SEC Issues No-Action Letter Expanding Interpretation of the Definition of “Knowledgeable Employee”

The staff of the Division of Investment Management of the U.S. Securities and Exchange Commission (the “Staff”) has issued a no-action letter in response to a request by the Managed Funds Association (the “MFA Letter”), broadening the Staff’s prior interpretations of the definition of “knowledgeable employee” in Rule 3c-5 (the “Rule”) under the Investment Company Act of 1940, as amended (the “Investment Company Act”). In doing so, the Staff expanded and clarified some of its positions regarding the definition of knowledgeable employee set forth in a 1999 no-action letter to the American Bar Association Section of Business Law (the “ABA Letter”).1

Background: The Knowledgeable Employee Rule

The Rule permits a “knowledgeable employee” to invest in a private fund exempted from the definition of investment company under either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act (a “Covered Fund”) without being counted for purposes of the 100-person limit in Section 3(c)(1) or even though he or she is not a “qualified purchaser” as is generally required by Section 3(c)(7). The Rule is premised on the view that certain persons do not need the protection of the Investment Company Act because of their financial knowledge and sophistication and their relationship with a Covered Fund.2

A “knowledgeable employee” is a natural person who is: (1) an “executive officer,” director, trustee, general partner, advisory board member or a person serving in a similar capacity, of a Covered Fund or of an affiliated person that manages the investment activities of a Covered Fund (“Affiliated Management Person,” typically a Covered Fund’s investment adviser); or (2) an employee (other than an employee performing solely clerical, secretarial or administrative functions) who, for at least 12 months, in connection with his or her regular functions or duties, has participated in the investment activities of a Covered Fund or substantially similar functions for or on behalf of another company. The term “executive officer” is further defined as the president, any vice president in charge of a principal business unit, division or function, or any other person who performs similar policy-making functions for a Covered Fund or its investment adviser.

Prior Staff Guidance

The last important interpretation of the scope of the definition of “knowledgeable employee” was in the 1999 ABA Letter where the Staff indicated that whether an employee is participating in investment activities is a factual determination to be made on a case-by-case basis, and that the definition of knowledgeable employee is intended to encompass persons who “actively participate” in the management of a Covered Fund’s investments and not employees who merely obtain information regarding the investment activities of a Covered Fund. Against that background, the Staff analyzed certain situations involving marketing and investor relations professionals, research analysts, attorneys, brokers and traders of a related broker-dealer and financial, compliance, operational and accounting officers, and determined that, with the exception of some research analysts,3 such types of employees would not qualify as knowledgeable employees.

The MFA No-Action Letter

Although the Staff’s interpretation in the ABA Letter appeared to narrow the scope of employees who could be considered to “actively participate” in the investment activities of a Covered Fund, the MFA Letter now reassures that the Staff’s guidance in the ABA Letter was not intended to limit the definition of knowledgeable employees to only those individuals charged with overall responsibility for the investment activity of a Covered Fund. The MFA Letter expands the interpretation of the definition of “knowledgeable employee” by giving situations where certain employees could be considered providing analysis or advice that is material to an investment decision of a portfolio manager. Moreover, the MFA Letter provides the first indication of what the Staff believes may be considered to be a “principal” business unit, division or function, as well as the types of personnel who may be considered to be performing a “policy-making function.” Finally, the MFA Letter states that employees of Covered Funds advised by “relying advisers” and employees who participate in the investment activities of certain separate accounts may also be deemed knowledgeable employees.

Certain Analytical or Risk Team Members, Traders, Tax Professionals and Attorneys may be Knowledgeable Employees

In the MFA Letter, the Staff indicates that any employee who regularly participates in the management of a Covered Fund’s investments could be considered a knowledgeable employee under the Rule, provided that such activity has been a regular part of such employee’s duties for at least 12 months with the Covered Fund, an Affiliated Management Person or another company. Whether an individual participates in the management of a Covered Fund’s investments depends on whether he or she provides analysis or advice that is material to an investment decision of a portfolio manager. This is a facts and circumstances determination based on whether a reasonable person would consider such analysis or advice to be important to the investment decision. In the Staff’s view, this would be the case if the analysis or advice is “material to the merits of buying, selling or holding an investment,” but not if it relates to whether a potential investment is merely eligible for investment by a Covered Fund.

The MFA Letter states that individuals who actively participate in the management of a Covered Fund’s investment activities in the following capacities and who have done so for the previous 12-months with respect to the Covered Fund, an Affiliated Management Person or another company may be knowledgeable employees:

Analytical or Risk Team Members: A member of the analytical or risk team who regularly “develops models and systems to implement the Covered Fund’s trading strategies by translating quantitative signals into trade orders or by providing analysis or advice that is material to the investment decisions of a portfolio manager” could be considered a knowledgeable employee. However, someone who merely writes the computer code to a program used by the portfolio manager would not be considered a knowledgeable employee.

Research Analysts: The Staff had stated in the ABA Letter that research analysts who research all potential portfolio investments and provide recommendations to the portfolio manager may qualify as knowledgeable employees under the Rule. The MFA request letter had inquired whether, as set forth in the ABA Letter, an analyst would be required to research “all potential portfolio investments” (emphasis added) of a Covered Fund in order to qualify as a knowledgeable employee. The MFA Letter clarifies that an employee can be regarded as participating in the investment activities of a Covered Fund under the Rule if his or her functions relate to only a portion of a portfolio of a Covered Fund or Covered Separate Account (defined below) and not the entire Covered Fund or Covered Separate Account.

Traders: A trader who, based on his or her market knowledge and expertise, regularly provides analysis or advice material to a portfolio manager’s investment decisions, may be considered a knowledgeable employee. A trader that simply executes investment decisions previously made by a portfolio manager would not be considered a knowledgeable employee.

Tax professionals: A tax professional who regularly provides analysis or advice that is material to the investment decisions of a portfolio manager may be deemed to be a knowledgeable employee. Merely preparing tax filings for a Covered Fund is insufficient. The Staff provides an example that a tax professional’s analysis of whether income from an offshore fund’s investment may be considered “effectively connected income” could be material to a portfolio manager’s decision to invest in certain debt instruments.

Attorneys: An attorney who regularly provides analysis and advice as to the legal terms of investments that are material to a portfolio manager’s investment decisions may be deemed to be a knowledgeable employee under the Rule. As an example, the Staff indicates that an attorney’s legal analysis of tranches of a distressed debt investment could be material to a portfolio manager’s decision to invest in the loan. However, merely negotiating agreements for transactions based on the investment decisions of the portfolio manager or evaluating whether an investment is permitted under a Covered Fund’s governing documents would likely not be considered to be actively participating in the investment decisions of a Covered Fund.

These examples are not exclusive and the Staff states in the MFA Letter that other employees may qualify as knowledgeable employees based on the facts and circumstances of a particular investment adviser.

Principal Status of a Business Unit, Division or Function

Under the Rule, knowledgeable employees include executive officers of a Covered Fund or Affiliated Management Person, and the definition of “executive officer” includes persons in charge of a principal business unit, division or function. The MFA Letter affirms that whether a business unit, division or function may be considered to be “principal” for the purposes of the Rule depends on the investment adviser’s business operations. Moreover, the Staff states that more than one business unit, division, or function might each be considered “principal,” and that a principal business unit, division or function need not be part of the investment activities of a Covered Fund.

Based on this, the Staff affirms that the information technology department of an investment adviser that utilizes technologically driven trading models or that “employs technology professionals to build performance and risk monitoring systems that interact with the investment program” could be considered a principal business unit. Similarly, an investor relations department could be a principal business unit if the investment relations personnel “conduct substantive portfolio reviews with investors” and “respond to substantive due-diligence questions from institutional investors and consultants.” However, an investor relations department that only arranges meetings between portfolio managers and prospective investors, or which communicates materials written by senior executives of other departments, would not be considered a principal business unit. Consequently, individuals in charge of departments that qualify as principal business units would be knowledgeable employees.

Policy-Making Functions within a Committee or Group

Executive officers also include “any other person who performs similar policy-making functions.” The Staff affirms that, even without a title connoting senior manager status, persons who are involved in developing and adopting policy for the investment adviser as part of their day-to-day functions may be executive officers, and therefore, knowledgeable employees. A person’s involvement can be in his or her individual capacity or as a member of a committee or group, such as an investment adviser’s valuation committee. However, in the Staff’s view, those who “merely observe committee proceedings or merely provide information or analysis to the decision-makers of a committee or group” would not be engaged in policy-making and therefore would not be considered executive officers under the Rule.

Employees of a “Relying Adviser” may be Treated as Knowledgeable Employees

The ABA Letter acknowledged that the definition of Affiliated Management Person of a Covered Fund could include an affiliated entity of such a Covered Fund, depending on the particular facts and circumstances of the affiliate. A key consideration expressed by the Staff in determining whether employees of an affiliated entity would be considered knowledgeable employees is whether such employees would have significant access to information about the Covered Funds in which they wished to invest. The MFA Letter confirms that employees of an investment adviser or any of its “relying advisers”may be treated as knowledgeable employees with respect to any Covered Fund managed by such filing investment adviser or its relying advisers, because employees of relying advisers would generally have significant access to information about the Covered Funds managed by the other affiliated investment advisers within a single advisory business.

Employees who Participate in the Investment Activities of Separate Accounts may be Treated as Knowledgeable Employees

The MFA Letter states that persons who participate in the investment activities of separate accounts (i) for clients that are “qualified clients” and are otherwise eligible to invest in the Covered Funds, and (ii) which pursue investment objectives and strategies that are substantially similar to those pursued by one or more Covered Funds (“Covered Separate Account”) may be knowledgeable employees.5 The Staff indicates that such employees are “likely to be as financially knowledgeable and sophisticated as an employee who participates in the investment activities of a Covered Fund or investment company” so as to not require the protection of the Investment Company Act.

Conclusion

The MFA Letter expands and clarifies the interpretation of the definition of knowledgeable employee under the Rule. This broader interpretation by the Staff will allow investment advisers to more confidently classify their executive officers and other personnel as knowledgeable employees and will encourage increased investment participation by such knowledgeable employees in the Covered Funds, better aligning the interests of investment advisers with the interests of their investors. Nonetheless, there are still a number of aspects of the definition of knowledgeable employee that have yet to be addressed and which will require further interpretation. Since it is an investment adviser’s obligation to make determinations as to which of its employees qualify as knowledgeable employees under the Rule based on the facts and circumstances relevant to its business and to maintain a written record of such determinations, it is important that investment advisers ensure that such determinations are reasonable in light of the Rule, MFA Letter and other Staff interpretations.

Footnotes

1

 
American Bar Association Section of Business Law, SEC No-Action Letter (Apr. 22, 1999). 

2

 
PPM America Special Investments CBO II, L.P., SEC No-Action Letter (Apr. 16, 1998) (the “PPM Letter”).

3

 
The ABA Letter gave as an example of when some research analysts may qualify as knowledgeable employees the case where a research analyst researches all potential portfolio investments and provides recommendations to the portfolio manager.

4

 
A “relying adviser” is an investment adviser that relies on the Form ADV filed by an affiliated investment adviser with which it forms a single advisory business under the circumstances set forth in the American Bar Association Section of Business Law, SEC No-Action Letter (Jan. 18, 2012).

5

 
This statement by the Staff is premised on the findings in the PPM Letter and ABA Letter that employees who participate in the investment activities of a company that is excluded from the definition of investment company under Section 3(c)(2), 3(c)(3) or 3(c)(11) may be deemed knowledgeable employees because of their financial knowledge and sophistication and their relationship with a Covered Fund.

 

Topics:  Actual or Constructive Knowledge, No-Action Letters, SEC

Published In: Labor & Employment Updates, Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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