SEC Liberalizes Rule 3c-5 Definition of “Knowledgeable Employee” for Private Funds

February 12, 2014


On February 6, 2014, the Securities and Exchange Commission’s Division of Investment Management staff (“SEC staff”) issued a no-action letter providing guidance on the definition of “Knowledgeable Employee” in Rule 3c-5 under the Investment Company Act of 1940 (“Company Act”). Rule 3c-5 allows Knowledgeable Employees of a private fund, or an affiliated person that manages the investment activities of a private fund (“Affiliated Management Person”), to acquire fund securities without being counted for purposes of the 100-person limit in Section 3(c)(1) of the Company Act or being a “qualified purchaser” for purposes of Section 3(c)(7) of the Company Act. In other words, the Rule allows certain employees of a private fund adviser to co-invest. By elaborating on the terms “Executive Officer,” “Policy-Making Employees” and “Participating Employees” as used within the definition of Knowledgeable Employee, the no-action letter provides guidance on which employees are eligible to invest. The no action letter (“MFA Letter”) is available here.

Executive Officers and Policy-Making Employees

Under Rule 3c-5, an Executive Officer—president, any vice president in charge of a principal business unit (division or function), and any other officer or person who performs a policy-making function—is a Knowledgeable Employee. The MFA Letter provides clarity on when a business unit qualifies for “principal” status as well as when a person performs a policy-making function on behalf of an investment manager.

Principal Business Unit

Regarding the principal status of a business unit, the MFA Letter confirms that:

  • the status depends on the facts and circumstances of a particular investment manager’s business operations;
  • several business units within an investment manager may each have a principal status;
  • a unit does not need to be part of the investment activities of the investment manager’s private fund to be considered principal; and
  • the size of an investment manager or a particular unit is not determinative in the status consideration.

In a 1999 no-action letter to the American Bar Association (the “1999 ABA Letter”),[1] the SEC staff indicated that investor relations professionals and others employed in a non-executive capacity generally would not qualify as Executive Officers or Knowledgeable Employees. The MFA Letter expands the scope of “Executive Officer,” providing that an investment manager’s information technology and investor relations departments could be principal business units under certain circumstances and that the individual in charge of each such unit, as a result, could be considered a Knowledgeable Employee.

Policy-Making Function

The MFA Letter confirms that Rule 3c-5 applies to all individuals who have the power to, and do, make policies, regardless of such individual’s title. Furthermore, the no-action letter provides that the policy-making function does not need to be concentrated in one individual; an employee serving as an active member of a policy-making group or committee could be an Executive Officer, and thus, a Knowledgeable Employee under the rule.

Participating Employees

Under Rule 3c-5, Knowledgeable Employees include employees of a private fund who have participated in the investment activities of such fund (other than in a clerical, secretarial, or administrative capacity) for at least one year, or are currently participating in the investment activities of the fund and have at least one year of similar experience at another company (“Participating Employees”). The MFA Letter clarifies the scope of Participating Employees, expands the investment eligibility for employees not participating in the investment activities of the private fund itself, and allows Knowledgeable Employees of an adviser filing Form ADV, or any of its relying advisers that manages a private fund, to qualify as Knowledgeable Employees of the private fund.

Scope of Participating Employees

In the 1999 ABA Letter, the SEC staff stated that whether an employee could be considered a Participating Employee was a case-by-case, factual determination. It allowed that “some research analysts (e.g., a research analyst who researches all potential portfolio investments and provides recommendations to the portfolio manager)” would qualify as Knowledgeable Employees. However, it generally excluded from the definition of Knowledgeable Employee traders; attorneys; and financial, compliance, operational, and accounting officers who are employed in a non executive capacity. The SEC staff noted that such employees generally would not be participating in the investment activities of the private fund as distinguished from, for example, merely “obtain[ing] information” regarding such activities.

In the MFA Letter, the SEC staff has provided greater guidance for identifying Participating Employees. It confirms 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 is also a Participating Employee. Moreover, the SEC staff confirms that the following individuals could be considered Participating Employees, depending on the facts and circumstances:

  • member of the analytical or risk team;
  • a trader or a tax professional who is regularly consulted for analysis or advice; and
  • an attorney whose analysis or advice of legal terms and provisions of investments is material to the portfolio manager’s investment decisions.

The SEC staff specifically states that an individual seeking to qualify as a Participating Employee, and hence, a Knowledgeable Employee, is still subject to the requirement that the employee regularly performs such functions and has been doing so for at least 12 months.

Separate Accounts

The SEC staff has previously allowed that employees participating 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) of the Company Act could be considered Participating Employees.

The MFA Letter extends this allowance to employees participating in the investment activities of a separate account. The SEC staff confirms that an employee of an Affiliated Management Person who participates in the investment activities of a separate account (or a portfolio or portion of a separate account) may also qualify as a Participating Employee eligible for investment in a private fund if:

  • the separate account is established for a “qualified client”;[2]
  • the employee is otherwise eligible to invest in the private fund that is being advised by the Affiliated Management Person; and
  • the account pursues investment objectives and strategies that are substantially similar to those pursued by one or more of the private funds advised by the investment manager or the Affiliated Management Person.

Affiliated Management Person

The MFA Letter clarifies the scope of an Affiliated Management Person with respect to an adviser and its relying advisers. The SEC staff, in a January 18, 2012 no-action letter to the ABA, permitted an investment adviser, under certain circumstances, to file a single Form ADV on behalf of itself and each relying adviser controlled by or under common control of the filing adviser as part of a single advisory business (please see our prior alert here).[3] If a private fund is managed by the filing adviser or any of its relying advisers, then each of the filing adviser and relying advisers may be considered an Affiliated Management Person of the private fund. Accordingly, Knowledgeable Employees of a filing adviser and its relying advisers may be treated as Knowledgeable Employees of the private fund, provided that the employees meet the other conditions of Rule 3c-5.

Other Employees

The SEC staff does not intend for the Knowledgeable Employees discussed in the MFA Letter to be exclusive; other employees may also qualify as Knowledgeable Employees under Rule 3c-5 depending on the facts and circumstances.

O’Melveny & Myers LLP is assisting fund clients with analysis of and compliance with the Rule 3c-5. For questions or additional information regarding your obligations under the Rule, please contact your O’Melveny attorney or Heather Traeger at htraeger@omm.com or (202) 383-5232.

[1] See American Bar Association Section of Business Law, SEC No-Action Letter (Apr. 22, 1999).
[2] “Qualified client” is defined in Rule 205-3 under the Investment Advisers Act of 1940.
[3] See American Bar Association Section of Business Law, SEC No-Action Letter (Jan. 18, 2012).

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Heather Traeger, an O'Melveny partner licensed to practice law in the District of Columbia and Texas, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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