In February, the SEC’s Division of Investment Management (the Division) issued a very helpful No-Action Letter to the Managed Funds Association that provided guidance on the definition of “knowledgeable employees” under the Investment Company Act of 1940 (as amended, the Investment Company Act). Generally, under Rule 3c-5 of the Investment Company Act (the Rule), a “knowledgeable employee” of a private fund (a Covered Fund), or a “knowledgeable employee of an affiliated person that manages the investment activities of a Covered Fund” is permitted to invest in a Covered Fund without being counted for purposes of the 100-person limit in Section 3(c)(1) of the Investment Company Act, regardless of whether the knowledgeable employee would be a “qualified purchaser” for purposes of Section 3(c)(7) of the Investment Company Act. As a result, the No-Action Letter generally expanded the pool of possible employee investors in Covered Funds by providing the following guidance: 

Executive Officers and Policy-Making Employees. The first category of “knowledgeable employees” of a Covered Fund includes any natural person who is an executive officer, director, trustee, general partner, or person serving in a similar capacity of a Covered Fund or the investment adviser of such Covered Fund. An “executive officer” is defined as (i) the president or a vice president of a “principal business unit, division or function”, or (ii) any other person who performs similar policy-making functions for a Covered Fund. The No-Action Letter provided guidance as to what parts of an adviser’s business may be deemed to be a “principal” unit, division or function, as well as clarifying the definition of “executive officers”: 

  • Principal Status. The Division noted that the “principal status” of an investment adviser’s business unit, division or function depends on the facts and circumstances and must be made on a case-by-case basis, further clarifying that while not all business units, divisions or functions are necessarily “principal”, it is possible that several business units, divisions or functions could be deemed to have “principal status” depending on the facts and circumstances. The No-Action Letter highlighted as an example that an investment adviser could determine that its IT and investor relations departments are principal business units, divisions or functions under certain circumstances and therefore, the individual(s) in charge of each such department may be deemed to be “knowledgeable employees”.
  • Executive Officers. Under the Rule, an “executive officer” is deemed to be any officer or other person who has the power to make, and actually makes, policy decisions on behalf of an investment adviser. In the No-Action Letter, the Division clarified that employees who serve policy-making functions may be deemed to be an “executive officer” regardless of their specific title. Specifically, an employee who does not have a senior management title may be still be deemed to be a “knowledgeable employee” under the Rule if he or she makes policy through the day-to-day involvement in the development and adoption of an investment adviser’s policies.

Participating in Investment Activities of a Covered Fund. The second category of “knowledgeable employees” of a Covered Fund includes any person who, in connection with his or her regular duties and functions, participates in the investment activities of such Covered Fund. The No-Action Letter clarified when an employee participating in the investment activities of a Covered Fund would be a “knowledgeable employee”: 

  • Participating in Part of a Portfolio. The No-Action Letter provided that an employee may be deemed to be “participating in the investment activities of a Covered Fund” even if his or her functions relate only to a portion of the portfolio of the Covered Fund, instead of the entire fund. As an example, a research analyst who researches and provides analysis and advice only with respect to a portion of the portfolio of a private fund may also be deemed to be a “knowledgeable employee”, as such analyst is participating in the investment activities of the Covered Fund. The ultimate determination of whether an individual “participates in the investment activities of a Covered Fund” is a factual determination that must be made on a case-by-case basis.
  • Separate Accounts. The Division further clarified that for purposes of the Rule, an employee that participates in the investment activities of separate accounts may be treated as a “knowledgeable employee”, notwithstanding the fact that such employees does not participate in the investment activities of a Covered Fund, so long as (i) the separate account is established for a client that is a “qualified client”, (ii) the separate account is otherwise eligible to invest in the private fund advised by the investment adviser, and (iii) the separate account pursues an investment strategy substantially similar to one pursued by one or more funds managed by the investment adviser.

The Division concluded by noting that investment advisers will be required to make determinations as to which employees qualify as “knowledgeable employees” based on the facts and circumstances relevant to their business. The Division further suggested that investment advisers should appropriately maintain, in their books and records, a written record of employees that are permitted to invest in a Covered Fund as a “knowledgeable employee” and the basis of such qualification as a “knowledgeable employee.” 

This expanded definition of “knowledgeable employees” may be helpful for investment advisers wanting to ensure their employees are able to invest in their funds without running afoul of the exemptions set forth in Section 3 of the Investment Company Act. We note that the analysis is very fact-specific, and each situation should be carefully reviewed in light of the new guidance.