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 non- executive 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 non- executive 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 manager2 (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.