The staff of the SEC’s Division of Investment Management (the “Staff”) provided additional guidance (the “Guidance”) on the scope of the “knowledgeable employee” category of investors who may be disregarded in determining whether or not a pooled investment vehicle (a “Private Fund”) may rely on the exclusion from the definition of investment company by Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the “1940 Act”). Rule 3c‑5 under the 1940 Act permits a knowledgeable employee of a Private Fund, or a knowledgeable employee of an affiliated person that manages the investment activities of a Private Fund (an “Investment Manager”), to invest in the Private Fund without (a) being counted for purposes of the 100-person limit if the Private Fund intends to rely on Section 3(c)(1) or (b) being a “qualified purchaser” if the Fund intends to rely on Section 3(c)(7). The Staff had previously provided guidance in this area in American Bar Association, SEC No-Action Letter (pub. avail. Apr. 22, 1999) (the “ABA Private Funds Letter”) and PPM America Special Investments CBO II, L.P., SEC No-Action Letter (pub. avail. Apr. 16, 1998) (the “PPM America Letter”).
Principal Business Unit Status
In part, the Guidance addresses the category of knowledgeable employee consisting of any “Executive Officer, director, trustee, general partner, advisory board member, or person serving in a similar capacity” of a Private Fund or its Investment Manager. “Executive Officer” means the “president, any 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 Private Fund or an Investment Manager. The Guidance provides confirmation of the following general interpretive principles relating to this category:
- “[W]hether a business unit, division, or function qualifies as a principal business unit, division, or function should be determined through an analysis by the investment manager of the relevant facts and circumstances regarding the investment manager’s business operations.”
- “While not all business units, divisions, or functions are necessarily principal, it is possible that several business units, divisions, or functions could each be a principal unit, division, or function depending on the facts and circumstances.”
- “[A] business unit, division, or function need not be part of the investment activities of a [Private] Fund in order to be considered principal, nor is the size of the investment manager or a particular department determinative as to whether a function should be considered principal.]”
The Guidance goes on to state that under the following circumstances, an Investment Manager’s information technology (“IT”) department or its investor relations department could be a principal business unit under Rule 3c‑5 such that the individual in charge of the unit could be a knowledgeable employee:
- The Investment Manager “employs one or more technologically driven trading models,” and its “IT professionals are charged with building the models and systems that translate certain quantitative signals into trade orders”; or
- The Investment Manager “employs technology professionals to build performance and risk monitoring systems that interact with the investment program.”
Investor relations personnel “conduct substantive portfolio reviews with investors and . . . respond to substantive due-diligence inquiries from institutional investors and consultants.” Principal business unit status would not, however, apply if the investor relations department “merely assisted in arranging meetings between an investment manager’s investment staff and prospective investors, disseminated investor communications written by senior executives outside of the investor-relations department, or performed other relatively administrative tasks.”
Executive Officer Status
The Guidance confirms that an individual can be an “Executive Officer” for purposes of Rule 3c-5 without having a senior officer title, provided the individual “makes policy through day-to-day involvement in the development and adoption of an investment manager’s policies.” The Guidance also provides that an individual may be an Executive Officer on the basis of participation in collective policy-making activity by serving as “an active member of a group or committee that develops and adopts an investment manager’s policies, such as the valuation committee.” The Guidance cautions, however, that “individuals who merely observe committee proceedings or merely provide information or analysis to the decision-makers of a committee or group would [not] be engaged in making policy and, therefore, such individuals generally would not be executive officers under the rule.”
Participation in Investment Activities
The Guidance also addresses a second category of knowledgeable employee defined in Rule 3c‑5(a)(4)(ii). This category consists of each employee of a Private Fund or its Investment Manager who, in connection with that person’s regular function or duties, participates in the investment activities of the Private Fund, other Private Funds, or investment companies whose investment activities are managed by the Investment Manager, provided that the employee has been performing those functions and duties for or on behalf of the Private Fund or the Investment Manager, or substantially similar functions or duties for or on behalf of another company for at least 12 months (a “Participating Employee”).
The Guidance revises the Staff’s views expressed in the ABA Private Funds Letter regarding the possible knowledgeable employee status of (a) certain research analysts and (b) personnel not directly charged with investment management responsibilities.
Research Analysts. The Guidance provides that a research analyst “who researches only a portion of the portfolio of a [Private] Fund and provides analysis or advice to the portfolio manager with respect to such portion of the [Private] Fund’s portfolio is participating in the investment activities of the [Private] Fund for purposes of the rule,” and “could be a knowledgeable employee under rule 3c-5(a)(4)(ii).” The ABA Private Funds Letter stated that “some research analysts (e.g., a research analyst who researches all potential portfolio investments and provides recommendations to the portfolio manager)” could be knowledgeable employees.
Non-Portfolio Management Employees. The Guidance provides that Investment Manager employees performing the following functions could be considered Participating Employees, provided they regularly perform such functions or duties and have been doing so for at least 12 months:
- Risk/Analytics - “a member of the analytical or risk team who regularly develops models and systems to implement the [Private] 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);”
- Trading - “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);”
- Tax – “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 [Private] Fund); and”
- Legal – “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 [Private] Fund’s governing documents).”
Knowledgeable Employee Status from Managing Separate Accounts. The Guidance provides that an employee of an Investment Manager may qualify as a knowledgeable employee under Rule 3(c)‑5(a)(4)(ii) on the basis of participation in “the investment activities of separate accounts (or a portfolio (or portion thereof) of a separate account) for clients that are ‘qualified clients’ [as defined in Rule 205-3 under the Investment Advisers Act of 1940] and are otherwise eligible to invest in the private funds advised by the [Investment Manager] and whose accounts pursue investment objectives and strategies that are substantially similar to those pursued by one or more of those private funds.” The Staff had previously provided guidance in the PPM America Letter that an employee of an Investment Manager could also be a knowledgeable employee on the basis of participating in the investment activities of a pooled investment vehicle that is excluded from the definition of investment company by Section 3(c)(2), 3(c)(3), or 3(c)(11) of the 1940 Act.
Employees of Filing and Relying Advisers
The Guidance provides that if a filing adviser and its relying adviser(s) (as defined below) collectively conduct a single advisory business and otherwise meet the conditions of American Bar Association, Business Law Section, SEC No-Action Letter (pub. avail. Jan. 18, 2012) (the “ABA Form ADV Letter”), then a knowledgeable employee of the filing adviser or any of its relying advisers that otherwise meets the applicable conditions may be treated as a knowledgeable employee with respect to any Private Fund managed by the filing adviser or any relying adviser. As discussed in the January 24, 2012 Financial Services Alert, the ABA Form ADV Letter permits an adviser (the “filing adviser”) to file a single Form ADV for itself and each other adviser that it controls or is under common control with (each such other adviser being a “relying adviser”) when, among other things, the filing and relying advisers (1) individually are eligible for federal investment adviser registration and (2) collectively conduct a single advisory business.
Knowledgeable Employee Determinations – Recordkeeping
The Guidance instructs investment managers to “maintain in their books and records a written record of employees the investment manager has permitted to invest in a [Private] Fund as knowledgeable employees and should be able to explain the basis in the rule pursuant to which the employee qualifies as a knowledgeable employee.”