United States: Registered Fund with Performance Fee may Permit Share Transfers to Persons Who Are Not Qualified Clients

Co-authored by Mr Reuben Kopel

In a recent no-action letter issued to J. & W. Seligman & Co. Incorporated ("Seligman") and Seligman New Technologies Fund II, Inc. (the "Fund"), a registered investment company, the staff of the Division of Investment Management (the "Staff") of the Securities and Exchange Commission (the "SEC") stated that it would not recommend enforcement action to the SEC under Section 205 of the Investment Advisers Act of 1940 (the "Advisers Act") if Seligman is paid a performance fee by the Fund notwithstanding the fact that certain Fund shareholders who acquired their shares by means of a permitted transfer of shares by other shareholders are not "qualified clients" as defined by Rule 205-3 under the Advisers Act. This position means that registered investment companies that pay performance fees (or make performance-based incentive allocations) to their investment advisers may now have the option of permitting investors to transfer their shares (or interests) to persons who would not themselves be eligible to invest directly in the companies. Providing this additional flexibility to investors has the potential to enhance the attractiveness of registered investment companies that have performance-based fees or allocations to the extent that investors may be given greater latitude in transferring their investments to family members and others for estate planning and other purposes.

Section 205 of the Advisers Act generally prohibits a registered investment adviser from entering into, extending or renewing, or in any way performing, any investment advisory contract with a client if the contract provides for compensation to the adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client (a "Performance Fee"). However, Rule 205-3 under the Advisers Act permits the use of a Performance Fee in an advisory contract if, among other things, the client entering into the contract is a "Qualified Client." Rule 205-3 defines a Qualified Client to include: (1) a natural person or company that immediately after entering into the advisory contract has at least $750,000 under the management of the investment adviser; (2) a natural person or company that the investment adviser reasonably believes, immediately prior to entering into the contract, either has a net worth of more than $1,500,000 at the time the contract is entered into, or is a "qualified purchaser" as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940 (the "1940 Act"); and (3) a natural person who is an executive officer, director, trustee or general partner of the adviser, or an employee of the adviser who, in connection with his or her regular duties participates in the adviser's investment activities and has been performing those duties for the adviser, or performing substantially similar duties for another company, for at least 12 months. Where the client to be charged a Performance Fee is an investment company registered under the 1940 Act or a private investment fund relying on Section 3(c)(1) of the 1940 Act, Rule 205-3 requires a "look through" to the equity owners of the company or fund for purposes of applying the client eligibility requirement of the Rule. Because the Section 205 prohibition on Performance Fees does not apply to Section 3(c)(7) private investment funds, Rule 205-3 has no applicability to Performance Fees of those funds.

In order to comply with Rule 205-3, registered investment companies and Section 3(c)(1) private investment funds that have Performance Fees must restrict their investors to persons who are Qualified Clients. Moreover, registered investment companies and Section 3(c)(1) private funds that pay Performance Fees, typically impose various restrictions to ensure that shares (or interests) are not transferred to persons who are not Qualified Clients.

The Fund is registered under the 1940 Act as a non-diversified, closed-end, management investment company. Seligman, a registered investment adviser, serves as the Fund's investment adviser. Under the investment advisory contract between the Fund and Seligman, the Fund pays a fixed management fee as well as a Performance Fee. Shares of the Fund were sold to investors in an initial public offering, but are not listed for trading on any securities exchange and are not traded in any secondary market. To provide liquidity to shareholders, the Fund offers to repurchase its shares on a quarterly basis in reliance on Rule 23c-3 under the 1940 Act (known as the interval fund rule).

In conducting the offering of its shares, the Fund took steps to ensure that shares were sold only to investors who were Qualified Clients. It did this by requiring all investors purchasing shares to certify as to their Qualified Client status. In addition, to assure ongoing compliance with the Qualified Client requirement of Rule 205-3, the Fund implemented transfer restrictions and other procedures.

Seligman and the Fund advised the Staff that, during the initial offering of the Fund's shares, several prospective investors had commented that they were concerned about the effect the Fund's transfer restrictions would have on their ability to make gifts or bequests of shares. The transfer restrictions could, in the opinion of Seligman and the Fund, also dissuade shareholders, as well as potential new investors, from acquiring shares in future offerings by the Fund and influence the decisions of shareholders as to whether to tender their shares in connection with the Fund's quarterly repurchase offers. Seligman and the Fund expressed concern that, although existing transfer restrictions were clearly disclosed in the prospectus under which Fund shares were offered to investors, the restrictions on transfer may give rise to shareholder relations problems if shareholders continue to be prohibited from effecting certain transfers of shares that they might wish to effect for estate planning purposes or for purposes of divorce settlements.

For these reasons, Seligman and the Fund wished to ease the transfer restrictions by permitting certain types of transfers of shares without regard to whether the transferee is a Qualified Client ("Permitted Transfers"). These Permitted Transfers would include transfers to: (1) persons by way of a gift, bequest, or pursuant to an agreement related to a legal separation or divorce; (2) a shareholder's estate; and (3) a company established by the shareholder exclusively for the benefit of (or owned exclusively by) the shareholder, the shareholder's estate and/or persons described in (1) above (collectively, "Permitted Transferees"). Because Permitted Transferees could include persons who are not Qualified Clients, Seligman and the Fund requested the Staff's assurance that it would not recommend enforcement action under Section 205(a) of the Advisers Act if, as a result of Permitted Transfers, certain shareholders of the Fund were not Qualified Clients.

Seligman and the Fund stated that the requested relief was not intended to provide a means for Seligman or investors to circumvent the purposes of Section 205(a) or the requirements of Rule 205-3. They also stated that Seligman would comply with Section 205 and Rule 205-3 in performing under, renewing or extending the terms of the Fund's advisory contract, with the exception that Permitted Transferees may be Fund shareholders. Under the proposal, a Permitted Transferee holding shares of the Fund would be allowed to effect a Permitted Transfer, but would not be permitted to purchase additional Fund shares unless he or she was a Qualified Client at the time of purchase.

In their request for no-action relief, Seligman and the Fund noted that Rule 205-3 requires that "the client entering into the contract" be a Qualified Client. They also noted, however, that neither the Rule, nor SEC releases proposing or adopting the Rule or amendments to the Rule, address the question of when an investor in a fund should be deemed for purposes of Rule 205-3 to enter into a contract with the fund's adviser. If a transferee is deemed to enter into a contract at the time of the transfer, a transfer to a person who is not a Qualified Client could be deemed to violate the Rule. In this regard, Seligman and the Fund asserted that an investor in a fund should be deemed to enter into a contract with the fund's adviser at the time shares are purchased. They observed that it is the purchaser who makes the investment decision and thus, that it is the purchaser of a fund's shares whom Rule 205-3 is intended to protect by requiring that the client be a Qualified Client, rather than a Permitted Transferee who is essentially a passive assignee of an existing advisory contract. Seligman and the Fund acknowledged that Permitted Transferees might not have the same degree of sophistication in financial matters as Qualified Clients, and might not fully understand the implications of a Performance Fee, but argued that Permitted Transferees do not need the protection of Section 205(a) of the Advisers Act because they are not putting their own money at risk or making investment decisions in connection with Permitted Transfers.

The Staff advised Seligman and the Fund that, based on the facts and representations set forth in their letter, and without necessarily agreeing with their legal analysis, it would not recommend enforcement action to the SEC if Seligman performs under, renews or extends its advisory contract with, the Fund notwithstanding that Permitted Transferees are Fund shareholders. This position was expressly based on representations that: (1) no person, including a Permitted Transferee, may purchase shares of the Fund unless the person is a Qualified Client at the time of the purchase; (2) Seligman will comply with Section 205 of the Advisers Act and Rule 205-3 in performing under, renewing or extending the terms of the advisory contract, with the exception that Permitted Transferees may be Fund shareholders; and (3) the Fund will not submit any matter relating to an increase in, or material amendment requiring share-holder vote to, the Performance Fee provisions of the advisory contract unless all of Seligman's clients (within the meaning of Rule 205-3) subject to the advisory contract are Qualified Clients as of the record date for the vote.

It is significant that, in taking its no-action position, the Staff stated that any different facts or representations may require a different conclusion. Moreover, the Staff noted that its response expressed the position of the Division of Investment Management on enforcement action only and did not purport to express any legal or interpretive conclusion on the issue presented.

The clear implication of the Staff's position is that registered investment companies that have sold shares in public offerings and have Performance Fees may allow investors to effect transfers of shares by means of gift or bequest, or pursuant to the terms of agreements related to a legal separation or divorce, to persons who are not Qualified Clients. Such companies may also permit transfers of shares to a shareholder's estate and transfers to companies established by the shareholder exclusively for the benefit of (or owned exclusively by) certain persons without requiring the transferees to be Qualified Clients. What remains unclear is whether registered investment companies that have not made public offerings (and have offered shares in private placements) and Section 3(c)(1) private investment funds may allow these types of transfers by investors because the Staff's no-action response is a position on enforcement action only and is specifically based on the facts presented to it by Seligman and the Fund.

An investment company seeking to rely on the Staff's position must consider the potential implications of the requirement that any increase in, or a material amendment requiring a shareholder vote to, the Performance Fee provisions of an advisory contract not be submitted for shareholder approval unless all shareholders as of the record date for the shareholder vote are Qualified Clients. This requirement raises the issue of how a Performance Fee can be modified if, as a result of Permitted Transfers, shares (or interests) are held by persons who are not Qualified Clients. Presumably, the only option at such time would be to compel the mandatory redemption of shares (or interests) held by those persons. The ability to effect such a mandatory redemption would depend on the provisions of the company's governing organization documents (i.e., its declaration of trust, articles of incorporation, limited partnership agreement or limited liability company operating agreement).

In addition, the Staff's position applies only to performing under, renewing or extending an advisory contract and thus, would not be applicable in a situation where an investment company is seeking share-holder approval of a new advisory contract. It is important in this regard to recognize that an advisory contract with a registered investment company must provide for its automatic termination in the event of its assignment. Thus, in the event of the acquisition of an investment company's adviser (or another transaction involving a transfer of a controlling block of the adviser's stock), which would trigger an assignment, the investment company would be unable to seek shareholder approval of a new advisory agreement unless it first compelled a mandatory redemption of all shares (or interests) held by Permitted Transferees who are not Qualified Clients.

For the reasons discussed, the Staff's position may only be of limited benefit. Moreover, registered investment companies eligible to rely on the Staff's position will have to weigh carefully the potential implications of permitting transfers to persons who are not Qualified Clients against the potential benefits of allowing Permitted Transfers by their investors.