By:
Mary Moran Zeven
New York
On October 11, 1996, President Clinton signed into law the National Securities Markets Improvement Act of 1996 (the "1996 Act"), which revised several aspects of the regulation of investment companies and which will take effect in April 1997.
Amendments to the Definition of Investment Company. Section 3(c)(1) of the Investment Company Act of 1940 (the "1940 Act") exempted from registration any fund that had no more than 100 investors and did not publicly offer its securities ("Section 3(c)(1) funds"). Certain shareholders of 3(c)(1) funds, such as companies, were "looked through" to their underlying investors for purposes of the 100 person limit in a complex analysis if any such shareholder acquired 10% of the fund's securities and, pursuant to a second 10% test, also invested 10% of its assets in one or more of these Section 3(c)(1) funds. Under the new legislation, Section 3(c)(1) of the 1940 Act is being amended with regard to the definition of investment company to eliminate the "look through" provisions associated with beneficial owners of more than 10% of the issuer's securities. Pursuant to the amendment, Section 3(c)(1) funds will no longer be required to count the underlying shareholders of its corporate, non-investment company investors under any circumstances.
Also, in response to the concerns about the small percentage of investors that historically relied on the second 10% test in order to avoid being looked through, the SEC has proposed Rule 3c-1 under the 1940 Act which provides that the amended "look through" provisions will not apply to funds or qualified purchaser pools that held more than 10% of the outstanding voting securities of a Section 3(c)(1) fund prior to April 1996, provided that such funds continue to satisfy the second 10% test as set forth in Section 3(c)(1) previously. In addition, the SEC has proposed a rule which provides that, for purposes of counting toward the 100 investor limit, certain transfers such as those pursuant to a gift, bequest, legal separation, divorce or other involuntary event will not cause a Section 3(c)(1) fund to exceed the 100 investor limit.
Exemption for Qualified Purchaser Pools. A new Section 3(c)(7) has been added to the 1940 Act to exclude from the definition of investment company private investment pools which are sold exclusively to highly sophisticated, "qualified purchasers" in a private offering. These new qualified purchaser pools, while prohibited from making public offerings, will not be required to limit their number of investors. A "qualified purchaser" is defined as (i) any natural person who owns at least $5 million in investments, (ii) trusts not formed for the specific purpose of acquiring the securities offered and which have settlors and trustees which meet such definition, (iii) family-owned companies that have at least $5 million in investments, and (iv) any other person, such as an institutional investor, that owns and manages on a discretionary basis at least $25 million in investments. Since all pool participants will have to be highly sophisticated, when purchasers, such as investment advisers, invest in the pool on behalf of clients, such clients will also have to meet the qualified purchaser requirements.
The SEC has proposed a new Rule 2a51-1 of the 1940 Act which would define "investments" for purposes of meeting the $5 million and $25 million asset thresholds for the Section 3(c)(7) definition of "qualified purchaser." "Investments" for purposes of this definition, would include
(i) securities (other than controlling interests in the case of most issuers);
(ii) real estate held for investment purposes;
(iii) physical commodities and futures contracts held for investment purposes (to the extent of initial margin and option premium deposited with a futures commission merchant); and
(iv) cash or cash equivalents held for investment purposes (excluding working capital).
While family-held businesses and personal residences would not be considered investments, interest in investment companies and other entities such as private investment companies, banks and insurance companies would not be excluded from the definition.
Foreign funds have historically also been able to rely on the Section 3(c)(1) exclusion to conduct a private offering in the United States. In a recent SEC no-action letter, Goodwin, Procter & Hoar, the SEC extended this doctrine to Section 3(c)(7) and indicated that foreign funds could also rely on Section 3(c)(7) to conduct private offerings in the United States. Moreover, the SEC Staff stated in Goodwin that the non-U.S. shareholders of a foreign fund relying on Section 3(c)(7) of the 1940 Act to conduct a private offering in the Untied States need not be "qualified purchasers." Thus, an offshore fund can have an unlimited number of U.S. persons who are qualified purchasers and an unlimited number of non-U.S. persons, regardless of whether they are qualified purchasers. For purposes of determining who is a U.S. person, the Goodwin no-action letter indicated that the definition of "U.S. person" in Regulation S, with some modifications, should be employed.
Funds that are currently relying on the exemption in Section 3(c)(1) may elect to be "grandfathered" or converted into a qualified purchaser pool under the provisions of Section 3(c)(7) if certain conditions are met. Specifically, if a fund currently has investors who are not qualified purchasers, these purchasers must have acquired their interests prior to September 1, 1996, and the fund is required to disclose the conversion to each investor and provide it with a reasonable opportunity to redeem its interests in the fund. The SEC also noted in Goodwin that a foreign fund need meet the notice and redemption requirements of the grandfather provisions of the 1940 Act only with respect to its U.S. resident investors.
Investments in Section 3(c)(7) funds by Private Funds. The 1996 Act provides that in order for an investment company or excepted investment company, such as a Section 3(c)(1) fund, to invest in a Section 3(c)(7) fund as a "qualified purchaser," such private fund must obtain the consent of its beneficial owners to be treated as a "qualified purchaser," under the theory that such investors must have an opportunity to review a potential change in the manner in which the private fund makes investments, i.e., by investing in qualified purchaser funds under Section 3(c)(7). The SEC has proposed Rule 2a51-2 which would clarify the definition of "beneficial owner" for purposes of this consent provision and would provide guidance regarding whether a private fund would have to look through its corporate, fund or institutional shareholders and seek the consent of the beneficial owners of such corporate, fund or institutional shareholders. The rule provides that, with certain exceptions, the securities of a private fund seeking qualified purchaser status that are owned by a corporation, institution or another fund generally will be deemed to be beneficially owned by one person (i.e., no look through for consent purposes).
Integration of Section 3(c)(1) funds and Section 3(c)(7) funds. The SEC has indicated that a Section 3(c)(1) fund and a bona fide Section 3(c)(7) fund operated by the same investment adviser will generally not be integrated for purposes of calculating the 100-investor limit for Section 3(c)(1) funds. The SEC has proposed Rule 3c-5 to the 1940 Act which would permit executive officers, directors, general partners and other knowledgeable employees who participate in the investment activities of a Section 3(c)(1) fund or of an affiliate of the fund to purchase securities of the issuer without being counted for purposes of the 100-person limit. The proposed rule would also permit such individuals to invest in a Section 3(c)(7) qualified purchaser pool without meeting the definition of a qualified purchaser.
The amendments to the definition of investment company will be effective on April 9, 1997. The proposed rules, with minor changes in response to comments received, will become effective in early June 1997.
Pre-Emption of State Regulation of Mutual Funds. Under the 1996 Act, the SEC was granted exclusive authority for the registration of investment company offerings and for securities offered or sold to qualified purchasers. Therefore, investment companies registered under the 1940 Act will no longer be required to register their shares in each of the states in which they propose to sell shares. However, the Investment Company Institute, the trade association of U.S. registered investment companies, has recommended that filings still be made with the states, but marked as "notice filings" only until proper filing regulations are finalized. The amendment to the 1940 Act also codifies certain state law exemptions for issuers whose securities are nationally traded on the New York Stock Exchange, American Stock Exchange or the NASDAQ National Market System, securities equal to or senior to such securities, and other types of securities which are exempt. The states will still be able to require notice filings and collect fees with respect to certain securities filings.
The amendment regarding pre-emption of state regulation of mutual funds was effective immediately upon signature of the legislation.
