employees (other than those performing solely clerical, secretarial or administrative functions) who regularly participate in the investment activities of a Covered Fund or an Affiliated Management Person of a Covered Fund, provided such employee has been performing such functions and duties on behalf of the Covered Fund or Affiliated Management Person or substantially similar functions or duties for or on behalf of another company for least 12 months.

Principal Business Units

In respect of whether an activity or function rises to the level of principal status, the SEC Staff confirmed its view that:

  • The principal status of an adviser's unit, division, or function depends on the relevant facts and circumstances of a particular investment manager's business operations;
  • Several business units, divisions, or functions within an adviser may each be considered a principal unit, division, or function; and
  • The unit, division, or function of an adviser need not be part of the investment activities of a Covered Fund to be considered a principal unit, division, or function.

While the Staff's confirmation of these considerations is helpful, perhaps more notable is the Staff's stated belief that Rule 3c-5 is intended to provide "flexibility in determining whether an individual is in charge of a principal business unit, division, or function." In its request letter, the MFA suggested that activities could be "principal" if they were "high value" and integral to the investment manager's operations. Certain examples were provided by the MFA in respect of certain information technology ("IT") and investor relations functions, including, in the case of IT professionals, professionals (i) charged with building models and systems that translate into certain quantitative trade orders and (ii) who build performance and risk monitoring systems that interact with the investment program.

An investor relations function could be a principal unit if investor relations personnel conduct substantive portfolio reviews with investors and respond to substantive due diligence inquiries. The Staff agreed that such functions could be determined to be "principal," while reiterating the fairly direct and critical ties to the investment manager's investment program and investor due diligence, as opposed to inconsequential assistance.

The Staff's guidance also seems to provide that the heads of certain functions may qualify as knowledgeable employees in addition to the heads of the business units in which they report. For instance, if IT reports to operations, and investor relations to the sales department, the heads of IT and investor relations may potentially qualify as knowledgeable employees in addition to an investment manager's chief operating officer and director of sales and marketing.

Further, the flexibility shown by the Staff, together with a framework for arguing that other functions may be integrally involved with the investment program, may prove particularly beneficial for smaller, flatter organizations where a certain individual may supervise few, if any, others, or may be the only individual (and, by default, the executive officer) leading such function. It is important to emphasize, however, that merely acting in such capacities alone will not make an individual a "knowledgeable employee." The Staff indicated that such individuals "could" be determined to be knowledgeable employees, which is intended to emphasize that status alone will not make an individual a knowledgeable employee. A separate and independent determination is required to be made that such persons generally have such financial knowledge and sophistication and sufficient access to information about the Covered Fund in question in order to understand the strategy and risks inherent in such investments. As noted by the SEC Staff, an investment manager should be able to explain "the basis in [Rule 3c-5] pursuant to which the employee qualifies as a knowledgeable employee."

Policy-Making Functions

With regard to policymaking functions, the MFA Letter essentially provides clarity around a "function over title" approach: regardless of their titles, employees can have a policy-making function and can meet the relevant standard either individually or as part of a committee or group. The MFA Letter clarifies that an employee need not even be an "officer" per se, and that policy-making may be viewed broadly, and can include active members of a group or committee that develops and adopts a manager's policies, such as a valuation committee. Such logic arguably might be extended to active members of other committees, including best execution, risk, operating and other committees that make policies on behalf of the investment manager, which may potentially significantly increasing the pool of potential knowledgeable employees.

Participation in Investment Activities

The MFA Letter significantly expands the SEC Staff's guidance set forth in the 1999 no-action letter addressed to the American Bar Association (the "ABA Letter"). In the ABA Letter, the SEC stated that Rule 3c-5 is intended to cover nonexecutive employees only if they actively participate in the investment activities of the Covered Fund and certain other investment companies. The SEC further stated that the rule is intended to encompass persons who actively participate in the management of a fund's investments, and not employees who merely obtain information regarding the investment activities of these funds.

The Staff noted that analysts, who research all potential portfolio investments and provide recommendations to the portfolio manager, could be determined to be knowledgeable employees. The Staff also noted that nonexecutive marketing and investor relations professionals, attorneys (even those who provide advice with respect to, or who participate in, the preparation of offering documents and the negotiation of related agreements), certain brokers and traders affiliated with the Covered Fund or an Affiliated Management Person, and financial, compliance, operational and accounting officers of a fund (including those who have management responsibilities for compliance, accounting and auditing functions of funds) would not qualify as knowledgeable employees under Rule 3c-5.

The MFA Letter makes clear that research analysts may qualify as knowledgeable employees, even if they provide analysis or advice to a portfolio manager with respect to only a portion of a Covered Fund's portfolio (as opposed to the entire portfolio, which was suggested in the ABA Letter) and, importantly, that certain non-investment, non-executive personnel may qualify as knowledgeable employees if they regularly participate in the management of a Covered Fund's portfolio (or a portion thereof).

While the ultimate determination is based on facts and circumstances, and must be made on a case-by-case basis, the SEC Staff noted explicitly that the following non-investment personnel may be knowledgeable employees:

  • 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 2 in contrast to someone who merely writes the code to a program used by the portfolio manager);
  • A trader who is regularly 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 who simply executes investment decisions made by the portfolio manager);
  • 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 the Covered Fund); and
  • 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).

Treatment of Separate Accounts

The MFA Letter also provides that an employee can be regarded as participating in the investment activities of a Covered Fund if his or her functions relate to a portfolio, or portion of a portfolio, of a separate account for clients that are "qualified clients" and are otherwise eligible to invest in the private funds managed by the adviser and whose accounts pursue investment objectives and strategies that are substantially similar to those pursued by one or more of those private funds.

Employees of Relying Advisers in Control Relationships

The MFA Letter provides that knowledgeable employees of a filing adviser, or any of its relying advisers (as set out in the ABA's 2012 no-action letter regarding which adviser entities have to file a Form ADV), may be treated as a knowledgeable employee 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.

Other Employees

The SEC Staff emphasized that employees of an adviser other than those described in the MFA Letter may also qualify as knowledgeable employees for purposes of Rule 3c-5 depending on the relevant facts and circumstances relevant to an investment manager's particular business.

Footnotes

1. The term "Affiliated Management Person" is defined in Rule 3c-5 to mean an affiliated person that manages the investment activities of a fund relying on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. The SEC Staff has also permitted Section 3(c)(1) and Section 3(c)(7) funds to treat employees who participate in the investment activities of a company that is excluded from the definition of investment company by Section 3(c)(2), 3(c)(3) or 3(c)(11) as a knowledgeable employee. See PPM America Special Investments CBO II, L.P. SEC No-Action Letter (pub. Avail. April 16, 1998) and the ABA Letter,

2. Whether an individual provides analysis or advice that is material to the investment decisions of a portfolio manager is a facts and circumstances determination based on whether a reasonable person would consider such analysis or advice to be important to the investment decision. See TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976). Generally, however, the analysis or advice must be material to the merits of buying, selling, or holding an investment. The SEC Staff does not believe that reviews, analysis, or advice as to whether a potential investment is merely eligible for investment by the Covered Fund would be material to the investment decisions of a portfolio manager.

Originally published 20 February 2014

Visit us at mayerbrown.com

Mayer Brown is a global legal services provider comprising legal practices that are separate entities (the "Mayer Brown Practices"). The Mayer Brown Practices are: Mayer Brown LLP and Mayer Brown Europe – Brussels LLP, both limited liability partnerships established in Illinois USA; Mayer Brown International LLP, a limited liability partnership incorporated in England and Wales (authorized and regulated by the Solicitors Regulation Authority and registered in England and Wales number OC 303359); Mayer Brown, a SELAS established in France; Mayer Brown JSM, a Hong Kong partnership and its associated entities in Asia; and Tauil & Chequer Advogados, a Brazilian law partnership with which Mayer Brown is associated. "Mayer Brown" and the Mayer Brown logo are the trademarks of the Mayer Brown Practices in their respective jurisdictions.

© Copyright 2014. The Mayer Brown Practices. All rights reserved.

This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

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