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Published: 2008-03-26

Employee Investment in Private Funds



Last year, the SEC gave various employees of a private investment company or its manager essentially a "free pass" to invest in the company. SEC Rule 3c-5 allows certain "knowledgeable" employees to invest in a private fund excluded from investment company status under Section 3(c)(1) or Section 3(c)(7) without being counted towards the "100-person" limit of Section 3(c)(1), or without having to be a "qualified purchaser," if the fund relies on Section 3(c)(7). While the Rule has been welcomed for the increased flexibility it provides, fund managers have been uncertain about the Rule's scope.

The Rule applies only to "knowledgeable employees." A "knowledgeable employee" includes an executive officer of a private fund or the fund's manager, or an employee that "participates in investment activities" in connection with the operations of the fund or its manager, if the employee has performed services of this type for at least 12 months. An "executive officer" includes 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 the fund or its manager. Employees performing solely clerical, secretarial or administrative functions are not covered.

The Rule does not indicate whether a "knowledgeable employee" of a company affiliated with the fund (other than the fund's manager) or with the fund's manager may rely on its provisions. For example, is the chief executive officer of the fund manager's parent company a "knowledgeable employee?" Is an executive officer of a company under common control with the fund's manager a "knowledgeable employee?" While the responses to these questions depend ultimately on the particular facts and circumstances, the SEC staff has stated informally that "knowledgeable employees" generally will include executive officers of companies in a control relationship with a private investment company or its manager in certain cases. The staff also has stated informally that a person who "participates in investment activities" includes not only portfolio managers or research personnel of a fund or its manager, but also legal, accounting, trading and other service personnel as well, in certain cases.

In spite of this informal advice, questions continue to abound. Certain segments of the investment company community have clamored for more certain legal guidance from the staff regarding the scope of Rule 3c-5. In response, the staff has stated that it intends to issue an interpretive release, but exactly when is not clear. In the meantime, investment managers would be advised to take a cautious approach when allowing participation by employees under the "knowledgeable employees" standard. The SEC's determination to define "knowledgeable employees" to mean (except for executive officers) only employees who participate meaningfully in investment decision-making seems at odds with the fundamental federal securities law principle that a person who is in a position to make meaningful investment decisions does not need the protections of the federal securities law that registration affords. By this reckoning, an employee that would be considered "sophisticated" for purposes of participating in an offering relying on Section 4(2) of the Securities Act of 1933, without more, would not be considered a "knowledgeable employee" for purposes of Rule 3c-5. This could hardly be the right result.