17512 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

SECURITIES AND EXCHANGE

COMMISSION

17 CFR Part 270

[Release No. IC–22597, International Series

Release No. 1071, File No. S7–30–96]

RIN 3235–AH09

Privately Offered Investment

Companies

AGENCY: Securities and Exchange

Commission

ACTION: Final rules.

SUMMARY: The Commission is adopting

rules under the Investment Company

Act of 1940 to implement provisions of

the National Securities Markets

Improvement Act of 1996 that apply to

privately offered investment companies.

The rules define certain terms for

purposes of the new exclusion from

regulation under the Investment

Company Act for privately offered

investment companies whose investors

are all highly sophisticated investors,

termed ‘‘qualified purchasers.’’ The

rules also address certain transition

issues relating to existing privately

offered investment companies that have

no more than 100 investors and other

matters concerning privately offered

investment companies.

EFFECTIVE DATE: The rules become

effective on June 9, 1997.

FOR FURTHER INFORMATION CONTACT:

David P. Mathews, Senior Counsel,

Nadya B. Roytblat, Assistant Office

Chief, or Kenneth J. Berman, Assistant

Director, at (202) 942–0690, Office of

Regulatory Policy, Division of

Investment Management, Mail Stop 10–

2, Securities and Exchange Commission,

450 Fifth Street, N.W., Washington, D.C.

20549. Requests for formal

interpretative advice should be directed

to the Office of Chief Counsel at (202)

942–0659, Division of Investment

Management, Securities and Exchange

Commission, 450 Fifth Street, N.W.,

Mail Stop 10–6, Washington, D.C.

20549.

SUPPLEMENTARY INFORMATION: The

Commission today is adopting rules

2a51–1, 2a51–2, 2a51–3, 3c–1, 3c–5 and

3c–6 [17 CFR 270.2a51–1, .2a51–2,

.2a51–3, .3c–1, .3c–5 and .3c–6] under

the Investment Company Act of 1940

[15 U.S.C. 80a] (the ‘‘Investment

Company Act’’ or ‘‘Act’’).

Table of Contents:

Executive Summary

I. Background

A. Statutory Exclusions for Privately

Offered Funds

B. Amendments to Section 3(c)(1)

C. The Commission’s Rule Proposals

II. Rules Relating to Section 3(c)(7) Funds

A. Investments and Other Matters

1. Qualified Institutional Buyers as

Qualified Purchasers

2. Definition of Investments

a. Securities

b. Real Estate

c. Commodity Interests, Commodities and

Financial Contracts

d. Cash and Cash Equivalents

e. Other Types of Investments

3. Determining the Amount of Investments

a. Value of Investments

b. Deductions from Amount of Investments

i. Certain Indebtedness

ii. Other Payments

4. Jointly Held Investments

5. Investments Held by Certain Affiliated

Entities

6. Reasonable Belief

7. Retirement Plans and Other Forms of

Holding Investments

8. Pension and Retirement Plans as

Qualified Purchasers

9. Other Issues Relating to Qualified

Purchasers

B. Definitions of Beneficial Ownership and

Other Issues Relating to the Grandfather

and Consent Provisions

1. The Grandfather Provision

a. Background

b. Operation of the Rule

c. Interpretative Issues Relating to the

Grandfather Provision

i. Scope of the Grandfather Provision

ii. ‘‘Net Assets’’

2. The Consent Provision

a. Definition of Beneficial Owner

b. Required Consent

C. Conforming Rule

D. Non-Exclusive Safe Harbor for Certain

Section 3(c)(7) Funds

III. Other Rules Relating to Privately Offered

Funds

A. Section 3(c)(1) Funds

1. Transition Rule

2. Applicability of the Amended LookThrough Provision

B. Investments by Knowledgeable

Employees

C. Involuntary Transfers

IV. Cost/Benefit Analysis and Effects on

Competition, Efficiency and Capital

Formation

V. Summary of Regulatory Flexibility

Analysis

VI. Statutory Authority

Text of Rules

Executive Summary

The Commission is adopting rules to

implement certain provisions of the

National Securities Markets

Improvement Act of 1996 (the ‘‘1996

Act’’). The 1996 Act, among other

things, added section 3(c)(7) to the

Investment Company Act to create a

new exclusion from regulation under

the Act for privately offered investment

companies that sell their securities

solely to ‘‘qualified purchasers’’ owning

or investing on a discretionary basis a

specified amount of ‘‘investments’’

(‘‘Section 3(c)(7) Funds’’). The 1996 Act

also amended section 3(c)(1) of the

Investment Company Act, which

excludes from regulation under the Act

privately offered investment companies

with 100 or fewer ‘‘beneficial owners’’

(‘‘Section 3(c)(1) Funds’’). Reflecting a

relationship between section 3(c)(1) and

new section 3(c)(7), the 1996 Act

contains provisions that permit an

existing Section 3(c)(1) Fund to convert

into a Section 3(c)(7) Fund or invest in

a Section 3(c)(7) Fund as a qualified

purchaser, subject to certain

requirements designed to protect the

Section 3(c)(1) Fund’s existing

‘‘beneficial owners.’’

The 1996 Act requires the

Commission to prescribe rules defining

the terms ‘‘investments’’ and ‘‘beneficial

owner’’ relevant to the new provisions

by April 9, 1997. Other changes to the

provisions of the Investment Company

Act relating to privately offered

investment companies require

Commission rulemaking as well. The

Commission is adopting rules under the

Investment Company Act that:

• Define the term ‘‘investments’’ for

purposes of the qualified purchaser

definition;

• Define the term ‘‘beneficial owner’’

for purposes of the provisions that

permit an existing Section 3(c)(1) Fund

to convert into a Section 3(c)(7) Fund or

to be treated as a qualified purchaser;

• Clarify certain interpretative issues

under section 3(c)(7);

• Permit certain Section 3(c)(1) Funds

to rely on the pre-1996 Act provisions

of section 3(c)(1) rather than restructure

their existing relationships with

investors;

• Permit knowledgeable employees of

a Section 3(c)(1) Fund or a Section

3(c)(7) Fund (referred to collectively in

this Release as ‘‘privately offered funds’’

or ‘‘funds’’), and knowledgeable

employees of certain affiliates of these

Funds, to invest in the Funds; and

• Address transfers of securities in a

privately offered fund when the transfer

was a gift or caused by divorce or death.

The rules reflect modifications

suggested by commenters that are

designed to make the rules less complex

and easier to apply, consistent with the

policies underlying the Investment

Company Act and the 1996 Act’s

provisions relating to privately offered

funds.

I. Background

A. Statutory Exclusions for Privately

Offered Funds

Section 3(c)(1) of the Investment

Company Act excludes from regulation

under the Act certain privately offered

investment companies ‘‘whose
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17513

1 15 USC 80a-3(c)(1). In addition, the Section

3(c)(1) Fund must be an issuer that ‘‘is not making

and does not presently propose to make a public

offering of its securities.’’ Id.

2See Division of Investment Management, SEC,

Protecting Investors: A Half Century of Investment

Company Regulation (hereinafter Protecting

Investors Report) at 104 (1992).

3The National Securities Markets Improvement

Act of 1996, Pub. L. No. 104–290 (1996) (codified

in scattered sections of the United States Code).

4 15 U.S.C. 80a-3(c)(7). For the history of the

development of section 3(c)(7), see Private

Investment Companies, Investment Company Act

Release No. IC–22405 (Dec. 18, 1996) [61 FR 68100

(Dec. 26, 1996)] (hereinafter Proposing Release) at

nn.3–9 and accompanying text.

5Section 3(c)(7) of the Act. While the legislative

history of the 1996 Act does not explicitly discuss

section 3(c)(7)’s limitation on public offerings by

Section 3(c)(7) Funds, the limitation appears to

reflect Congress’s concerns that unsophisticated

individuals not be inadvertently drawn into a

Section 3(c)(7) Fund. See The Investment Company

Act Amendments of 1995: Hearing on H.R. 1495

before the Subcomm. on Telecommunications and

Finance of the Comm. on Commerce, House of

Representatives, 104th Cong., 1st Sess. 53 (1995)

(hereinafter House Hearings) (testimony of Matthew

P. Fink, President, Investment Company Institute,

urging that section 3(c)(7) include a public offering

limitation). Section 3(c)(1)’s limitation on public

offerings has been interpreted to permit

‘‘transactions by an issuer not involving any public

offering’’ under section 4(2) of the Securities Act of

1933 (‘‘Securities Act’’) [15 U.S.C. 77d(2)]. See, e.g.,

Engelberger Partnerships (Dec. 7, 1981). The

Commission believes that section 3(c)(7)’s public

offering limitation should be interpreted in the

same manner as the limitation in section 3(c)(1).

6Section 2(a)(51)(A)(i) of the Act [15 U.S.C. 80a2(a)(51)(A)(i)]. The 1996 Act directed the

Commission to prescribe rules defining the term

‘‘investments’’ by April 9, 1997. 15 U.S.C. 80a–2

note.

7A Family Company is a company ‘‘that is owned

directly or indirectly by or for 2 or more natural

persons who are related as siblings or spouse

(including former spouses), or direct lineal

descendants by birth or adoption, spouses of such

persons, the estates of such persons, or foundations,

charitable organizations, or trusts established by or

for the benefit of such persons * * * *’’ Section

2(a)(51)(A)(ii) of the Act [15 U.S.C. 80a2(a)(51)(A)(ii)].

8A trust may be a qualified purchaser if (i) it was

not formed for the specific purpose of acquiring the

securities offered, and (ii) the trustee or other

person authorized to make decisions with respect

to the trust, and each settlor or other person who

has contributed assets to the trust, are qualified

purchasers. Section 2(a)(51)(A)(iii) of the Act [15

U.S.C. 80a-2(a)(51)(A)(iii)].

9A qualified purchaser that meets the $25 million

threshold may act for its own account or for the

accounts of other qualified purchasers. See section

2(a)(51)(A)(iv) of the Act [15 U.S.C. 80a2(a)(51)(A)(iv)].

10 15 U.S.C. 80a–3(c)(7)(B).

11Section 3(c)(7)(B)(i)(I) of the Act [15 U.S.C.

80a–3(c)(7)(B)(i)(I)].

12See S. Rep. No. 293, 104th Cong., 2d Sess. 23

(1996) (hereinafter Senate Report); H.R. Rep. No.

622, 104th Cong., 2d Sess. 51 (1996) (hereinafter

House Report). These Reports relate to bills that

were eventually enacted as the 1996 Act.

13Section 3(c)(7)(B)(ii) of the Act [15 U.S.C. 80a–

3(c)(7)(B)(ii)].

14 15 U.S.C. 80a–3 note.

15Section 2(a)(51)(C) of the Act [15 U.S.C. 80a–

2(a)(51)(C)].

16 15 U.S.C. 80a–3(c)(1)(A). Section 2(a)(42) of the

Investment Company Act [15 U.S.C. 80a–2(a)(42)]

defines a voting security as any security ‘‘presently

entitling the owner or holder thereof to vote for the

election of a company.’’ See Thomas P. Lemke and

Gerald T. Lins, Private Investment Companies

Under Section 3(c)(1), 44 Bus. Law. 401, 416–18

(Feb. 1989) (discussing the types of non-voting

interests that have been treated as voting securities).

17The 1996 Act was signed into law by President

Clinton on October 11, 1996. The provisions

relating to privately offered funds do not become

effective until the earlier of April 9, 1997 or the date

on which the rule defining the term investments is

published in the Federal Register. For purposes of

convenience, this Release assumes that the

amendments to section 3(c)(1) are now effective.

18To illustrate the operation of the pre-1996 Act

Look-Through Provision, assume Company A is

seeking to rely on section (3)(c)(1). If one of

Company A’s security holders, Company B,

beneficially owned 10% or more of Company A’s

voting securities (the First 10% Test), then the

security holders of Company B would have been

counted as security holders of Company A, unless

no more than 10% of Company B’s assets consisted

of securities of Section 3(c)(1) Funds (the Second

10% Test). The operation of the pre-1996 Act LookThrough Provision also is relevant to determining

who is a beneficial owner of a Section 3(c)(1)

Fund’s securities for purposes of the Grandfather

and Consent Provisions. See section II.B. of this

Release.

19This approach recognizes that an investment in

a Section 3(c)(1) Fund by a company that is not

itself an investment company generally does not

Continued

outstanding securities (other than shortterm paper) are beneficially owned by

not more than one hundred persons.’’ 1

A wide variety of investment vehicles

rely on section 3(c)(1), ranging from

small groups of individual investors,

such as investment clubs, to venture

capital and other investment pools

designed primarily for sophisticated

investors. 2

The 1996 Act 3 added new section

3(c)(7) of the Investment Company Act

to create an alternative exclusion for

investment companies that sell their

securities solely to investors who are

‘‘qualified purchasers.’’ 4 As is the case

for a Section 3(c)(1) Fund, a Section

3(c)(7) Fund cannot make, or propose to

make, a public offering of its securities. 5

New section 2(a)(51)(A) of the

Investment Company Act defines the

term qualified purchaser as (i) any

natural person who owns not less than

$5 million in investments (as defined by

the Commission), 6 (ii) a family-owned

company (‘‘Family Company’’) that

owns not less than $5 million in

investments, 7 (iii) certain trusts, 8 and

(iv) any other person (e.g., an

institutional investor) that owns and

invests on a discretionary basis not less

than $25 million in investments.9

Section 3(c)(7)(B) includes a

‘‘grandfather’’ provision (‘‘Grandfather

Provision’’) that permits an existing

Section 3(c)(1) Fund to convert into a

Section 3(c)(7) Fund (‘‘Grandfathered

Fund’’).10 The outstanding securities of

a Grandfathered Fund may be

beneficially owned by as many as 100

persons that are not qualified

purchasers, provided that these persons

acquired the securities of the

Grandfathered Fund on or before

September 1, 1996.11 The Grandfather

Provision is designed to allow an

existing Section 3(c)(1) Fund wishing to

avail itself of section 3(c)(7) to continue

its existing relationships with investors

that are not qualified purchasers.12

The Grandfather Provision requires

the Grandfathered Fund, prior to the

conversion, to provide each beneficial

owner of its securities (i) notice of the

Fund’s intention to become a Section

3(c)(7) Fund and (ii) an opportunity to

redeem the owner’s interest in the

Fund.13 The 1996 Act directs the

Commission to define the term

‘‘beneficial owner’’ for this purpose.14

The 1996 Act also requires an existing

privately offered fund that wishes to

become a qualified purchaser to obtain

the consent of certain beneficial owners

of its securities and certain other

persons (the ‘‘Consent Provision’’).15

B. Amendments to Section 3(c)(1)

To prevent circumvention of the 100-

investor limit, section 3(c)(1)(A) (the

‘‘Look-Through Provision’’) requires, in

some instances, that a fund seeking to

rely on section 3(c)(1) ‘‘look through’’

certain companies (e.g., corporations,

partnerships and other investors that are

not natural persons) that hold its voting

securities and count the company’s

security holders as beneficial owners of

the fund’s securities.16 Prior to the 1996

Act,17 the Look-Through Provision

applied (i) if a company owned 10% or

more of a Section 3(c)(1) Fund’s voting

securities (‘‘First 10% Test’’) and (ii)

more than 10% of the company’s total

assets consisted of securities of Section

3(c)(1) Funds generally (‘‘Second 10%

Test’’).18

The 1996 Act’s amendments to

section 3(c)(1) were designed, in part, to

simplify the way in which the number

of investors in a fund is calculated for

purposes of the 100-investor limit. The

amended Look-Through Provision does

not apply to an investor that is an

operating company. In other words, a

Section 3(c)(1) Fund must only look

through an investor to count its

shareholders if the investor is an

investment company or a privately

offered fund.19 In addition, the Second
17514 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

implicate the concerns that the Look-Through

Provision was intended to address—that the

investor may be a conduit that was created to

enable a Section 3(c)(1) Fund to have indirectly

more than 100 investors. See The Securities

Investment Promotion Act of 1996: Hearing on S.

1815 before the Senate Comm. on Banking, Housing

and Urban Affairs, 104th Cong., 2d Sess. 40 (1995)

(testimony of Arthur Levitt, Chairman, SEC).

20This change reflects the view that the private

nature of a Section 3(c)(1) Fund may be brought

into question when an investment company has a

substantial investment in the Section 3(c)(1) Fund.

See, e.g., Protecting Investors Report, supra note 2,

at 106–09. See section III.A.2 of this Release for a

discussion of when a Section 3(c)(1) Fund should

determine whether an investor is subject to the

amended Look-Through Provision.

21Proposing Release, supra note 4.

22 15 U.S.C. 80a–3 note. The purpose of this

provision appears to be to allow privately offered

funds to offer persons who participate in the funds’

management the opportunity to invest in the fund

as a benefit of employment. See House Hearings,

supra note 5, at 22–23 (testimony of Barry P.

Barbash, Director, Division of Investment

Management, SEC).

23 15 USC 80a–3 note.

24 15 USC 80a–3(c)(1)(B).

25See section 3(c)(7)(A) of the Act [15 USC 80a–

3(c)(7)(A)] (permitting certain transfers by qualified

purchasers).

26The 1996 Act provides that the term

investments is to be defined by Commission rule.

15 USC 80a–2 note. Section 2(a)(51)(B) of the Act

[15 USC 80a–2(a)(51)(B)] also gives the Commission

authority to prescribe such rules and regulations

governing qualified purchasers as the Commission

determines are necessary or appropriate in the

public interest or for the protection of investors.

27 17 CFR 230.144A(a). In each case, the QIB must

be acting for its own account or the account of

another QIB.

28Rule 2a51–1(g)(1) [17 CFR 270.2a51–1(g)(1)].

The QIB must be acting for its own account, the

account of another QIB or the account of a qualified

purchaser. A person’s status as a QIB would be

determined based on QIB Securities, not

investments as defined by rule 2a51–1.

29Rule 144A(a)(1)(ii) [17 CFR 230.144A(a)(1)(ii)].

30Rule 2a51–1(g)(1)(i) [17 CFR 270.2a51–

1(g)(1)(i)]. A dealer that does not own and invest on

a discretionary basis $25 million of QIB Securities

could still be a qualified purchaser if the dealer

owns and invests on a discretionary basis $25

million of investments, determined in accordance

with rule 2a51–1.

31Rule 144A(a)(1)(i)(D) (government employee

benefit plans), (E) (any employee benefit plan

within the meaning of Title I of the Employee

Retirement Income Security Act of 1974), and (F)

(trust funds whose participants are exclusively

plans of the types identified in paragraphs (D) and

(E)) [17 CFR 230.144A(a)(1)(i)(D),(E), and (F)].

10% Test has been eliminated. As a

result, a Section 3(c)(1) Fund must

count all of the shareholders of an

investment company or fund investor

that owns 10% or more of the Section

3(c)(1) Fund’s voting securities even if

the investor does not have more than

10% of its assets invested in Section

3(c)(1) Funds.20 These revisions, while

generally narrowing the scope of the

Look-Through Provision, have raised

questions regarding the regulatory status

of existing Section 3(c)(1) Funds that

have relied on the Second 10% Test.

C. The Commission’s Rule Proposals

On December 26, 1996, the

Commission published a release

proposing several rules under the

Investment Company Act to implement

the provisions of the 1996 Act relating

to privately offered funds (‘‘Proposing

Release’’).21 Proposed rule 2a51–1

would define the term ‘‘investments’’

for purposes of the qualified purchaser

definition. Proposed rule 2a51–2 would

define the term ‘‘beneficial owner’’ for

purposes of the Grandfather and

Consent Provisions. Proposed rule

2a51–3 would provide that a company

could not be a qualified purchaser if it

was formed for the specific purpose of

acquiring the securities of a Section

3(c)(7) Fund unless each beneficial

owner of the company’s securities is a

qualified purchaser. Proposed rule 3c–7

would address certain issues related to

a Grandfathered Fund and an affiliated

Section 3(c)(1) Fund.

The Commission also proposed two

other rules that the 1996 Act directed

the Commission to adopt. The 1996 Act

directed the Commission to prescribe

rules permitting ‘‘knowledgeable

employees’’ of a privately offered fund

(or knowledgeable employees of the

fund’s affiliates) to invest in the fund

without causing the fund to lose its

exclusion from regulation under the

Investment Company Act.22 The

Commission proposed rule 3c–5 to

permit knowledgeable employees to

make such investments.

The 1996 Act also directed the

Commission to prescribe rules

implementing section 3(c)(1)(B) of the

Act.23 Section 3(c)(1)(B) provides that

beneficial ownership of securities of a

Section 3(c)(1) Fund by any person who

acquires the securities as a result of ‘‘a

legal separation, divorce, death, or other

involuntary event’’ will be deemed to be

beneficial ownership by the person from

whom the transfer was made, pursuant

to such rules and regulations as the

Commission prescribes.24 The

Commission proposed rule 3c–6 to

implement section 3(c)(1)(B) of the Act.

The proposed rule also would address

similar transfers of securities issued by

Section 3(c)(7) Funds.25

The Commission received letters from

48 commenters concerning the

proposals. While commenters generally

supported the proposed rules, many

suggested changes designed to simplify

the rules, make them more flexible or

resolve technical issues. The

Commission is adopting the proposed

rules with several modifications that

reflect, in part, many of the commenters’

suggestions.

II. Rules Relating to Section 3(c)(7)

Funds

A. Investments and Other Matters

Rule 2a51–1 under the Investment

Company Act defines the term

investments for purposes of determining

whether a prospective investor in a

Section 3(c)(7) Fund (‘‘Prospective

Qualified Purchaser’’) meets the $5

million/$25 million thresholds.26 Rule

2a51–1 also contains provisions

designed to clarify how the amount of

a Prospective Qualified Purchaser’s

investments should be determined.

1. Qualified Institutional Buyers as

Qualified Purchasers

Many commenters suggested that the

determination of qualified purchaser

status could be made significantly easier

if qualified institutional buyers

(‘‘QIBs’’), as defined in rule 144A under

the Securities Act of 1933 (‘‘Securities

Act’’), were deemed to be qualified

purchasers. Rule 144A generally defines

QIBs as certain institutions (including

registered investment companies) that

own and invest on a discretionary basis

$100 million of securities of issuers that

are not affiliated with the institution

(‘‘QIB Securities’’); banks that own and

invest on a discretionary basis $100

million of QIB Securities and that have

an audited net worth of at least $25

million; and certain registered dealers.27

The Commission believes that it is

generally appropriate to treat QIBs as

qualified purchasers for purposes of

section 3(c)(7) in light of the high

threshold of securities ownership that

these institutions must meet under rule

144A, a threshold much higher than the

investment ownership threshold

required for qualified purchasers under

section 2(a)(51)(A) of the Act.

Rule 2a51–1 therefore provides that,

with two exceptions, a QIB is deemed

to be a qualified purchaser.28 The first

exception relates to dealers. Under rule

144A, a dealer (other than a dealer

acting for a QIB in a riskless principal

transaction) must own and invest on a

discretionary basis $10 million of QIB

Securities.29 In order to coordinate the

definition of QIB with the statutory

definition of qualified purchaser, rule

2a51–1 requires the dealer to own and

invest on a discretionary basis $25

million of QIB Securities.30

The second exception relates to

employee benefit plans. Rule 144A

includes in its QIB definition certain

employee benefit plans, as well as

certain trusts that hold assets of

employee benefit plans.31 A selfdirected employee benefit plan (such as

a ‘‘401(k)’’ plan) generally would not be
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17515

32See infra section II.A.8 of this Release

(discussing the circumstances under which pension

and retirement plans can be treated as qualified

purchasers).

33Rule 2a51–1(g)(1)(ii) [17 CFR 270.2a51–

1(g)(1)(ii)] provides that a plan will not be deemed

to be acting for its own account if investment

decisions with respect to the plan are made by the

beneficiaries of the plan. In other words, the

investment decision must be made by a qualified

purchaser.

34See Proposing Release, supra note 4, at nn.29–

31 and accompanying text.

35 Id. The legislative history was confined to

addressing new section 3(c)(7), and should not be

viewed as suggesting how issues of investor

sophistication should be analyzed in other contexts

under the federal securities laws. Although Section

3(c)(7) Funds are not subject to regulation under the

Investment Company Act, these Funds and persons

who sell their securities are subject to the antifraud,

civil liability, and other applicable provisions of the

federal securities laws. Persons who sell the

securities issued by Section 3(c)(7) Funds should

also consider the applicability of the broker-dealer

registration provisions of the Securities Exchange

Act of 1934 [15 USC 78a-78jj] (‘‘Exchange Act’’).

36 17 CFR 270.2a51–1(b)(1).

37See section 2(a)(1) of the Securities Act [15 USC

77b(a)(1)].

38The rule excludes from the definition of

investments securities of an issuer that ‘‘controls, is

controlled by, or is under common control with, the

person that owns the securities.’’ The term

‘‘control’’ is defined in section 2(a)(9) of the Act [15

USC 80a–2(a)(9)] as ‘‘the power to exercise a

controlling influence over the management or

policies of a company, unless such power is solely

the result of an official position with such

company.’’ Section 2(a)(9) also provides that a

person who owns beneficially, ‘‘either directly or

through one or more controlled companies, more

than 25 per centum of the voting securities of a

company shall be presumed to control such

company.’’ Id.

39Rule 2a51–1(a)(3) [17 CFR 270.2a51–1(a)(3)]

(defining the term ‘‘investment vehicle’’).

40 15 USC 80a–3(c)(1) through (9); 17 CFR 270.3a–

6 (exemption for foreign banks and insurance

companies) and .3a–7 (exemption for certain

structured finance vehicles).

41Rule 2a51–1(a)(3).

42Rule 2a51–1(b)(1)(ii) [17 CFR 270.2a51–

1(b)(1)(ii)]. A control interest in an issuer may be

treated as an investment if the issuer files reports

pursuant to section 13 or 15(d) of the Exchange Act

[15 USC 78m and 78o(d)].

43Rule 2a51–1(a)(7)(ii) [17 CFR 270.2a51–

1(a)(7)(ii)]; 17 CFR 230.901 through .904.

44Commenters did not agree, however, on how to

identify such a company. Several commenters

suggested that the definition be based on the

company’s shareholders’ equity (e.g., $25 million or

$50 million). Other commenters suggested that the

Continued

considered to be a qualified purchaser

for purposes of rule 2a51–1; rather, an

employee could invest in a Section

3(c)(7) Fund through a self-directed plan

only if the employee is a qualified

purchaser.32 This provision therefore is

not available to a self-directed plan.33

2. Definition of Investments

Rule 2a51–1, as proposed, would have

defined investments broadly to include

securities (other than controlling

interests in certain issuers), and real

estate, futures contracts, physical

commodities, and cash and cash

equivalents held for investment

purposes. The Commission believes that

this approach is consistent with the

legislative history of the 1996 Act,

which suggests that Congress expected

that the definition of investments would

be broader than securities, but that not

every asset be treated as an

investment.34 Rather, the legislative

history suggests that the asset should be

held for investment purposes and that

the nature of the asset should indicate

that its holder has the investment

experience and sophistication necessary

to evaluate the risks of investing in

unregulated investment pools.35

Commenters generally supported the

approach of the proposal, although

many commenters suggested alternative

approaches to addressing particular

issues. The Commission is adopting the

definition of investments substantially

as proposed, with modifications made

in view of the commenters’ suggestions,

as discussed below.

a. Securities

Rule 2a51–1(b)(1) includes securities

within the definition of investments.36

This approach should result in a broad

range of assets being treated as

investments for purposes of the

qualified purchaser definition. Many

investment opportunities, such as

limited partnerships and limited

liability companies, are offered in the

form of securities.37

Under the rule, securities that

constitute a ‘‘control interest’’ in an

issuer generally do not come within the

definition of investments.38 Limiting the

definition in this manner is designed to

exclude, among other things, controlling

ownership interests in family-owned

and other closely-held businesses.

These holdings may not demonstrate the

degree of financial sophistication

necessary to invest in unregulated

investment pools.

The Commission proposed certain

exceptions from the control interest

exclusion. The Commission is

broadening these exceptions in certain

respects, in light of the suggestions of

commenters as discussed below.

Investment Vehicles. The rule permits

control interests in ‘‘investment

vehicles’’ excluded or exempted from

the definition of investment company

by sections 3(c)(1) through 3(c)(9) of the

Act or rule 3a–6 or 3a–7 under the Act

to be treated as investments.39 Sections

3(c)(1) through 3(c)(9) and rules 3a–6

and 3a–7 except from the definition of

investment company, in addition to

privately offered funds, certain types of

issuers that engage in significant

investment-related activities (i.e.,

brokers and other financial

intermediaries, banks, insurance

companies, finance companies, and

certain structured finance vehicles).40

A control interest in these types of

companies generally suggests a

significant degree of investment

experience. In a change from the

proposal, the rule also specifies that a

control interest in a commodity pool

may be treated as an investment.41 As in

the case of a control interest in an

investment company, a control interest

in a commodity pool may suggest a

significant degree of investment

experience on the part of the

Prospective Qualified Purchaser.

Public Companies. The rule, as

proposed, would have included in the

definition of investments a control

interest in a ‘‘listed’’ company that is

not a majority-owned subsidiary of the

Prospective Qualified Purchaser. A

listed company would have been

defined as a company whose equity

securities are listed on a national

securities exchange, traded on the

National Association of Securities

Dealers Automated Quotation System

(NASDAQ), or listed on a designated

offshore securities market. Commenters

generally supported treating control

interests in listed companies as

investments, but suggested that the

category should be broadened to include

control interests (including majority

ownership interests) in any public

company.

The Commission agrees, and has

revised the rule to include in the

definition of investments a control

interest in a company that files periodic

reports in accordance with the

Securities Exchange Act of 1934.42 The

Commission has concluded that a

person that holds a control interest in a

reporting company is likely to have

significant experience in financial

matters and investments. The fact that

the control interest is a majority interest

should not affect this analysis. As

proposed, a control interest in an issuer

whose securities are listed on a

designated offshore securities market (as

defined by Regulation S under the

Securities Act) also may be treated as an

investment.43

Large Private Companies. Many

commenters suggested that a control

interest in a large private operating

company should be treated as an

investment. These commenters asserted

that the very size of such a company

suggests that a person who controls it is

sophisticated and has significant

financial acumen.44 The commenters
17516 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

definition be based on the company’s revenues,

assets or going concern value. Still other

commenters suggested that a control interest should

be included if its value was in excess of a specified

amount.

45Rule 2a51–1(b)(1)(iii) [17 CFR 270.2a51–

1(b)(1)(iii)]. The company must have had $50

million of shareholders’ equity on its most recent

financial statements (whether annual or quarterly).

Id.

46 17 CFR 270.2a51–1(b)(2).

47Rule 2a51–1(c)(1) [17 CFR 270.2a51–1(c)(1)].

Rule 2a51–1(a)(8) [17 CFR 270.2a51–1(a)(8)] defines

‘‘related person’’ as a sibling, spouse or former

spouse of the prospective qualified purchaser, or a

direct lineal descendant or ancestor by birth or

adoption of the Prospective Qualified Purchaser, or

a spouse of the descendant or ancestor.

48 Internal Revenue Code (‘‘IRC’’) section 280A(d)

[26 USC 280A(d)]. Rule 2a51–1(c) [17 CFR

270.2a51–1(c)] treats residential real estate as an

investment if it is not treated as a dwelling unit

used as a residence in determining whether

deductions for depreciation and other items are

allowable under the IRC. Section 280A provides,

among other things, that a taxpayer uses a dwelling

unit during the taxable year as a residence if he or

she uses such unit for personal purposes for a

number of days that exceeds the greater of 14 days

or 10 percent of the number of days during which

the unit is rented at a fair market value.

49Rule 2a51–1(c)(1).

50Real property held by a Prospective Qualified

Purchaser primarily engaged in the real estate

investment and development business as part of

that business may be treated as an investment. Id.

51 17 CFR 270.2a51–1(b)(3). Paragraph (a)(1) of

rule 2a51–1 [17 CFR 270.2a51–1(a)(1)] defines

Commodity Interests to mean commodity futures

contracts, options on commodity futures contracts,

and options on physical commodities traded on or

subject to the rules of (a) any contract market

designated for trading such transactions under the

Commodity Exchange Act (the ‘‘CEA’’) [7 USC 1]

and the rules thereunder; or (b) any board of trade

or exchange outside the United States, as

contemplated in Part 30 of the rules under the CEA.

17 CFR 30.1 through 30.11. Commodity Interests

held as part of a business by a Prospective Qualified

Purchaser that is primarily engaged in the business

of investing or trading in Commodity Interests may

be treated as investments. Rule 2a51–1(c)(2) [17

CFR 270.2a51–1(c)(2)].

52Rule 2a51–1(b)(4) [17 CFR 270.2a51–1(b)(4)].

Physical commodities, for purposes of the rule, are

defined as any commodity with respect to which a

Commodity Interest is traded on a domestic or

foreign commodities exchange. Rule 2a51–1(a)(5)

[17 CFR 270.2a51–1(a)(5)].

53Rule 2a51–1(b)(5) [17 CFR 270.2a51–1(b)(5)]

includes in the definition of investments ‘‘financial

contracts’’ as defined by section 3(c)(2) of the Act

[15 USC 80a–3(c)(2)]. This definition was added to

section 3(c)(2) by the 1996 Act in order to expand

the exclusion from the definition of investment

company applicable to securities brokers to include

certain other market intermediaries (e.g., ‘‘swap’’

dealers). Section 3(c)(2) provides, in pertinent part,

that a financial contract is any arrangement that—

(I) takes the form of an individually negotiated

contract, agreement, or option to buy, sell, lend,

swap, or repurchase, or other similar individually

negotiated transaction commonly entered into by

participants in the financial markets;

(II) is in respect of securities, commodities,

currencies, interest or other rates, other measures of

value, or any other financial or economic interest

similar in purpose or function to any of the

foregoing; and

(III) is entered into in response to a request from

a counter party for a quotation, or is otherwise

entered into and structured to accommodate the

objectives of the counter party to such arrangement.

Some ‘‘financial contracts’’ are also securities,

and thus investments under rule 2a51–1(b)(1). See

In re BT Securities Corp., Exchange Act Release No.

35136 (Dec. 22, 1994).

54As with other investments, a financial contract

can be valued at its fair market value or cost. See

section II.A.3.a of this Release. The rule does not

permit a financial contract to be valued at its

notional amount (e.g., the principal amount upon

which the interest payments in a swap transaction

are based).

55 17 CFR 270.2a51–1(b)(7).

56For example, an investor may have a significant

amount of Cash as a result of a recent sale of an

investment or because market conditions resulted

in the investor taking a ‘‘defensive’’ position. Cash

also may be integral to certain sophisticated

investment strategies (such as hedging).

also pointed out that sophisticated

investors, such as venture capital

investors, often hold control interests in

private companies, and that not treating

these holdings as investments could

result in these investors not being

treated as qualified purchasers.

Under the rule as adopted, a control

interest in a company that has

shareholders’ equity of $50 million or

more may be treated as an investment.45

The Commission believes that this

change should respond to the concerns

of the commenters in a manner

consistent with the legislative history

indicating Congress’ view that control

interests in family-owned and other

small businesses may not evidence

investment sophistication.

b. Real Estate

Rule 2a51–1(b)(2) includes real estate

held for investment purposes within the

definition of investments.46 Most

commenters strongly supported treating

real estate as an investment.

Consistent with the examples

provided by the legislative history of the

1996 Act, real estate is not considered

to be held for investment purposes if the

real estate is used by the Prospective

Qualified Purchaser or a member of the

Prospective Qualified Purchaser’s

family (‘‘Related Person’’) for personal

purposes (e.g., as a personal

residence).47 The term ‘‘personal

purposes’’ is derived from the Internal

Revenue Code provision that addresses

circumstances under which a taxpayer

is allowed deductions with respect to

certain ‘‘dwelling units.’’ 48 Thus,

residential property may be treated as

an investment if it is not treated as a

residence for tax purposes. Many

commenters agreed that the reference to

the Internal Revenue Code provisions is

appropriate because it would allow a

Prospective Qualified Purchaser to

determine whether residential real

estate is an investment based on the

same provisions he or she would apply

in determining whether certain

expenses related to the property are

deductible for purposes of his or her tax

returns.

Property owned by a Prospective

Qualified Purchaser that has been used

by the Prospective Qualified Purchaser

or a Related Person as a place of

business or in connection with the

conduct of a trade or business

(‘‘Business-Related Property’’) also is

not considered to be held for investment

purposes.49 While Business-Related

Property may have been acquired with

an investment goal in mind, these

holdings may not be indicative of

extensive experience in the financial or

real estate markets and may have been

acquired for reasons other than the

potential investment merits of the

property.50

c. Commodity Interests, Commodities

and Financial Contracts

Rule 2a51–1(b)(3) includes contracts

for the purchase or sale of a commodity

for future delivery (‘‘Commodity

Interests’’) held for investment purposes

within the definition of investments.51

Most commenters agreed that

Commodity Interests should be treated

as investments.

The rule also includes in the

definition of investments commodities

that are held in physical form and for

investment purposes.52 This provision

recognizes that many investors hold

gold, silver or other commodities as part

of their investment portfolios. While

some commenters suggested that the

definition include any commodity,

other commenters stated that the rule’s

definition would include most

commodities held as investments.

The rule has been revised from the

proposal to include ‘‘swaps’’ and similar

financial contracts in the definition of

investments.53 The Commission agrees

with the commenters that, because these

instruments often are used in

connection with investments, it is

appropriate to treat them as

investments.54

d. Cash and Cash Equivalents

Rule 2a51–1(b)(7) includes cash and

cash equivalents held for investment

purposes (‘‘Cash’’) in the definition of

investments.55 Most commenters agreed

that treating Cash as an investment was

appropriate because many investors are

likely at any given time to have a

component of their investment portfolio

in Cash.56 In response to a request for

comment in the Proposing Release

whether the ‘‘investment purposes’’ test

for Cash needed further elaboration,

many commenters responded that the
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17517

57Rule 2a51–1(b)(7). See also Proposing Release,

supra note 4, at n.48.

58Rule 2a51–1(b)(7). One commenter suggested

that the rule be specific on this point because

certain bank instruments with longer maturities

might not be considered to be either cash

equivalents or securities. The rule does not specify

that securities of a money market fund are Cash

because they are securities and would be

investments under rule 2a51–1(b)(1).

59Rule 2a51–1(b)(6) [17 CFR 270.2a51–1(b)(6)].

60See also American Bar Association, Section of

Business Law, Committee on Federal Regulation of

Securities, Task Force on Hedge Funds, Report on

Section 3(c)(1) of the Investment Company Act of

1940 and Proposals to Create an Exception for

Qualified Purchasers, 51 Bus. Law. 773, 778 (Dec.

5, 1995) (hereinafter Hedge Funds Task Force

Report) (suggesting that automobiles, jewelry and

art be excluded from investments for purposes of

measuring financial sophistication).

61 17 CFR 270.2a51–1(d). In the case of a security,

market value could be determined in the manner

described in rule 17a–7(b) under the Investment

Company Act [17 CFR 270.17a–7(b)].

62See Proposing Release, supra note 4, at n.53.

63Rule 2a51–1(e) [17 CFR 270.2a51–1(e)].

64 It also should be noted that Cash held for

investment purposes is an investment. Therefore, if

the cash proceeds of a loan are treated as an

investment, the outstanding amount of the loan

must be deducted.

‘‘investment purposes’’ test was an

appropriate formulation.

The rule clarifies certain issues

related to Cash that were addressed in

the Proposing Release or raised by

commenters. The rule specifies that the

net cash surrender value of an insurance

policy may be considered to be Cash.57

The rule also specifies that, for purposes

of the rule, bank deposits, certificates of

deposit, bankers acceptances and

similar bank instruments may be treated

as Cash.58

The rule also provides that a

Prospective Qualified Purchaser that is

a privately offered fund or a commodity

pool may treat as investments unfunded

capital commitments (i.e., firm

agreements by investors to provide these

Prospective Qualified Purchasers with

cash upon request).59 Several

commenters noted that privately offered

funds often do not require their

investors to provide the moneys the

investors have committed to invest in

the fund until investment opportunities

become available to the fund. The fund

therefore has access to cash that will be

used for investment purposes, through

commitments that reflect investors’

assessment of the fund sponsor’s

investment expertise. The Commission

thus considers it appropriate to treat

these capital commitments in a manner

similar to Cash.

e. Other Types of Investments

The Commission requested comment

whether certain assets (such as jewelry,

artwork, antiques and other collectibles)

that may be held by some for investment

purposes should be treated as

investments. While several commenters

suggested that such assets should be

included in the definition of

investments, others agreed that they

should be excluded because these

holdings do not necessarily suggest any

experience in the financial markets or

investing in unregulated investment

pools.60 The Commission agrees with

this analysis and the rule therefore does

not include such assets in the definition

of investments.

3. Determining the Amount of

Investments

Rule 2a51–1 permits the amount of a

Prospective Qualified Purchaser’s

investments to be based either on the

market value of the investments or on

their cost. In either case, the rule

requires indebtedness incurred to

acquire investments to be deducted

from the amount of investments owned

as discussed below.

a. Value of Investments

Rule 2a51–1(d) specifies that the

value of an investment may be either its

market value on the most recent

practicable date or its cost.61 Most

commenters supported this approach.

The rule as adopted has been

reformulated to state that the value of an

investment may be either its cost or

‘‘fair market value’’ on the most recent

practicable date. This change is

designed to clarify that, in the absence

of a recent market value, an

investment’s value could be determined

by an appraisal by an independent third

party.62

The rule does not specify which

valuation methodology should be used

in a particular circumstance. A Section

3(c)(7) Fund could allow Prospective

Qualified Purchasers to provide the

amount of their investments based on

either methodology, since either

methodology is an appropriate way to

measure a Prospective Qualified

Purchaser’s investment experience.

b. Deductions from Amount of

Investments

i. Certain Indebtedness

The rule, as proposed, would have

required the deduction from the amount

of a Prospective Qualified Purchaser’s

investments (i) of any indebtedness

incurred to acquire the investments and

(ii) of certain mortgage-related

indebtedness incurred during the

preceding 12 months (‘‘Mortgage

Deduction’’). These provisions,

(collectively, the ‘‘Indebtedness

Deduction Provision’’) reflected the

Commission’s belief that, in establishing

the $5 million/$25 million investment

thresholds, Congress intended that

qualified purchasers generally be

limited to persons who own a specified

amount of investments. This intention

would appear to be inconsistent with

permitting a Prospective Qualified

Purchaser to accumulate the requisite

amount of investments through

borrowing or similar means.

Most commenters objected to the

Indebtedness Deduction Provision as

unnecessary and inconsistent with

Congress’s intent. Some commenters,

however, believed that the provision

was appropriate and consistent with the

policies underlying section 3(c)(7).

Many commenters, whether opposing or

supporting the provision, suggested that

it be revised in certain respects to make

it easier to apply.

After considering all of the comments

received and the 1996 Act’s legislative

history, the Commission continues to

believe that the Indebtedness Deduction

Provision appropriately implements

Congress’s intent. The Commission is

therefore adopting this provision

substantially as proposed with one

change designed to simplify its

application. The rule, as adopted, does

not include the Mortgage Deduction.

This deduction was designed to

preclude a personal residence or a

vacation home from, in effect, being

converted into Cash or another type of

investment for purposes of meeting the

$5 million threshold. Some commenters

suggested that this provision was overly

complex and would be difficult to

administer. Other commenters

suggested generally that the

Indebtedness Deduction Provision, if

included in the rule, be limited to

indebtedness incurred to acquire

investments. These commenters noted

that indebtedness secured by a mortgage

could be incurred for various reasons

other than to acquire investments and

that the provision was therefore

overbroad.

Upon reflection, the Commission has

concluded that the Mortgage Deduction

is unnecessary. As discussed above, the

rule requires that indebtedness incurred

to acquire an investment be deducted.63

If a mortgage loan (or any other type of

loan) is incurred to acquire, or for the

purpose of acquiring, an investment, the

outstanding amount of such loan would

have to be deducted.64

Consistent with these changes to the

Indebtedness Deduction Provision, the

rule’s provision with respect to

indebtedness deductions by Family

Companies has been significantly

simplified. Certain proposed deductions

relating to indebtedness incurred by a
17518 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

65Under the proposed rule, a Family Company

also would have been required to deduct (i) the

amount of any real estate loans that any owner of

the Family Company would have had to deduct if

the owner were the Prospective Qualified

Purchaser; (ii) the amount of any indebtedness

incurred by the Family Company during the

preceding 12 months to the extent that the principal

amount of the indebtedness exceeded the fair

market value of any assets of the Family Company

other than investments; and (iii) the amount of any

indebtedness incurred during the preceding 12

months by an owner of the Family Company or by

a related person of an owner of the Family

Company and guaranteed by the Family Company.

See Proposing Release, supra note 4, at nn.59–61

and accompanying text.

66Rule 2a51–1(f) [17 CFR 270.2a51–1(f)].

67Rule 2a51–1(g)(2) [17 CFR 270.2a51–1(g)(2)].

Joint Investments also include investments in

which the person shares with his or her spouse a

community property or similar shared ownership

interest. Id. In determining the amount of Joint

Investments, the Prospective Qualified Purchaser

must deduct from the amount of any Joint

Investments any outstanding indebtedness incurred

by the spouse to acquire the investments. Id.

68Section 2(a)(51)(A)(i) of the Act.

69Rule 2a51–1(g)(2). Consistent with this

approach, the Commission believes that, for

purposes of determining the number of beneficial

owners of voting securities of a Section 3(c)(1)

Fund, securities of the Section 3(c)(1) Fund jointly

owned by both spouses should be considered to be

owned by one beneficial owner. This approach is

a departure from an earlier staff position on this

issue. See, e.g., Joseph H. Moss (Feb. 27, 1984).

70This approach is designed to recognize, for

example, holding company structures necessitated

by legal, tax or other factors that may require or

make advantageous the holding of investments in

separate corporate entities. See, e.g., Resale of

Restricted Securities; Changes To Method of

Determining Holding Period of Restricted Securities

Under Rules 144 and 145, Securities Act Release

No. 6862 (Apr. 23, 1990) [55 FR 17933 (Apr. 30,

1990)] (describing bank holding company

structures).

71Rule 2a51–1(g)(3) [17 CFR 270.2a51–1(g)(3)].

Several commenters noted that the rule, as

proposed, would not have extended to noncorporate structures. The rule as adopted refers

generally to ‘‘companies’’ rather than

‘‘corporations.’’ Id.

72Proposed rule 2a51–1(j).

73The legislative history of the 1996 Act indicates

that the Commission can use its rulemaking

authority provided in section 2(a)(51) of the Act [15

USC 80a–2(a)(51)] to ‘‘develop reasonable care

defenses when an issuer relying on the qualified

Family Company or its owners are not

required by the adopted rule.65 The rule,

as adopted, requires a Family Company

to deduct the amount of any outstanding

indebtedness incurred by the Family

Company or any of the Family

Company’s owners to acquire the

investments held by the Family

Company.66

ii. Other Payments

The rule, as proposed, would have

required a Prospective Qualified

Purchaser who is a natural person to

deduct certain payments that he or she

received during the preceding 12

months relating to, among other things,

lawsuits, insurance policies, divorce

and separation agreements, and gifts

and bequests. This provision (‘‘Other

Payments Provision’’) was designed to

assure that Prospective Qualified

Purchasers who are natural persons

would be required to deduct from the

amount of their investments certain

amounts received during the preceding

12 months that could inflate the amount

of their investments (particularly Cash)

without reflecting any investment

experience.

As with the Indebtedness Deduction

Provision, most commenters objected to

the Other Payments Provision as overly

complex and potentially difficult to

administer. One commenter, however,

believed that the Other Payments

Provision was consistent with the

policies underlying section 3(c)(7) and

suggested that the Commission consider

additional deductions (such as the

proceeds from the sale of a familyowned business).

After considering the comments

received, the Commission has

determined not to adopt the Other

Payments Provision at this time.

Similarly, the provision that would have

required Other Payments received by

owners of a Family Company to be

deducted by the Family Company is not

being adopted. At this time, the burdens

that might be associated with the Other

Payments Provision appear to outweigh

its benefits to investors. The

Commission may revisit this issue in the

future if experience with section 3(c)(7)

suggests that a provision similar to the

Other Payments Provision is necessary

or appropriate in the public interest or

for the protection of investors.

4. Jointly Held Investments

The rule provides that, in determining

whether a natural person is a qualified

purchaser, the person may include in

the amount of his or her investments

any investments held jointly with the

person’s spouse (‘‘Joint Investments’’).67

Thus, a person who owns $3 million of

investments individually and $2 million

of Joint Investments would be a

qualified purchaser. The spouse also

would be a qualified purchaser if he or

she owned, individually, an additional

$3 million of investments.

A spouse who is not a qualified

purchaser can hold a joint interest in a

Section 3(c)(7) Fund with his or her

qualified purchaser spouse.68 The

Commission requested comment

whether spouses who hold $5 million in

investments in the aggregate (regardless

of whether the investments are held

jointly) should be treated as qualified

purchasers if they make a joint

investment in a Section 3(c)(7) Fund.

All the commenters that addressed this

issue agreed that permitting such

investments would be appropriate. The

rule as adopted reflects this approach.69

The Commission believes that this

approach will simplify the

determination of whether spouses

making a joint investment are qualified

purchasers.

5. Investments Held by Certain

Affiliated Entities

The rule, as proposed, would have

permitted a parent company that is a

Prospective Qualified Purchaser to

aggregate investments it owns with

those owned by its majority-owned

subsidiaries, provided that the

subsidiaries’ investments were managed

under the direction of the parent

company.70 Most commenters agreed

with this approach, but suggested that

the provision should address a broader

range of corporate and other intercompany structures. Commenters

suggested, for example, that when a

company that is part of a group of

related companies is making an

investment in a Section 3(c)(7) Fund, it

is not necessary to focus on which of

these companies actually owns or

manages the investments.

The Commission agrees with this

analysis. The rule as adopted permits

the investments of a parent company

and its majority-owned subsidiaries to

be aggregated, regardless of which

company is the Prospective Qualified

Purchaser.71

6. Reasonable Belief

The rule, as proposed, would have

permitted a Section 3(c)(7) Fund or a

person acting on its behalf, when

determining whether a Prospective

Qualified Purchaser is a qualified

purchaser, to rely upon audited

financial statements, brokerage account

statements and other appropriate

information and certifications provided

by the Prospective Qualified Purchaser

or its representatives, as well as upon

publicly available information as of a

recent date.72 The rule would have

required that reliance on this

information be reasonable and that the

Section 3(c)(7) Fund or its

representatives, after reasonable inquiry,

have no basis for believing that the

information is incorrect in any material

respect.

Commenters generally agreed that the

proposed rule was consistent with the

suggestion in the 1996 Act’s legislative

history that the Commission use its

rulemaking authority to adopt rules

with respect to ‘‘reasonable care

defenses.’’ 73 The commenters suggested,
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17519

purchaser exception in good faith sells securities to

a purchaser that does not meet the qualified

purchaser definition.’’ House Report, supra note 12,

at 53.

74 17 CFR 230.144A, .506.

75 17 CFR 230.144A(d)(1), .501(a).

76Rule 2a51–1(h) [17 CFR 270.2a51–1(h)]

provides, in relevant part, that the term ‘‘qualified

purchaser’’ as used in section 3(c)(7) of the Act

includes a person who a Section 3(c)(7) Fund or its

representative ‘‘reasonably believes’’ is a qualified

purchaser.

77Rule 2a51–1(g)(4) [17 CFR 270.2a51–1(g)(4)]. A

401(k) plan is established in accordance with

section 401(k) of the IRC [26 USC 401(k)]. If a 401(k)

plan provides several options in which an

employee can choose to invest his or her account,

the employee would be making the investment

decision with respect to the account even though

the plan’s trustee or sponsor selects the range of

options from which the employee can choose.

78Many of the issues raised by commenters have

been addressed by the provision of the rule dealing

with ownership of investments by certain affiliated

companies. See rule 2a51–1(g)(3); supra section

II.A.5 of this Release.

79See Senate Report, supra note 12, at 10. The

Commission staff has taken a similar position under

section 3(c)(1) of the Act, with which the

Commission agrees, with respect to how to ‘‘count’’

401(k) plans for purposes of determining whether

a Section 3(c)(1) Fund has 100 or fewer investors.

Thus, each participant in the plan who chooses to

invest in the Fund, as opposed to the plan itself,

should be treated as a separate investor in the

Section 3(c)(1) Fund for purposes of determining

the number of beneficial owners of the Fund’s

securities. See The PanAgora Group Trust (Apr. 29,

1993).

The Commission is aware that the staff has taken

the position under section 3(c)(1) that a selfdirected employee benefit plan can be considered

to be a single investor under certain circumstances.

In particular, the staff has indicated that such a plan

would be a single investor for purposes of section

3(c)(1) if the plan operates in a manner resembling

that of a defined benefit plan. See The Standish

Ayer & Wood, Inc. Stable Value Group Trust (Dec.

28, 1995). In adopting the analysis set forth in the

PanAgora letter, the Commission is not endorsing

the analysis set forth in the Standish Ayer letter for

purposes of section 3(c)(7). The Commission has

requested the staff to consider whether the position

taken in the Standish Ayer letter is appropriate in

the context of section 3(c)(7) and to reconsider

whether the position taken in the Standish Ayer

letter is consistent with that reflected in the

PanAgora letter for purposes of section 3(c)(1).

however, that the rule should conform

to the provisions of other Commission

rules under the Securities Act that

address transactions involving certain

categories of sophisticated investors,

such as rule 506 of Regulation D

(offerings to ‘‘accredited investors’’ and

‘‘sophisticated investors’’) and rule

144A (sales to QIBs).74 These rules focus

on whether an issuer ‘‘reasonably

believes’’ that a purchaser of securities

satisfies certain criteria for investors

specified in the rules.75 Rule 2a51–1, as

adopted, reflects this approach.76

The Commission requested comment

whether the rule should contain a list of

the types of documents (similar to the

list included in rule 144A) that a

Section 3(c)(7) Fund could rely on in

determining whether a Prospective

Qualified Purchaser was a qualified

purchaser. Commenters had mixed

reactions to this approach. Some

commenters objected to the inclusion of

a list, while others argued that the types

of documents set forth in rule 144A

were not sufficiently inclusive.

Although the Commission understands

that the list provided in rule 144A has

been useful in that context, that list

reflects the type of information that

usually is publicly available concerning

institutional investors (the only type of

investor that can be a QIB). Commenters

suggested that similar information

typically is not available for individual

investors. Because a list similar to that

included in rule 144A would be of

limited use, it is not included in rule

2a51–1.

7. Retirement Plans and Other Forms of

Holding Investments

The Commission requested comment

whether there are other structures for

holding ownership interests in

investments that should be addressed by

the rule. Many commenters requested

clarification on various issues related to

assets held in individual retirement

accounts (‘‘IRAs’’) and employee benefit

plans. The rule provides that a

Prospective Qualified Purchaser who is

a natural person may include

investments held in his or her IRA or in

other retirement accounts (such as a

‘‘401(k)’’ plan) when the Prospective

Qualified Purchaser makes all of the

investment decisions for the account.77

The Commission understands that

there are other forms of holding

investments that may raise

interpretative issues concerning

whether a Prospective Qualified

Purchaser ‘‘owns’’ an investment.78 For

instance, when an entity that holds

investments is the ‘‘alter ego’’ of a

Prospective Qualified Purchaser (as in

the case of an entity that is wholly

owned by a Prospective Qualified

Purchaser who makes all the decisions

with respect to such investments), it

would be appropriate to attribute the

investments held by such entity to the

Prospective Qualified Purchaser.

8. Pension and Retirement Plans as

Qualified Purchasers

A number of commenters raised

interpretative questions concerning the

circumstances under which a pension or

other type of employee benefit plan that

holds $25 million of investments in the

aggregate could be treated as a qualified

purchaser. Most of these questions

concerned 401(k) plans that allow an

employee to direct the investment of his

or her account balance (which may

consist of amounts contributed by the

employee, the employer, or both) to

specified investment alternatives

available through the plan. Some

commenters suggested that if such a

plan holds $25 million of investments

in the aggregate, participants in the plan

should have an opportunity to invest in

a Section 3(c)(7) Fund offered as an

investment option. Other commenters

argued that the Section 3(c)(7) Fund

should ‘‘look through’’ the 401(k) plan

to its participants for purposes of

determining whether each investor in

the Fund is a qualified purchaser.

The latter approach reflects the

Commission’s interpretation of section

3(c)(7). The legislative history of the

1996 Act indicates that Section 3(c)(7)

Funds are to be limited to investors who

own a specified amount of

investments.79 The critical issue,

therefore, is not whether the employee

is directing his or her investments

through a 401(k) plan or a similar

intermediary, but whether the employee

owns the requisite amount of

investments. Congress determined

generally that the person making the

investment decision to invest in a

Section 3(c)(7) Fund had to own a

requisite amount of investments; the Act

generally does not permit a person who

does not own the requisite amount of

investments to be treated as a qualified

purchaser even if he or she received

advice from a third party concerning the

investment.

The approach described above would

not apply to a defined benefit or other

retirement plan that owns $25 million of

investments and does not permit

participants to decide whether or how

much to invest in particular investment

alternatives. If the decision to invest in

a Section 3(c)(7) Fund is made by the

plan trustee or other plan fiduciary that

makes investment decisions for the

plan, and the plan owns at least $25

million of investments that is not

subject to participant direction, the plan

would be a qualified purchaser with

respect to investments made by the plan

trustee.

9. Other Issues Relating to Qualified

Purchasers

Section 3(c)(7)(A) of the Act provides

that the outstanding securities of a

Section 3(c)(7) Fund must be owned

‘‘exclusively by persons who, at the

time of acquisition of such securities,

are qualified purchasers.’’ The

Commission believes that, as a general

matter, this provision requires the

determination whether a person is a

qualified purchaser to be made or
17520 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

80See, e.g., Williamson v. Tucker, 645 F.2d 404

(5th Cir.), cert. denied, 454 U.S. 897 (1981).

81See, e.g., Shoreline Fund, L.P and Condor Fund

International, Inc. (Nov. 14, 1994) (taking a similar

approach under section 3(c)(1)).

82See 142 Cong. Rec. at E1929 (Oct. 4, 1996)

(Remarks of Hon. Thomas J. Bliley, Jr.). These nonqualified purchasers must have acquired all or a

portion of their investment in the Grandfathered

Fund on or before September 1, 1996. The

Grandfather Provision was designed to enable

existing Section 3(c)(1) Funds to preserve their

arrangements with these non-qualified purchasers,

and does not limit additional purchases by these

non-qualified purchasers of the Grandfathered

Fund’s securities. Any person owning a security of

the Grandfathered Fund who acquired the security

after September 1, 1996 must be, either on the date

of the acquisition or on the date that the Fund

avails itself of section 3(c)(7), a qualified purchaser.

83The opportunity must be provided

‘‘notwithstanding any agreement to the contrary

between the [Grandfathered Fund] and such

beneficial owner.’’ Section 3(c)(7)(B)(ii)(II) of the

Act [15 USC 80a-3(c)(7)(B)(ii)(II)].

84See supra note 18 and accompanying text

(describing section 3(c)(1)(A) of the Investment

Company Act).

85See Remarks of Hon. Thomas J. Bliley, supra

note 82.

86 Id.

87See supra note 19 and accompanying text

(discussing the elimination of the Second 10%

Test).

88This reliance can be illustrated by the following

example. An investor invested in a Section 3(c)(1)

Fund (‘‘Fund A’’) through another Section 3(c)(1)

Fund (‘‘Fund B’’) that was subject to the LookThrough Provision as then in effect. The investor

may have made its investment in Fund B (or Fund

B may have made its investment in Fund A)

recognizing that under section 3(c)(1)(A) as then in

effect, each security holder of Fund B was deemed

to be a beneficial owner of Fund A’s voting

securities. In this way, the Look-Through Provision

would have limited the number of additional

persons that could invest in Fund A. As noted

above, however, even in these circumstances,

Congress appears to have intended that investors in

Fund B not be deemed beneficial owners of Fund

A’s securities for purposes of the Grandfather

Provision unless there is a control relationship

between Fund A and Fund B.

89 17 CFR 270.2a51–2(a).

90 17 CFR 270.2a51–2(b).

91The applicability of the Look-Through

Provision is determined as of October 11, 1996 to

reaffirmed each time the person

acquires securities of a Section 3(c)(7)

Fund.

Commenters noted that privately

offered funds often allow investors to

make their investment in a fund in

installments or as the fund’s manager

needs capital to make investments.

These commenters requested that the

Commission clarify whether section

3(c)(7) requires the investor to be a

qualified purchaser at the time each

installment is paid. The Commission

would interpret section 3(c)(7) as not

requiring a Section 3(c)(7) Fund to

determine whether the investor is a

qualified purchaser each time the

investor makes additional investments

in the Fund pursuant to a binding

commitment to make such payments,

provided the investor was a qualified

purchaser at the time the investor made

the commitment. The Commission

believes that this approach is consistent

with section 3(c)(7).

Commenters also requested guidance

whether affiliates of a Section 3(c)(7)

Fund’s sponsor that hold interests in the

Fund are required to be qualified

purchasers. A privately offered fund is

often organized as a limited partnership

with the fund’s sponsor or investment

adviser (or one of their affiliates) serving

as the general partner. In these

circumstances, if the general

partnership interest is not a security 80

and is not being used as a device to

evade the provisions of section 3(c)(7)

limiting security holders of the Section

3(c)(7) Fund to qualified purchasers, the

general partner need not be a qualified

purchaser.81

B. Definitions of Beneficial Ownership

and Other Issues Relating to the

Grandfather and Consent Provisions

Rule 2a51–2 defines the term

‘‘beneficial owner’’ for purposes of the

Grandfather Provision governing

Section 3(c)(1) Funds that wish to

convert into Section 3(c)(7) Funds and

the Consent Provision governing Section

3(c)(1) and Section 3(c)(7) Funds that

wish to become qualified purchasers.

The rule also addresses what types of

ownership constitute ‘‘indirect’’

beneficial ownership for purposes of the

Consent Provision.

1. The Grandfather Provision

a. Background

Under the Grandfather Provision, a

Grandfathered Fund may convert into a

Section 3(c)(7) Fund without requiring

investors that are not qualified

purchasers to dispose of their interests

in the Fund.82 The Grandfather

Provision requires the Grandfathered

Fund, prior to the conversion, (i) to

disclose to each ‘‘beneficial owner’’ that

future investors will be limited to

qualified purchasers, and that

ownership in the Grandfathered Fund

will no longer be limited to 100 persons,

and (ii) concurrently with or after the

disclosure, to provide each beneficial

owner with a reasonable opportunity to

redeem any part or all of its interests in

the Fund for that beneficial owner’s

proportionate share of the Fund’s ‘‘net

assets.’’ 83

The 1996 Act directs the Commission

to define the term ‘‘beneficial owner’’

for purposes of the Grandfather

Provision. The legislative history of the

1996 Act suggests that the Commission

was to use this authority to alleviate any

unnecessary burdens that might arise as

a result of the application of section

3(c)(1)’s Look-Through Provision.84

Specifically, Congress appears not to

have intended to require a

Grandfathered Fund to provide the

notice and redemption opportunity to

security holders of its institutional

investors, even when those security

holders would be deemed beneficial

owners of the Grandfathered Fund’s

voting securities under the LookThrough Provision.85 Rather, the notice

and redemption opportunity generally

are intended to be provided only to the

institutional investor, unless the

institutional investor is controlled by or

under common control with the

Grandfathered Fund.86

Consistent with the purposes

indicated in the legislative history of the

1996 Act, the Commission believes that

the grandfather notice and redemption

opportunity requirements were

intended not only for the purposes

described above, but for the benefit of

certain persons who were deemed to be

beneficial owners prior to the 1996 Act’s

amendments to the Look-Through

Provision.87 These persons may have

relied on the then-existing LookThrough Provision as a way to limit the

Grandfathered Fund’s ability to sell its

securities to additional investors.88

Allowing the Grandfathered Fund to

raise substantial new capital from an

unlimited number of qualified

purchasers could significantly alter the

nature of an investment in the

Grandfathered Fund. Most commenters

agreed that the manner in which the

proposed rule defined beneficial

ownership for purposes of the

Grandfather Provision is consistent with

the 1996 Act’s legislative history and

supported the rule.

b. Operation of the Rule

Paragraph (a) of rule 2a51–2 provides

generally that beneficial ownership is to

be determined in accordance with

section 3(c)(1) of the Act.89 Paragraph

(b) of the rule provides a special rule for

determining beneficial ownership of

securities held by a company.90

Paragraph (b) provides that securities of

a Grandfathered Fund beneficially

owned by a company (without giving

effect to the Look-Through Provision)

are deemed to be beneficially owned by

one person (the ‘‘Owning Company’’)

unless (i) on October 11, 1996, under

section 3(c)(1)(A) of the Act as then in

effect, the voting securities of the

Grandfathered Fund were deemed to be

beneficially owned by the holders of the

Owning Company’s outstanding

securities,91 (ii) the Owning Company
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17521

assure that the Grandfathered Fund did not engage

in transactions subsequent to the enactment of the

1996 Act designed to limit the applicability of the

Look-Through Provision (such as the issuance of

additional voting securities so that the percentage

of voting securities owned by an Owning Company

falls below 10%).

92See supra note 38 (describing the Act’s

definition of control).

93Limiting the application of the Look-Through

Provision in this context to Owning Companies that

are investment companies or privately offered funds

is consistent with amended section 3(c)(1)(A). If the

Owning Company is not an investment company or

a privately offered fund, its security holders are

unlikely to have a sufficient interest in its

investment in the Grandfathered Fund to justify

providing them with the grandfather notice and

redemption opportunity. See supra note 19 and

accompanying text.

94See supra section I.B. of this Release.

95Compare House Report, supra note 12, at 51

(describing original provision in H.R. 3005, as

reported by the Committee on Commerce, which

limited the notice and redemption opportunity to

investors that were not qualified purchasers) and

Senate Report, supra note 12, at 23 (‘‘The issuer

must allow section 3(c)(1) fund owners ‘of record’

to redeem their interests in the fund in either cash

or a proportionate share of the fund’s assets.’’); see

also supra note 82.

96Section 3(c)(7)(B)(ii)(II) of the Act. Each person

electing to redeem must receive its proportionate

share of the Grandfathered Fund’s net assets in

cash, unless the person agrees to accept such

amount in kind (i.e., in assets of the Grandfathered

Fund). If the Grandfathered Fund elects to provide

investors with an opportunity to receive an in-kind

distribution, this election must be disclosed in the

grandfather disclosure.

97See, e.g., section 2(a)(32) of the Investment

Company Act [15 U.S.C. 80a–2(a)(32)] (defining the

term redeemable security as a ‘‘security * * *

under the terms of which the holder * * * is

entitled (whether absolutely or only out of surplus)

to receive approximately his proportionate share of

the issuer’s current net assets, or the cash

equivalent thereof’’) and rule 2a–4 [17 CFR 270.2a–

4] (definition of current net asset value for certain

purposes).

98See Proposing Release, supra note 4, at n.76

and accompanying text.

99The Grandfather Provision requires that a

Grandfathered Fund afford its beneficial owners a

redemption opportunity ‘‘notwithstanding any

agreement to the contrary between’’ the Fund and

Continued

has a control relationship with the

Grandfathered Fund,92 and (iii) the

Owning Company is itself an

investment company or a privately

offered fund.93 If these conditions do

not apply, the grandfather notice and

redemption opportunity should be

provided to the Owning Company. If the

conditions do apply, the grandfather

notice and redemption opportunity

should be provided to the Owning

Company’s security holders as the

beneficial owners of the Grandfathered

Fund’s securities.

The application of the rule can best be

illustrated by the following example.

Assume Company A is a Grandfathered

Fund and that Company B, a Section

3(c)(1) Fund, owned more than 10% of

the voting securities of Company A on

October 11, 1996. If Company B does

not have a control relationship with

Company A, the grandfather notice and

redemption opportunity can be

provided directly to Company B. If a

control relationship does exist, and on

October 11, 1996, the security holders of

Company B were deemed to be the

beneficial owners of Company A’s

voting securities (because of the Second

10% Test),94 Company A must provide

the grandfather notice and redemption

opportunity to each of Company B’s

security holders.

c. Interpretative Issues Relating to the

Grandfather Provision

i. Scope of the Grandfather Provision

The Commission believes that the

notice and redemption opportunity

requirements of the Grandfather

Provision were intended for the benefit

of all persons who are beneficial owners

of the securities of a Grandfathered

Fund. The Commission noted in the

Proposing Release that, consistent with

this legislative intent, it believed that

the conditions in the Grandfather

Provision must be complied with by any

Section 3(c)(1) Fund that wishes to rely

on the Grandfather Provision, even if

each beneficial owner of the Fund meets

the definition of qualified purchaser.

While several commenters objected to

this interpretation, the Commission

believes that it clearly reflects the

legislative history of the Grandfather

Provision. If the notice and redemption

opportunity requirements had been

intended only for the benefit of

beneficial owners who are not qualified

purchasers, Congress could have limited

the Grandfather Provision accordingly.95

ii. ‘‘Net Assets’’

The Grandfather Provision states that

a redeeming beneficial owner of a

Grandfathered Fund is entitled to

receive its proportionate share of the

Fund’s ‘‘net assets.’’ 96 The Act does not

define the term ‘‘net assets.’’ In the

Proposing Release, the Commission

noted that the term ‘‘current net assets’’

is used in the Investment Company Act

and defined by Commission rule.97 The

Commission requested comment

whether ‘‘net assets,’’ for purposes of

the Grandfather Provision, should be

determined based upon the methods

used to determine ‘‘current net assets,’’

or the methods that would have been

used to determine the amount that the

beneficial owner would have received

in accordance with existing withdrawal

provisions in the Grandfathered Fund’s

governing documents. Most commenters

suggested that ‘‘net assets’’ be

determined in accordance with the

latter approach.

The Commission does not believe that

the term ‘‘net assets’’ as used in the

Grandfather Provision was intended to

be identical to the term ‘‘current net

assets’’ as used in the Act. The

Commission believes that the term ‘‘net

assets’’ should be interpreted in a

manner consistent with the legislative

purposes of the notice and redemption

opportunity requirements of the

Grandfather Provision. The Grandfather

Provision was designed to afford

investors in the Grandfathered Fund an

opportunity to redeem their investment,

without penalty, before the

Grandfathered Fund raises substantial

new capital by increasing the number of

the Fund’s security holders above the

limit in section 3(c)(1), thereby possibly

altering the nature of an investment in

the Grandfathered Fund.98

It would be consistent with the

Grandfather Provision for a

Grandfathered Fund to conclude that it

could redeem a beneficial owner’s pro

rata share of the net asset value of the

Fund in accordance with the methods

specified in the Fund’s governing

documents. Valuation methods that

‘‘hold back’’ certain amounts (e.g.,

reserves for contingent liabilities) may

be consistent with the Grandfather

Provision to the extent that they do not

act as a penalty for exercising the

redemption right afforded by section

3(c)(7). If a fund is unable to conclude

that the hold back is not a penalty, the

fund could continue to comply with

section 3(c)(1) until all amounts due to

redeeming beneficial owners have been

paid.

Commenters requested guidance

concerning how to determine the pro

rata share of net assets to which debt

and senior securities redeemed in

accordance with the Grandfather

Provision would be entitled. The

Commission believes that the ‘‘net

assets’’ attributable to these securities

would generally be determined by the

repayment or redemption provisions

governing such instruments. In most

cases, this amount could be the

principal amount of the securities (or, in

the case of preferred stock, the

liquidation preference or other amount

payable upon redemption), any accrued

and unpaid interest or dividends, and

any premium due upon prepayment or

redemption.

The Commission also notes that the

Grandfather Provision does not override

provisions in fund documents, other

agreements or applicable law that could

have the effect of preventing a fund

from converting into a Section 3(c)(7)

Fund.99 For example, if a fund’s
17522 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

its investors. Section 3(c)(7)(B)(ii)(II) of the Act.

This provision is designed to assure that the

Grandfathered Fund affords the redemption

opportunity prior to admitting qualified purchasers

in accordance with section 3(c)(7), notwithstanding

contractual provisions that only require redemption

opportunities to be provided periodically.

100Similarly, if a Grandfathered Fund has issued

debt securities pursuant to an indenture that

requires a prepayment premium if the debt

securities are repaid before a specified date (or

precludes prepayment), the Grandfather Provision

does not override these provisions.

101For example, commenters suggested that in

order to meet redemption requests, a fund might be

required to sell illiquid portfolio positions at a loss

or when it would not otherwise be in the best

interests of the fund’s investors to do so.

102The legislative history of the 1996 Act does

not explain the purpose of the Consent Provision.

Section 2(a)(51)(C) uses the term ‘‘excepted

company’’ to refer to Section 3(c)(1) and Section

3(c)(7) Funds. The inclusion of Section 3(c)(7)

Funds in this provision was presumably designed

to require the consent to be obtained by any

Grandfathered Fund that wished to be a qualified

purchaser.

103 Id.

104 17 CFR 270.2a51–2(c).

105 17 CFR 270.2a51–2(d).

106Many of these commenters believed that such

consent was not required under the provision of the

proposed rule defining indirect beneficial

ownership.

107Such conduct also may raise issues under

section 48(a) of the Investment Company Act [15

USC 80a-47(a)] (prohibiting violations of the Act’s

provisions by indirect means).

108The Consent Provision also may have been

designed to give investors in an existing privately

offered fund the opportunity to review what could

be a significant change in the manner in which the

fund makes investments as a result of the regulatory

changes effected by the 1996 Act. In the absence of

a control relationship, however, it is unlikely that

the investors in the Owning Fund would have a

significant interest in the Purchasing Fund’s

decision to invest in a Section 3(c)(7) Fund.

109 17 CFR 270.2a51–2(e). The following example

illustrates the operation of the rule. Assume

Company A is a Purchasing Fund that wishes to

invest in Company B as a qualified purchaser, and

that Companies C and D are beneficial owners of

Company A’s voting securities. Company C is an

operating company that does not have a control

relationship with Company A, but whose security

holders were deemed to be beneficial owners of

Company A’s voting securities on April 30, 1996.

Company D is a privately offered fund that was

deemed to own beneficially Company A’s voting

securities on April 30, 1996 (in other words, the

Look-Through Provision did not apply). Each of

Company D’s investors (Companies E through G)

are themselves privately offered funds, but none has

a control relationship with Company D or Company

A.

partnership agreement prohibits the

fund from having more than 100

investors, the fund may have to seek to

amend the agreement before selling its

securities to qualified purchasers (if the

fund already has 100 investors).100

Many commenters observed that in

the case of certain privately offered

funds, providing the redemption

opportunity required by the Grandfather

Provision could have significant adverse

effects on a fund’s investment

strategy.101 The Grandfather Provision

does not override the fiduciary duties

that a sponsor of a Grandfathered Fund

may have to the beneficial owners of the

Fund’s securities under the Fund’s

governing documents or applicable law.

Thus, the general partner or other

fiduciary of a privately offered fund may

have to consider whether effecting the

notice and redemption required by the

Grandfather Provision in order to be

able to open the fund to new investors

(and increase the amount of assets in the

fund and the general partner’s fee) is in

the best interests of the fund’s security

holders.

2. The Consent Provision

Section 2(a)(51)(C) of the Act requires

that a privately offered fund that wishes

to become a qualified purchaser

(‘‘Purchasing Fund’’) obtain the consent

of all of its beneficial owners that had

invested in the Purchasing Fund on or

before April 30, 1996.102 The beneficial

owners of the securities of any privately

offered fund that is a direct or indirect

beneficial owner of the securities of the

Purchasing Fund also must consent to

the treatment of the Purchasing Fund as

a qualified purchaser.103

a. Definition of Beneficial Owner

Paragraph (c) of rule 2a51–2 clarifies

the meaning of the term ‘‘beneficial

owner’’ for purposes of the Consent

Provision.104 The rule provides that

securities of a Purchasing Fund

beneficially owned by a company

(‘‘Owning Company’’), without giving

effect to the Look-Through Provision,

are deemed to be beneficially owned by

one person unless (i) on April 30, 1996,

under section 3(c)(1)(A) of the Act as

then in effect, the voting securities of

the Purchasing Fund were deemed to be

beneficially owned by the holders of the

Owning Company’s outstanding

securities, (ii) the Owning Company has

a control relationship with either the

Purchasing Fund or the Section 3(c)(7)

Fund with respect to which the

Purchasing Fund will be a qualified

purchaser (‘‘Target Fund’’), and (iii) the

Owning Company itself is a privately

offered fund. If these conditions do not

apply, the consent must be obtained

from the Owning Company. If the

conditions do apply, the consent must

be obtained from the Owning

Company’s security holders as the

beneficial owners of the Purchasing

Fund’s securities under the rule.

As in the case of the definition of

beneficial owner for purposes of the

Grandfather Provision, the rule relating

to the Consent Provision is intended to

allow an institutional investor to

provide the required consent even if,

under the Look-Through Provision, the

security holders of the institutional

investor are deemed to be beneficial

owners of the Purchasing Fund’s

securities. If there is a control

relationship between the Purchasing

Fund and either the Owning Company

or the Target Fund, and the Owning

Company is a privately offered fund

whose security holders were deemed

beneficial owners of the Purchasing

Fund on April 30, 1996, then the

consent must be obtained from those

security holders.

b. Required Consent

As proposed, paragraph (d) of the rule

clarifies what constitutes ‘‘indirect’’

ownership with regard to the

requirement in section 2(a)(51)(C) of the

Act that the consent be obtained from

the security holders of a privately

offered fund that is an indirect

beneficial owner of the Purchasing

Fund.105 The rule provides that the

privately offered fund would not be

considered to own the securities of the

Purchasing Fund indirectly unless the

privately offered fund has a control

relationship with either the Purchasing

Fund or the Target Fund. Commenters

generally supported this approach.

Several commenters also suggested

that the rule generally should limit the

circumstances under which a

Purchasing Fund must obtain the

consent of the beneficial owners of the

securities of a privately offered fund

that directly owns the securities of the

Purchasing Fund (‘‘Owning Fund’’).106

These commenters stated that if the rule

did not contain such a limitation,

consent would have to be obtained from

security holders who would not be

entitled to receive the notice and

redemption opportunity required by the

Grandfather Provision.

As noted in the Proposing Release, the

Consent Provision appears to be

designed to prohibit an existing Section

3(c)(1) Fund from avoiding the notice

and redemption opportunity

requirements of the Grandfather

Provision by investing its assets in a

Section 3(c)(7) Fund, either directly or

indirectly through another privately

offered fund.107 This purpose is served

if the scope of the Consent Provision is

the same as that of the Grandfather

Provision.108 Paragraph (e) of the rule,

as adopted, clarifies that the consent of

the beneficial owners of the Owning

Fund is not required unless the Owning

Fund directly or indirectly controls, is

controlled by, or is under common

control with, the Purchasing Fund or

the Target Fund.109
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17523

Company C would have to consent to Company

A being a qualified purchaser. Because Company C

is not a privately offered fund, Company C’s

shareholders would not be treated as beneficial

owners of Company A’s voting securities, and their

consent would not be required. (The consent of

Company C’s shareholders would not be required

even if Company C had a control relationship with

Company A.)

Company D would have to consent to Company

A being a qualified purchaser. Even though

Company D is a privately offered fund, the

beneficial owners of its outstanding securities (i.e.,

Companies E through G) would not have to consent

to Company A being a qualified purchaser unless

there was a control relationship between Company

D and either Company A or Company B. Security

holders of Companies E through G would not be

required to consent even if they are considered to

be beneficial owners of Company D’s securities

under the Look-Through Provision because there is

no control relationship. Similarly, Companies E

through G would not be deemed to indirectly own

voting securities of Company A.

110 17 CFR 270.2a51–3(a).

111Section 2(a)(51)(A)(iii) of the Act.

112See supra note 107 and accompanying text

(discussing section 48(a) of the Act). The rule, as

proposed, would have required all interests in the

company to be owned by qualified purchasers. The

rule, as adopted, recognizes that such a company

may be organized as a limited partnership, with a

person or company serving as the general partner.

In these circumstances, if the general partnership

interest is not being used as a device to evade the

provisions of section 3(c)(7) limiting security

holders of the Section 3(c)(7) Fund to qualified

purchasers, the general partner need not be a

qualified purchaser. See supra notes 78–79 and

accompanying text.

113Rule 2a51–3(b) [17 CFR 270.2a51–3(b)]; see

supra note 112.

114See 142 Cong. Rec. at E1938 (Oct. 21, 1996)

(Remarks of Hon. John D. Dingell); House Hearings,

supra note 5, at 71 (prepared statement of Marianne

Smythe); see also Hedge Funds Task Force Report,

supra note 60, at 779.

115The Non-Integration Provision states, in part,

that an issuer that is otherwise excepted under

section 3(c)(7) and an issuer that is otherwise

excepted under section 3(c)(1) are not to be treated

by the Commission as being a single issuer for

purposes of determining the number of beneficial

owners of the Section 3(c)(1) Fund or whether the

outstanding securities of the Section 3(c)(7) Fund

are owned by anyone who is not a qualified

purchaser. The Commission staff has addressed the

possibility of integrating Section 3(c)(1) Funds

established by the same sponsor for purposes of

determining whether they constitute the same

issuer and have exceeded the 100-investor limit of

section 3(c)(1). See, e.g., Shoreline Fund (Apr. 11,

1994) (the staff considers several factors in

determining whether funds should be integrated

and generally will require integration if ‘‘a

reasonable purchaser would view an interest in an

offering as not materially different from another’’).

116See Remarks of Hon. John D. Dingell, supra

note 114.

Under the rule, the Purchasing Fund

could obtain a general consent with

respect to most transactions in which it

will be a qualified purchaser. Whether

a specific consent would be required

when there is a control relationship

between the Purchasing Fund or certain

of its beneficial owners and the Target

Fund would depend upon whether the

general consent provided sufficient

information to elicit an informed

consent from the appropriate investors.

C. Conforming Rule

Rule 2a51–3(a) under the Investment

Company Act clarifies an interpretative

issue concerning companies that are

qualified purchasers.110 The statutory

definition of qualified purchaser

specifies that a trust that is a qualified

purchaser must not have been formed

‘‘for the specific purpose of acquiring

the securities offered.’’ 111 The rule

makes the same condition applicable to

any other company that is a Prospective

Qualified Purchaser (whether a Family

Company or another type of company)

unless each beneficial owner of the

company’s securities is a qualified

purchaser. The rule thus limits the

possibility that a company will be able

to do indirectly what it is prohibited

from doing directly (i.e., organize a

‘‘qualified purchaser’’ entity for the

purpose of making an investment in a

particular Section 3(c)(7) Fund available

to investors that themselves did not

meet the definition of qualified

purchaser).112

As suggested by several commenters,

the scope of the rule has been expanded

to permit a company to be a qualified

purchaser (even if the company did not

own $5 million of investments, in the

case of a Family Company, or $25

million of investments in the case of any

other type of company) if each

beneficial owner of the company’s

securities is a qualified purchaser.113

D. Non-Exclusive Safe Harbor for

Certain Section 3(c)(7) Funds

The legislative history of the 1996 Act

indicates that a sponsor of an existing

Section 3(c)(1) Fund could establish a

new Section 3(c)(7) Fund.114 Section

3(c)(7)(E) of the Act (the ‘‘NonIntegration Provision) provides that the

Commission may not ‘‘integrate’’ the

two Funds—that is, treat the two Funds

as a single issuer for purposes of

determining the number of beneficial

owners of the Section 3(c)(1) Fund or

whether the outstanding securities of

the Section 3(c)(7) Fund are owned by

anyone who is not a qualified

purchaser.115 The Non-Integration

Provision, however, is not intended to

allow a sponsor of an existing Section

3(c)(1) Fund nominally to convert that

fund into a Section 3(c)(7) Fund, and

then to create another Section 3(c)(1)

Fund (‘‘Related Section 3(c)(1) Fund’’)

thereby avoiding the 100-investor

limit.116 The Non-Integration Provision,

thus, was not designed to preclude the

Commission from treating a nominally

converted Section 3(c)(1) Fund and a

Section 3(c)(1) Fund organized by the

same sponsor as a single issuer for

certain purposes.

Prior to the publication of the

Proposing Release, representatives of

hedge funds and other investment pools

raised concerns regarding the ability of

a sponsor of a Section 3(c)(1) Fund that

undergoes a bona fide conversion into a

Section 3(c)(7) Fund (i.e., provides the

grandfather notice and redemption

opportunity and sells its securities to

new investors that are qualified

purchasers) to then create a new Section

3(c)(1) Fund. The Commission proposed

rule 3c–7 to respond to these concerns.

The rule would have provided that a

Grandfathered Fund will be treated as

an issuer excluded under section 3(c)(7)

of the Act if, at the time the new Section

3(c)(1) Fund offers its securities, 25% or

more of the value of all securities of the

Grandfathered Fund is held by qualified

purchasers that acquired these securities

after October 11, 1996.

Commenters had mixed reactions to

the proposed rule. Several commenters

supported the rule as proposed or with

modifications that would base

availability of the safe harbor on

securities held by qualified purchasers

regardless of when acquired. Other

commenters believed that the proposed

rule was unnecessary, that the

percentage threshold for qualified

purchasers investing in the fund would

preclude bona fide conversions, and

that the Commission could rely on its

anti-fraud authority to address ‘‘sham’’

grandfathering transactions.

Upon further consideration of the

issue, and after considering the views of

the commenters, the Commission does

not believe that a safe harbor rule is

necessary. In the Commission’s view,

the Non-Integration Provision was not

designed to permit a fund to rely on

section 3(c)(7) if the fund’s compliance

with the Grandfather Provision was

designed to evade the 100-investor

limitation of section 3(c)(1). A fund that

purports to rely on section 3(c)(7) based

on the Grandfather Provision must have

the bona fide purpose of selling its

securities to qualified purchasers. At

this time, the Commission does not

believe that it is necessary to set forth

a test based on the percentage of

securities owned by qualified

purchasers to establish the bona fides of

a conversion for purposes of

determining compliance with the Act.

Whether a conversion to a

Grandfathered Fund is bona fide and

undertaken in good faith would depend

upon the facts and circumstances. The

relevant facts would include, among

others, whether the fund has taken steps

to sell its securities to qualified

purchasers, and whether the fund is
17524 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

117The amended Look-Through Provision applies

only when an investment company or a privately

offered fund invests in a Section 3(c)(1) Fund. The

1996 Act expands the ability of corporate, noninvestment company investors to participate in

Section 3(c)(1) Funds by no longer requiring

Section 3(c)(1) Funds to count the underlying

shareholders of these investors under any

circumstances.

118The rule does not limit additional acquisitions

of securities by a 10%+ Security Holder, as long as

it satisfies the Second 10% Test on the date of

acquisition. For the purpose of the rule, securities

of Section 3(c)(7) Funds would be included in

applying the Second 10% Test, since a Section

3(c)(7) Fund probably would have been a Section

3(c)(1) Fund but for the new exclusion created by

the 1996 Act. The rule also applies to ownership

interests of 10% or more that are acquired as a

result of a conversion of convertible non-voting

securities.

119See supra note 107 (discussing section 48(a) of

the Act).

120The rule specifies that these persons must be

knowledgeable employees at the time they acquire

the fund’s securities. They do not have to dispose

of these securities (or be counted as security holders

for purposes of section 3(c)(1)’s 100-investor limit)

upon termination of employment.

121The fund will have to determine whether a

knowledgeable employee’s acquisition of the

securities is a transaction exempt from the

registration requirements of the Securities Act. See,

e.g., Regulation D under the Securities Act [17 CFR

230.501 through .508].

122Rule 3c–5(a)(4) [17 CFR 270.3c–5(a)(4)]. The

rule specifies that a fund’s investment adviser is

considered to be an affiliated person of the fund for

purposes of the rule. Rule 3c–5(a)(1) [17 CFR

270.3c–5(a)(1)].

123Rule 3c–5(a)(4)(i) [17 CFR 270.3c–5(a)(4)(i)].

124Rule 3c–5(a)(4)(ii) [17 CFR 270.3c–5(a)(4)(ii)].

subject to legal or other impediments

that would preclude it from selling its

securities to qualified purchasers.

III. Other Rules Relating to Privately

Offered Funds

A. Section 3(c)(1) Funds

1. Transition Rule

The 1996 Act amended section

3(c)(1)(A) of the Investment Company

Act, the Look-Through Provision, which

governs the way in which a Section

3(c)(1) Fund calculates the number of its

beneficial owners for purposes of

complying with the 100-investor limit.

Under amended section 3(c)(1)(A), a

Section 3(c)(1) Fund must include

among its beneficial owners the

underlying security holders of any

investment company or privately

offered fund that owns 10% or more of

the Section 3(c)(1) Fund (collectively,

‘‘10%+ Security Holders’’). The pre1996 Act Look-Through Provision did

not apply unless the 10%+ Security

Holder also had more than 10% of its

assets invested in Section 3(c)(1) Fund

securities generally. The amendment, in

effect, limits the ability of certain types

of investors to own more than 10% of

a Section 3(c)(1) Fund.117

Some existing Section 3(c)(1) Funds

have 10%+ Security Holders in reliance

on the pre-amendment application of

the Look-Through Provision. As a result

of the 1996 Act, such a fund may be

required to treat a 10% Security Holder

as more than one beneficial owner for

purposes of the 100-investor limit. The

Commission believes that the

amendment to the Look-Through

Provision was designed primarily to

simplify the application of the Provision

and was not intended to disrupt existing

investment arrangements. The

Commission, therefore, proposed rule

3c–1 under the Investment Company

Act to provide that the amended LookThrough Provision will not apply in the

case of a pre-1996 Act 10%+ Security

Holder, provided that the 10%+

Security Holder continues to satisfy the

Second 10% Test.118

The rule is adopted with one change.

The rule, as proposed, would have

applied only to a 10%+ Security Holder

that acquired its interest in the fund

before the 1996 Act was signed by the

President. Several commenters

suggested that the rule should apply to

any 10%+ Security Holder that acquired

its securities prior to the effective date

of the amendments to the Look-Through

Provision. These commenters noted that

Section 3(c)(1) Funds that admitted new

investors near the end of 1996 may not

have known, or appreciated the

significance, of the 1996 Act’s

amendments. In view of the

commenters’ suggestions, the rule as

adopted applies to 10%+ Security

Holders that acquired their securities on

or before April 1, 1997.

2. Applicability of the Amended LookThrough Provision

The Commission believes that, as a

general matter, the determination of

whether an investor is subject to the

amended Look-Through Provision must

be made each time the investor acquires

a voting security of a Section 3(c)(1)

Fund. Thus, an investor would not

become subject to the Look-Through

Provision if its proportionate ownership

of the Fund’s voting securities increased

solely because another investor

redeemed its securities in the Fund.

This analysis would not apply if the

redemption (or other transaction) were

part of a series of transactions designed

to avoid the Look-Through Provision.119

B. Investments by Knowledgeable

Employees

As directed by Congress, the

Commission is adopting rule 3c–5 under

the Investment Company Act to permit

‘‘knowledgeable employees’’ of a fund

and certain of its affiliates to acquire

securities issued by the fund without

being counted for purposes of section

3(c)(1)’s 100-investor limit.120 In

addition, as directed by Congress, the

rule permits knowledgeable employees

to invest in a Section 3(c)(7) Fund even

though they do not meet the definition

of qualified purchaser.121 Commenters

generally supported the rule, although

several commenters suggested that the

scope of the rule’s definition of

knowledgeable employees be expanded.

Rule 3c–5 defines knowledgeable

employees as the directors, executive

officers, and general partners of the fund

or an affiliated person of the fund that

oversees the fund’s investments

(‘‘Management Affiliate’’).122 The rule

also encompasses persons who serve in

capacities similar to directors, such as

trustees and advisory board members.123

The rule as proposed also would have

included as knowledgeable employees

other employees of the fund or its

Management Affiliate who, in

connection with their regular functions

or duties, participate in, or obtain

information regarding, the investment

activities of the fund or other

investment companies managed by the

Management Affiliate. One commenter

suggested that including employees who

‘‘obtain information’’ regarding the

investment activities could include

employees, such as compliance

personnel, who may not have any

investment experience. The

Commission agrees, and the rule as

adopted includes only employees who

‘‘participate in’’ the investment

activities of the fund or other

investment companies managed by the

fund’s Management Affiliate.124

The rule, as proposed, would have

required employees who are

knowledgeable employees by virtue of

their participation in investment

activities to have been engaged in these

activities on behalf of the fund or the

Management Affiliate for a period of at

least 12 months. Several commenters

suggested that the 12 month period

would unnecessarily limit the ability of

new employees who had equivalent

experience with their previous

employer to invest in the fund. The

Commission has concluded that it is not

necessary to require that an employee

work for the particular fund or

Management Affiliate for the entire 12-

month period as long as the employee

has the requisite experience to

appreciate the risks of investing in the

fund. The rule, as adopted, therefore

includes as knowledgeable employees

those employees who performed

substantially similar functions or duties
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17525

125 Id.

126Rule 3c–5(b)(2) [17 CFR 270.3c–5(b)(2)].

127Rule 3c–5(b)(3) [17 CFR 270.3c–5(b)(3)].

128H.R. Rep. No. 1341, 96th Cong., 2d Sess. at 36

(1980).

129 15 U.S.C. 80a–3 note.

130Transferees are not limited to natural persons.

Donative transfers to charitable organizations are

therefore permitted by the rule.

131The rule, as proposed, would have permitted

transfers to the specified categories of Transferees

pursuant to ‘‘other involuntary events.’’ Given the

breadth of the rule and the elimination of

restrictions on the classes of Transferees, the

Commission does not believe that it is necessary at

this time to address other involuntary transfers of

Section 3(c)(1) Fund securities.

132A person that acquires securities from a

Transferee for consideration or from the Section

3(c)(1) Fund would have to be counted toward the

100-investor limitation as a beneficial owner (or

more than one beneficial owner, if the amended

Look-Through Provision is applicable).

133Other involuntary transfers of Section 3(c)(7)

Fund securities may occur even if they are not

covered by rule 3c–6. See section 3(c)(7)(A) of the

Act (‘‘securities that are owned by persons who

received the securities from a qualified

purchaser * * * in a case in which the transfer

was caused by * * * other involuntary event,

shall be deemed to be owned by a qualified

purchaser, subject to such rules, regulations and

orders as the Commission may prescribe * * *’’).

The Commission does not contemplate adopting

additional rules concerning involuntary transfers

under section 3(c)(7) at the present time. 134 15 U.S.C. 80a-2(c).

for or on behalf of another person

during the preceding 12 months.125

The rule permits the acquisition of

privately offered fund securities by a

company all of whose owners are

knowledgeable employees.126 This

change is consistent with rule 2a51–3,

which permits a company all of whose

securities are owned by qualified

purchasers to itself be treated as a

qualified purchaser. In addition, the

rule permits knowledgeable employees

to transfer their securities of a privately

offered fund on the same terms as those

governing transfers by other owners of

fund securities in rule 3c–6 discussed

below.127

Several commenters suggested that

the rule permit purchases by broader

categories of employees. The provision

in the 1996 Act directing Commission

rulemaking with regard to investments

in privately offered funds by

knowledgeable employees appears to be

intended to encompass persons who

actively participate in the management

of a fund’s investments. At this time, the

Commission believes that the rule as

adopted is consistent with this

legislative purpose.

C. Involuntary Transfers

Section 3(c)(1)(B) of the Act provides

that beneficial ownership of securities

of a Section 3(c)(1) Fund by any person

who acquires the securities as a result

of a ‘‘legal separation, divorce, death, or

other involuntary event’’ will be

deemed to be beneficial ownership by

the person from whom the transfer was

made, pursuant to such rules and

regulations as the Commission

prescribes. This provision was designed

to address situations in which section

3(c)(1)’s 100-investor limit is exceeded

‘‘because of transfers which are neither

within the issuer’s control nor are

voluntary on the part of the present

beneficial owner.’’ 128

The 1996 Act directed the

Commission to prescribe rules to

implement section 3(c)(1)(B). 129 The

Commission is adopting rule 3c–6 under

the Investment Company Act to provide

that beneficial ownership by a person

(‘‘Transferee’’) who acquired securities

of a Section 3(c)(1) Fund pursuant to a

gift, bequest, or an agreement relating to

a legal separation or divorce will be

deemed to be beneficial ownership by

the person from whom the transfer was

made (‘‘Transferor’’).130 Rule 3c–6, as

proposed, would have permitted such

transfers of fund securities only to

certain persons, generally family

members. Commenters suggested that

the categories of Transferees were

unnecessarily limited. These

commenters also noted that, as long as

the transfer is in the form of a gift, the

relationship of the Transferee to the

Transferor was not particularly

important for purposes of the policies

underlying section 3(c)(1). The rule as

adopted reflects this approach.131

Unlike the proposed rule, the rule as

adopted does not limit subsequent

transfers by Transferees that are in the

form of a gift or bequest. Several

commenters suggested that this

limitation would be unnecessarily

restrictive. As noted by commenters, it

is not necessary for the rule to contain

restrictions on non-donative transfers

since the effect of the transfer may be to

cause the Section 3(c)(1) Fund to lose its

exclusion from Investment Company

Act regulation.132

Rule 3c–6 also deals with transfers of

securities by qualified purchasers under

section 3(c)(7)(A) of the Act. That

section provides that securities of a

Section 3(c)(7) Fund that are owned by

persons who received them from a

qualified purchaser as a gift or bequest,

or when the transfer was caused by legal

separation, divorce, death or other

involuntary event, will be deemed to be

owned by a qualified purchaser, subject

to such rules as the Commission may

prescribe. Rule 3c–6 permits transfers of

securities of a Section 3(c)(7) Fund

under essentially the same conditions as

those governing transfers under section

3(c)(1)(B).133 The rule treats a person

who acquires securities of a Section

3(c)(7) Fund in accordance with the rule

as qualified purchasers only for

purposes of those securities. If the

person acquires additional securities of

the Fund other than in accordance with

the rule, the person would have to meet

the definition of qualified purchaser

(without regard to the rule) at that time.

IV. Cost/Benefit Analysis and Effects on

Competition, Efficiency and Capital

Formation

Consistent with legislative intent and

the protection of investors, the rules

benefit privately offered funds and their

investors in a number of ways. The rules

define certain terms necessary to

effectuate the new exclusion from

regulation under the Investment

Company Act for Section 3(c)(7) Funds;

enable Section 3(c)(1) Funds that wish

to convert into Section 3(c)(7) Funds or

become qualified purchasers to do so

without being subject to unduly

burdensome notice and consent

requirements; enable knowledgeable

employees of a privately offered fund to

invest in the fund without causing the

fund to relinquish its exclusion from

regulation under the Act; permit certain

transfers of privately offered fund

securities; and clarify certain

interpretative issues for privately

offered funds. The Commission believes

that the rules would not impose any

additional costs on privately offered

funds. Rather, the rules would clarify

the statutory requirements for privately

offered funds in order to reduce any

unnecessary burdens without

jeopardizing investor protection.

Section 2(c) of the Investment

Company Act provides that whenever

the Commission is engaged in

rulemaking and is required to consider

or determine whether an action is

necessary or appropriate in the public

interest, the Commission also shall

consider, in addition to the protection of

investors, whether the action will

promote efficiency, competition, and

capital formation. 134 The Commission

believes that the rules will promote

efficiency, competition and capital

formation. The rules define terms and

clarify certain provisions of the new

statutory exclusion for Section 3(c)(7)

Funds and clarify other statutory

requirements applicable to privately

offered funds. The Commission believes

that the rules do so in a way that will

reduce unnecessary burdens and

provide greater flexibility, consistent

with investor protection.
17526 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

V. Summary of Regulatory Flexibility

Analysis

A summary of the Initial Regulatory

Flexibility Act Analysis (‘‘IRFA’’),

which was prepared in accordance with

5 U.S.C. 603, was published in

Investment Company Act Release No.

22405. No comments were received on

the IRFA.

The Commission has prepared a Final

Regulatory Flexibility Analysis

(‘‘FRFA’’) in accordance with 5 U.S.C.

604 regarding rules 2a51–1, 2a51–2,

2a51–3, 3c–1, 3c–5 and 3c–6 under the

Investment Company Act. The FRFA

indicates that the rules comply with the

provisions of the 1996 Act directing the

Commission to prescribe certain rules

concerning privately offered funds, and

address certain interpretive issues

raised by the 1996 Act’s amendments

relating to privately offered funds. The

FRFA states that the rules, among other

things, are designed to assure that

investors in Section 3(c)(7) Funds are

the types of investors that Congress

determined do not need the protections

of the Investment Company Act. The

FRFA further states that the rules give

privately offered funds greater flexibility

as well as minimize certain compliance

burdens imposed by the applicable

provisions of the Investment Company

Act.

The FRFA also discusses the effect of

the rules on small entities that are

Section 3(c)(7) or Section 3(c)(1) Funds.

For purposes of the rules, small entities

are those with assets of $50 million or

less at the end of their most recent fiscal

year. The FRFA states that the rules

make possible the creation of small

entities that are Section 3(c)(7) Funds,

and provide greater flexibility and

minimize certain compliance burdens

imposed by the provisions of the

Investment Company Act on small

entities that are Section 3(c)(1) Funds. It

is estimated that there are

approximately 600 U.S. venture capital

pools that are Section 3(c)(1) Funds, of

which about 50% may be considered

small entities. The number of U.S.

hedge funds has been estimated as being

between 800 and 3,000. Based on a

sample of 250 hedge funds, it is

estimated that approximately 75% may

be small entities.

The FRFA states that the rules do not

impose any new reporting,

recordkeeping or compliance

requirements, and that the Commission

believes that there are no rules that

duplicate, overlap or conflict with the

adopted rules.

The FRFA discusses the various

alternatives considered by the

Commission in connection with the

rules that might minimize the effect on

small entities, including: (a) the

establishment of differing compliance or

reporting requirements or timetables

that take into account the resources of

small entities; (b) the clarification,

consolidation or simplification of

compliance and reporting requirements

under the rule for small entities; (c) the

use of performance rather than design

standards; and (d) an exemption from

coverage of the rule or any part of the

rule, for small entities. The Commission

believes that it would be inconsistent

with the purposes of the Act to exempt

small entities from the rules or to use

performance standards to specify

different requirements for small entities.

Different compliance or reporting

requirements for small entities are not

necessary because the rules do not

establish any new reporting,

recordkeeping or compliance

requirements. The Commission has

determined that it is not feasible to

further clarify, consolidate or simplify

the rules for small entities.

Cost-benefit information reflected in

the ‘‘Cost/Benefit Analysis’’ section of

this Release also is reflected in the

FRFA. A copy of the FRFA may be

obtained by contacting David P.

Mathews, Securities and Exchange

Commission, 450 5th Street, N.W., Mail

Stop 10–2, Washington, D.C 20549.

VI. Statutory Authority

The Commission is adopting rules

2a51–1, 2a51–2 and 2a51–3 pursuant to

the authority set forth in sections

2(a)(51)(B), 6(c) and 38(a) of the

Investment Company Act [15 U.S.C.

80a–2(a)(51)(B), –6(c) and –37(a)] and

sections 209(d) (2) and (4) of the 1996

Act [15 U.S.C. 80a–2 note and –3 note).

The Commission is adopting rule 3c–1

pursuant to the authority set forth in

sections 6(c) and 38(a) of the Investment

Company Act [15 U.S.C. 80a–6(c) and

–37(a)]. The Commission is adopting

rule 3c–5 pursuant to the authority set

forth in sections 6(c) and 38(a) of the

Investment Company Act [15 U.S.C.

80a–6(c) and –37(a)] and section

209(d)(3) of the 1996 Act [15 U.S.C.

80a–3 note]. The Commission is

adopting rule 3c–6 pursuant to the

authority set forth in sections 3(c)(1),

3(c)(7), 6(c) and 38(a) of the Investment

Company Act [15 U.S.C. 80a–3(c)(1),

–3(c)(7), –6(c) and –37(a)] and section

209(d)(1) of the 1996 Act [15 U.S.C.

80a–3 note].

List of Subjects in 17 CFR Part 270

Investment companies, Securities.

Text of Rules

For the reasons set out in the

preamble, Title 17, Chapter II of the

Code of Federal Regulations is amended

as follows:

PART 270—RULES AND

REGULATIONS, INVESTMENT

COMPANY ACT OF 1940

1. The authority citation for Part 270

continues to read in part as follows:

Authority: 15 U.S.C. 80a–1 et seq., 80a–37,

80a–39 unless otherwise noted;

* * * * *

2. Section 270.2a51–1 is added to read

as follows:

§ 270.2a51–1. Definition of investments for

purposes of section 2(a)(51) (definition of

‘‘qualified purchaser’’); certain calculations.

(a) Definitions. As used in this

section:

(1) The term Commodity Interests

means commodity futures contracts,

options on commodity futures contracts,

and options on physical commodities

traded on or subject to the rules of:

(i) Any contract market designated for

trading such transactions under the

Commodity Exchange Act and the rules

thereunder; or

(ii) Any board of trade or exchange

outside the United States, as

contemplated in Part 30 of the rules

under the Commodity Exchange Act [17

CFR 30.1 through 30.11].

(2) The term Family Company means

a company described in paragraph

(A)(ii) of section 2(a)(51) of the Act [15

U.S.C. 80a–2(a)(51)].

(3) The term Investment Vehicle

means an investment company, a

company that would be an investment

company but for the exclusions

provided by sections 3(c)(1) through

3(c)(9) of the Act [15 U.S.C. 80a–3(c)(1)

through 3(c)(9)] or the exemptions

provided by §§ 270.3a–6 or 270.3a–7, or

a commodity pool.

(4) The term Investments has the

meaning set forth in paragraph (b) of

this section.

(5) The term Physical Commodity

means any physical commodity with

respect to which a Commodity Interest

is traded on a market specified in

paragraph (a)(1) of this section.

(6) The term Prospective Qualified

Purchaser means a person seeking to

purchase a security of a Section 3(c)(7)

Company.

(7) The term Public Company means

a company that:

(i) Files reports pursuant to section 13

or 15(d) of the Securities Exchange Act

of 1934 [15 U.S.C. 78m or 78o(d)]; or

(ii) Has a class of securities that are

listed on a ‘‘designated offshore
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17527

securities market’’ as such term is

defined by Regulation S under the

Securities Act of 1933 [17 CFR 230.901

through 230.904].

(8) The term Related Person means a

person who is related to a Prospective

Qualified Purchaser as a sibling, spouse

or former spouse, or is a direct lineal

descendant or ancestor by birth or

adoption of the Prospective Qualified

Purchaser, or is a spouse of such

descendant or ancestor, provided that,

in the case of a Family Company, a

Related Person includes any owner of

the Family Company and any person

who is a Related Person of such owner.

(9) The term Relying Person means a

Section 3(c)(7) Company or a person

acting on its behalf.

(10) The term Section 3(c)(7)

Company means a company that would

be an investment company but for the

exclusion provided by section 3(c)(7) of

the Act [15 U.S.C. 80a–3(c)(7)].

(b) Types of Investments. For

purposes of section 2(a)(51) of the Act

[15 U.S.C. 80a–2(a)(51)], the term

Investments means:

(1) Securities (as defined by section

2(a)(1) of the Securities Act of 1933 [15

U.S.C. 77b(a)(1)]), other than securities

of an issuer that controls, is controlled

by, or is under common control with,

the Prospective Qualified Purchaser that

owns such securities, unless the issuer

of such securities is:

(i) An Investment Vehicle;

(ii) A Public Company; or

(iii) A company with shareholders’

equity of not less than $50 million

(determined in accordance with

generally accepted accounting

principles) as reflected on the

company’s most recent financial

statements, provided that such financial

statements present the information as of

a date within 16 months preceding the

date on which the Prospective Qualified

Purchaser acquires the securities of a

Section 3(c)(7) Company;

(2) Real estate held for investment

purposes;

(3) Commodity Interests held for

investment purposes;

(4) Physical Commodities held for

investment purposes;

(5) To the extent not securities,

financial contracts (as such term is

defined in section 3(c)(2)(B)(ii) of the

Act [15 U.S.C. 80a–3(c)(2)(B)(ii)] entered

into for investment purposes;

(6) In the case of a Prospective

Qualified Purchaser that is a Section

3(c)(7) Company, a company that would

be an investment company but for the

exclusion provided by section 3(c)(1) of

the Act [15 U.S.C. 80a–3(c)(1)], or a

commodity pool, any amounts payable

to such Prospective Qualified Purchaser

pursuant to a firm agreement or similar

binding commitment pursuant to which

a person has agreed to acquire an

interest in, or make capital

contributions to, the Prospective

Qualified Purchaser upon the demand

of the Prospective Qualified Purchaser;

and

(7) Cash and cash equivalents

(including foreign currencies) held for

investment purposes. For purposes of

this section, cash and cash equivalents

include:

(i) Bank deposits, certificates of

deposit, bankers acceptances and

similar bank instruments held for

investment purposes; and

(ii) The net cash surrender value of an

insurance policy.

(c) Investment Purposes. For purposes

of this section:

(1) Real estate shall not be considered

to be held for investment purposes by a

Prospective Qualified Purchaser if it is

used by the Prospective Qualified

Purchaser or a Related Person for

personal purposes or as a place of

business, or in connection with the

conduct of the trade or business of the

Prospective Qualified Purchaser or a

Related Person, provided that real estate

owned by a Prospective Qualified

Purchaser who is engaged primarily in

the business of investing, trading or

developing real estate in connection

with such business may de deemed to

be held for investment purposes.

Residential real estate shall not be

deemed to be used for personal

purposes if deductions with respect to

such real estate are not disallowed by

section 280A of the Internal Revenue

Code [26 U.S.C. 280A].

(2) A Commodity Interest or Physical

Commodity owned, or a financial

contract entered into, by the Prospective

Qualified Purchaser who is engaged

primarily in the business of investing,

reinvesting, or trading in Commodity

Interests, Physical Commodities or

financial contracts in connection with

such business may be deemed to be held

for investment purposes.

(d) Valuation. For purposes of

determining whether a Prospective

Qualified Purchaser is a qualified

purchaser, the aggregate amount of

Investments owned and invested on a

discretionary basis by the Prospective

Qualified Purchaser shall be the

Investments’ fair market value on the

most recent practicable date or their

cost, provided that:

(1) In the case of Commodity Interests,

the amount of Investments shall be the

value of the initial margin or option

premium deposited in connection with

such Commodity Interests; and

(2) In each case, there shall be

deducted from the amount of

Investments owned by the Prospective

Qualified Purchaser the amounts

specified in paragraphs (e) and (f) of this

section, as applicable.

(e) Deductions. In determining

whether any person is a qualified

purchaser there shall be deducted from

the amount of such person’s

Investments the amount of any

outstanding indebtedness incurred to

acquire or for the purpose of acquiring

the Investments owned by such person.

(f) Deductions: Family Companies. In

determining whether a Family Company

is a qualified purchaser, in addition to

the amounts specified in paragraph (e)

of this section, there shall be deducted

from the value of such Family

Company’s Investments any outstanding

indebtedness incurred by an owner of

the Family Company to acquire such

Investments.

(g) Special rules for certain

Prospective Qualified Purchasers—(1)

Qualified institutional buyers. Any

Prospective Qualified Purchaser who is,

or who a Relying Person reasonably

believes is, a qualified institutional

buyer as defined in paragraph (a) of

§ 230.144A of this chapter, acting for its

own account, the account of another

qualified institutional buyer, or the

account of a qualified purchaser, shall

be deemed to be a qualified purchaser

provided:

(i) That a dealer described in

paragraph (a)(1)(ii) of § 230.144A of this

chapter shall own and invest on a

discretionary basis at least $25 million

in securities of issuers that are not

affiliated persons of the dealer; and

(ii) That a plan referred to in

paragraph (a)(1)(i)(D) or (a)(1)(i)(E) of

§ 230.144A of this chapter, or a trust

fund referred to in paragraph (a)(1)(i)(F)

of § 230.144A of this chapter that holds

the assets of such a plan, will not be

deemed to be acting for its own account

if investment decisions with respect to

the plan are made by the beneficiaries

of the plan, except with respect to

investment decisions made solely by the

fiduciary, trustee or sponsor of such

plan.

(2) Joint Investments. In determining

whether a natural person is a qualified

purchaser, there may be included in the

amount of such person’s Investments

any Investments held jointly with such

person’s spouse, or Investments in

which such person shares with such

person’s spouse a community property

or similar shared ownership interest. In

determining whether spouses who are

making a joint investment in a Section

3(c)(7) Company are qualified

purchasers, there may be included in
17528 Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations

the amount of each spouse’s

Investments any Investments owned by

the other spouse (whether or not such

Investments are held jointly). In each

case, there shall be deducted from the

amount of any such Investments the

amounts specified in paragraph (e) of

this section incurred by each spouse.

(3) Investments by Subsidiaries. For

purposes of determining the amount of

Investments owned by a company under

section 2(a)(51)(A)(iv) of the Act [15

U.S.C. 80a–2(a)(51)(A)(iv)], there may be

included Investments owned by

majority-owned subsidiaries of the

company and Investments owned by a

company (‘‘Parent Company’’) of which

the company is a majority-owned

subsidiary, or by a majority-owned

subsidiary of the company and other

majority-owned subsidiaries of the

Parent Company.

(4) Certain Retirement Plans and

Trusts. In determining whether a natural

person is a qualified purchaser, there

may be included in the amount of such

person’s Investments any Investments

held in an individual retirement

account or similar account the

Investments of which are directed by

and held for the benefit of such person.

(h) Reasonable Belief. The term

‘‘qualified purchaser’’ as used in section

3(c)(7) of the Act [15 U.S.C. 80a–3(c)(7)]

means any person that meets the

definition of qualified purchaser in

section 2(a)(51)(A) of the Act [15 U.S.C.

80a–2(a)(51)(A)]) and the rules

thereunder, or that a Relying Person

reasonably believes meets such

definition.

3. Section 270.2a51–2 is added to read

as follows:

§ 270.2a51–2. Definitions of beneficial

owner for certain purposes under sections

2(a)(51) and 3(c)(7) and determining indirect

ownership interests.

(a) Beneficial ownership: General.

Except as set forth in this section, for

purposes of sections 2(a)(51)(C) and

3(c)(7)(B)(ii) of the Act [15 U.S.C. 80a–

2(a)(51)(C) and -3(c)(7)(B)(ii)], the

beneficial owners of securities of an

excepted investment company (as

defined in section 2(a)(51)(C) of the Act

[15 U.S.C. 80a–2(a)(51)(C)]) shall be

determined in accordance with section

3(c)(1) of the Act [15 U.S.C. 80a–3(c)(1)].

(b) Beneficial ownership: Grandfather

provision. For purposes of section

3(c)(7)(B)(ii) of the Act [15 U.S.C. 80a–

3(c)(7)(B)(ii)], securities of an issuer

beneficially owned by a company

(without giving effect to section

3(c)(1)(A) of the Act [15 U.S.C. 80a–

3(c)(1)(A)]) (‘‘owning company’’) shall

be deemed to be beneficially owned by

one person unless:

(1) The owning company is an

investment company or an excepted

investment company;

(2) The owning company, directly or

indirectly, controls, is controlled by, or

is under common control with, the

issuer; and

(3) On October 11, 1996, under

section 3(c)(1)(A) of the Act as then in

effect, the voting securities of the issuer

were deemed to be beneficially owned

by the holders of the owning company’s

outstanding securities (other than shortterm paper), in which case, such holders

shall be deemed to be beneficial owners

of the issuer’s outstanding voting

securities.

(c) Beneficial ownership: Consent

provision. For purposes of section

2(a)(51)(C) of the Act [15 U.S.C. 80a–

2(a)(51)(C)], securities of an excepted

investment company beneficially owned

by a company (without giving effect to

section 3(c)(1)(A) of the Act [15 U.S.C.

80a–3(c)(1)(A)]) (‘‘owning company’’)

shall be deemed to be beneficially

owned by one person unless:

(1) The owning company is an

excepted investment company;

(2) The owning company directly or

indirectly controls, is controlled by, or

is under common control with, the

excepted investment company or the

company with respect to which the

excepted investment company is, or will

be, a qualified purchaser; and

(3) On April 30, 1996, under section

3(c)(1)(A) of the Act as then in effect,

the voting securities of the excepted

investment company were deemed to be

beneficially owned by the holders of the

owning company’s outstanding

securities (other than short-term paper),

in which case the holders of such

excepted company’s securities shall be

deemed to be beneficial owners of the

excepted investment company’s

outstanding voting securities.

(d) Indirect ownership: Consent

provision. For purposes of section

2(a)(51)(C) of the Act [15 U.S.C. 80a–

2(a)(51)(C)], an excepted investment

company shall not be deemed to

indirectly own the securities of an

excepted investment company seeking a

consent to be treated as a qualified

purchaser (‘‘qualified purchaser

company’’) unless such excepted

investment company, directly or

indirectly, controls, is controlled by, or

is under common control with, the

qualified purchaser company or a

company with respect to which the

qualified purchaser company is or will

be a qualified purchaser.

(e) Required consent: Consent

provision. For purposes of section

2(a)(51)(C) of the Act [15 U.S.C. 80a–

2(a)(51)(C)], the consent of the beneficial

owners of an excepted investment

company (‘‘owning company’’) that

beneficially owns securities of an

excepted investment company that is

seeking the consents required by section

2(a)(51)(C) (‘‘consent company’’) shall

not be required unless the owning

company directly or indirectly controls,

is controlled by, or is under common

control with, the consent company or

the company with respect to which the

consent company is, or will be, a

qualified purchaser.

Notes to § 270.2a51–2:

1. On both April 30, 1996 and October 11,

1996, section 3(c)(1)(A) of the Act as then in

effect provided that: (A) Beneficial

ownership by a company shall be deemed to

be beneficial ownership by one person,

except that, if the company owns 10 per

centum or more of the outstanding voting

securities of the issuer, the beneficial

ownership shall be deemed to be that of the

holders of such company’s outstanding

securities (other than short-term paper)

unless, as of the date of the most recent

acquisition by such company of securities of

that issuer, the value of all securities owned

by such company of all issuers which are or

would, but for the exception set forth in this

subparagraph, be excluded from the

definition of investment company solely by

this paragraph, does not exceed 10 per

centum of the value of the company’s total

assets. Such issuer nonetheless is deemed to

be an investment company for purposes of

section 12(d)(1).

2. Issuers seeking the consent required by

section 2(a)(51)(C) of the Act should note that

section 2(a)(51)(C) requires an issuer to

obtain the consent of the beneficial owners

of its securities and the beneficial owners of

securities of any ‘‘excepted investment

company’’ that directly or indirectly owns

the securities of the issuer. Except as set forth

in paragraphs (d) (with respect to indirect

owners) and (e) (with respect to direct

owners) of this section, nothing in this

section is designed to limit this consent

requirement.

4. Section 270.2a51–3 is added to read

as follows:

§ 270.2a51–3. Certain companies as

qualified purchasers.

(a) For purposes of section 2(a)(51)(A)

(ii) and (iv) of the Act [15 U.S.C. 80a–

2(a)(51) (A)(ii) and (iv)], a company

shall not be deemed to be a qualified

purchaser if it was formed for the

specific purpose of acquiring the

securities offered by a company

excluded from the definition of

investment company by section 3(c)(7)

of the Act [15 U.S.C. 80a–3(c)(7)] unless

each beneficial owner of the company’s

securities is a qualified purchaser.

(b) For purposes of section 2(a)(51) of

the Act [15 U.S.C. 80a–2(a)(51)], a

company may be deemed to be a

qualified purchaser if each beneficial
Federal Register / Vol. 62, No. 68 / Wednesday, April 9, 1997 / Rules and Regulations 17529

owner of the company’s securities is a

qualified purchaser.

5. Section 270.3c–1 is added to read

as follows:

§ 270.3c-1. Definition of beneficial

ownership for certain section 3(c)(1) funds.

(a) As used in this section:

(1) The term Covered Company means

a company that is an investment

company, a Section 3(c)(1) Company or

a Section 3(c)(7) Company.

(2) The term Section 3(c)(1) Company

means a company that would be an

investment company but for the

exclusion provided by section 3(c)(1) of

the Act [15 U.S.C. 80a–3(c)(1)].

(3) The term Section 3(c)(7) Company

means a company that would be an

investment company but for the

exclusion provided by section 3(c)(7) of

the Act [15 U.S.C. 80a–3(c)(7)].

(b) For purposes of section 3(c)(1)(A)

of the Act [15 U.S.C. 80a–3(c)(1)(A)],

beneficial ownership by a Covered

Company owning 10 percent or more of

the outstanding voting securities of a

Section 3(c)(1) Company shall be

deemed to be beneficial ownership by

one person, provided that:

(1) On April 1, 1997, the Covered

Company owned 10 percent or more of

the outstanding voting securities of the

Section 3(c)(1) Company or non-voting

securities that, on such date and in

accordance with the terms of such

securities, were convertible into or

exchangeable for voting securities that,

if converted or exchanged on or after

such date, would have constituted 10

percent or more of the outstanding

voting securities of the Section 3(c)(1)

Company; and

(2) On the date of any acquisition of

securities of the Section 3(c)(1)

Company by the Covered Company, the

value of all securities owned by the

Covered Company of all issuers that are

Section 3(c)(1) or Section 3(c)(7)

Companies does not exceed 10 percent

of the value of the Covered Company’s

total assets.

6. Section 270.3c–5 is added to read

as follows:

§ 270.3c–5. Beneficial ownership by

knowledgeable employees and certain other

persons.

(a) As used in this section:

(1) The term Affiliated Management

Person means an affiliated person, as

such term is defined in section 2(a)(3)

of the Act [15 U.S.C. 80a–2(a)(3)], that

manages the investment activities of a

Covered Company. For purposes of this

definition, the term ‘‘investment

company’’ as used in section 2(a)(3) of

the Act includes a Covered Company.

(2) The term Covered Company means

a Section 3(c)(1) Company or a Section

3(c)(7) Company.

(3) The term Executive Officer means

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 a Covered Company or for

an Affiliated Management Person of the

Covered Company.

(4) The term Knowledgeable Employee

with respect to any Covered Company

means any natural person who is:

(i) An Executive Officer, director,

trustee, general partner, advisory board

member, or person serving in a similar

capacity, of the Covered Company or an

Affiliated Management Person of the

Covered Company; or

(ii) An employee of the Covered

Company or an Affiliated Management

Person of the Covered Company (other

than an employee performing solely

clerical, secretarial or administrative

functions with regard to such company

or its investments) who, in connection

with his or her regular functions or

duties, participates in the investment

activities of such Covered Company,

other Covered Companies, or

investment companies the investment

activities of which are managed by such

Affiliated Management Person of the

Covered Company, provided that such

employee has been performing such

functions and duties for or on behalf of

the Covered Company or the Affiliated

Management Person of the Covered

Company, or substantially similar

functions or duties for or on behalf of

another company for at least 12 months.

(5) The term Section 3(c)(1) Company

means a company that would be an

investment company but for the

exclusion provided by section 3(c)(1) of

the Act [15 U.S.C. 80a–3(c)(1)].

(6) The term Section 3(c)(7) Company

means a company that would be an

investment company but for the

exclusion provided by section 3(c)(7) of

the Act [15 U.S.C. 80a–3(c)(7)].

(b) For purposes of determining the

number of beneficial owners of a

Section 3(c)(1) Company, and whether

the outstanding securities of a Section

3(c)(7) Company are owned exclusively

by qualified purchasers, there shall be

excluded securities beneficially owned

by:

(1) A person who at the time such

securities were acquired was a

Knowledgeable Employee of such

Company;

(2) A company owned exclusively by

Knowledgeable Employees;

(3) Any person who acquires

securities originally acquired by a

Knowledgeable Employee in accordance

with this section, provided that such

securities were acquired by such person

in accordance with § 270.3c–6.

7. Section 270.3c–6 is added to read

as follows:

§ 270.3c–6. Certain transfers of interests in

section 3(c)(1) and section 3(c)(7) funds.

(a) As used in this section:

(1) The term Donee means a person

who acquires a security of a Covered

Company (or a security or other interest

in a company referred to in paragraph

(b)(3) of this section) as a gift or bequest

or pursuant to an agreement relating to

a legal separation or divorce.

(2) The term Section 3(c)(1) Company

means a company that would be an

investment company but for the

exclusion provided by section 3(c)(1) of

the Act [15 U.S.C. 80a–3(c)(1)].

(3) The term Section 3(c)(7) Company

means a company that would be an

investment company but for the

exclusion provided by section 3(c)(7) of

the Act [15 U.S.C. 80a–3(c)(7)].

(4) The term Transferee means a

Section 3(c)(1) Transferee or a Qualified

Purchaser Transferee, in each case as

defined in paragraph (b) of this section.

(5) The term Transferor means a

Section 3(c)(1) Transferor or a Qualified

Purchaser Transferor, in each case as

defined in paragraph (b) of this section.

(b) Beneficial ownership by any

person (‘‘Section 3(c)(1) Transferee’’)

who acquires securities or interests in

securities of a Section 3(c)(1) Company

from a person other than the Section

3(c)(1) Company shall be deemed to be

beneficial ownership by the person from

whom such transfer was made (‘‘Section

3(c)(1) Transferor’’), and securities of a

Section 3(c)(7) Company that are owned

by persons who received the securities

from a qualified purchaser other than

the Section 3(c)(7) Company (‘‘Qualified

Purchaser Transferor’’) or a person

deemed to be a qualified purchaser by

this section shall be deemed to be

acquired by a qualified purchaser

(‘‘Qualified Purchaser Transferee’’),

provided that the Transferee is:

(1) The estate of the Transferor;

(2) A Donee; or

(3) A company established by the

Transferor exclusively for the benefit of

(or owned exclusively by) the Transferor

and the persons specified in paragraphs

(b)(1) and (b)(2) of this section.

Dated: April 3, 1997.

By the Commission.

Margaret H. McFarland,

Deputy Secretary.

[FR Doc. 97–8950 Filed 4–7–97; 10:26 am]

BILLING CODE 8010–01–P