10.1.

24: Avoiding Registration under the '40 Acts

There are, as always in the law, traps for the unwary in organizing the investment pool. Most importantly,
the organizers should seek to avoid the necessity of registering the fund under either of the 1940 Acts (the
Investment Company Act or the Investment Advisers Act). Despite amendments to those acts in 1980
designed to alleviate the problems faced by PIVs,
[1]
it is clearly desirable not to have to register at all.

The exemption from the Investment Company Act most commonly availed of provides that an entity which
would otherwise qualify as an investment company - and investment capital pools naturally qualify by
reason of their activities - need not register if its securities are held by 100 or fewer persons (and the
issuer "is not making and does not presently propose to make a public offering").
[2]
In most instances, the
definition is relatively simple to apply: Count the number of limited and general partners, and, if the count
comes up fewer than 100, the partnership is exempt. As the number creeps up toward 100, there are, to
be sure, complicated attribution and aggregation questions revolving around the proper definition of the
term "person." The Investment Company Act
[3]
now provides that one must look through the entity and
count the number of partners or shareholders if and only if the entity purchases 10% or more of the
"voting securities" in the investment entity and the investment represents more than 10% of the total
assets of the purchasing entity. Since the rule purports to be objective - a "black letter" rule - it should be
relatively easy to deal with. However, as legal philosophers like to testify, no exact rule is exact.
[4]

For example, as a technical matter a limited partnership interest is not usually considered a "voting
security" and, therefore, the "rule of 10" should not count limited partners. Not so fast! The SEC staff has
published no-action positions that make it imprudent to rely on the language of the rule in this respect. If
a limited partner otherwise qualifies under the 10/10 rule for "look through" treatment, the staff reserves
the right to claim that the technicalities of the Uniform Limited Partnership Act will not preclude the
possibility of a "look through" to the limited partner's members.
[5]

Moreover, the more successful funds are now operating in a multiple mode - Smith Brown Associates 1,
Smith Brown Associates II, and so forth-and those managers must face the possibility that, in applying the
"100 or fewer persons" test under the 3(c)(1) exemption, the staff may (in defining who is the issuer)
"integrate" legal entities; that is, the staff may treat separate limited partnerships as one "organized group
of persons so that the members of all the partnerships will be counted together."
[6]

The second issue, registration under the Investment Advisers Act, is conceptually much like the
Investment Company Act problem. For years, practitioners were concerned that investment partnerships
constituted unregistered investment advisers because of the quite expansive definition in the Investment
Advisers Act as to what activities so qualify.
[7]
The crutch on which counsel were accustomed to lean was,
again, a "numbers" exemption, the exemption in the Act for investment advisers whose clients number 15
or fewer in any year.
[8]
When the first partnerships were organized, this language did not pose a problem
in most cases, since the investing families were generally quite limited in number, generally fewer than 10.
However, as the activity became more popular, the number of limited partners crowded the "14 or fewer"
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threshold. In some cases a single fund would take in more than 14 partners and in others the success of
the first fund would give rise to others; fund number 2, fund number 3, and so forth, the first fund not
entirely wound up at the time when the second, and perhaps the third, were commencing operations.
Recognizing this problem, counsel took the view that the investment advisory "client" to be counted for
purposes of the 14 or fewer limitation was the fund itself and not the limited partners in the fund. This
gave the SEC staff problems because of the Commission's cultural imperative to the effect that entities
organized for the purpose of doing something are to be disregarded as mere artifices.
The problem culminated in a celebrated opinion in the Court of Appeals for the Second Circuit in the
Abrahamson case, the first version of which contained language supporting the SEC's view.
[9]
Since that
position would effectively have strangled many of the big players in the investment capital industry in their
cribs, the bar was able to prevail on the judges to withdraw their opinion on the point and substitute a
footnote which expressly acknowledged the court did not need to rule, and therefore was not ruling, on
that specific issue. The court of appeals's reversal of its field was construed as a reprieve by the industry
and business continued on the basis of that seemingly innocent language. Since that time, the Commission
has readdressed an essentially absurd situation and issued a rule to the effect that the fund constitutes
one advisee for purposes of the Investment Advisers Act.
[10]

The Commission has, as well, lightened up by rule on the most troublesome problem for those investment
funds thinking about registering under the Investment Advisers Act-the historic ban on performance-based
compensation.
[11]
If an investment fund takes in investors in units of $500,000 or more (or the investor's
net worth exceeds $1 million), the carried interest takes into account losses as well as gains (and/or
unrealized depreciation if unrealized appreciation drives compensation) and certain disclosures are made,
performance compensation is allowable.
[12]

The strict proscriptions in the Investment Company Act of 1940 (the "'40 Act") have proven to be a
significant obstacle facing the organizers of private equity funds in the United States. The '40 Act was
passed to deal with a series very grave offenses against the public weal by sharp practitioners gulling the
public to invest in "trusts," vehicles permeated with questionable business practices and extraordinary
conflicts of interest. The emphasis in the '40 Act is on mutual funds, primarily open end but including
closed end funds, which offer shares to the public; an entire division of the SEC has been recruited to
administer '40 Act matters and to oversee the booming mutual fund marketplace. Private equity funds,
particularly venture and buyout funds, are awkwardly appended to the '40 Act; the '40 Act's emphasis on
funds selling shares to the public was defined by an exemption, in Section 3(c)(1), which is quite
restrictive ...it exempts as non public, only funds with one hundred shareholders or fewer.
[13]
All others
are deemed to be "public," and, because of the way the definition works (or, more particularly, used to
work), the '40 Act caught a lot of fish in its net which no one interested in enlightened securities regulation
would, on the basis of economic reality, deem to be public funds in need of regulatory oversight. It is, of
course, true that most private equity funds have fewer than one hundred members (if the entity is a
limited liability company) or limited partners (if, as is usually the case, the entity is a limited partnership).
However, in its initial formulation, the exemption from the '40 Act for funds with one hundred or fewer
investors was complicated by a 'look through' rule. That is to say, any limited partner (in the case of a
limited partnership) which owned over 10% of the total interests in the fund would become transparent for
purposes of counting the number of investors, meaning that the owners of the entity owning the 10%
would themselves be counted ... a number which could be in the millions. The practice, therefore, required
the sponsors of the organization to limit the largest interest to 9.9%. In 1980, Section 3(c)(12) was
amended to introduce a 10/10 rule: no "look through" respecting a 10% or greater investor unless that
Page 2 of 7 10.1.24: Avoiding Registration under the '40 Acts - Encyclopedia - L...
investor had more than 10% of its assets invested in one or more investment companies ... either
registered or themselves relying on the Section 3(c)(1) exemption from the '40 Act. The 10/10 rule
spawned a number of interesting law school exam-type questions (Talmudic, or Jesuitical if you like). What
happened if the 10/10 threshold was not exceeded when the fund initially solicited the investor but
circumstances subsequently changed ... i.e., the investor's assets shrank and, therefore, the investment
broke through the 10% barrier. (For those interested in history, there is an excellent exposition in Halloran
5-3.)
In 1996 the rule was considerably simplified. The National Securities Markets Improvement Act of 1996
eliminated the '10% of assets' qualification, which would appear to be a step backwards; but the great
leap forward lay in the fact that the 'look through' provisions, while maintaining the threshold of 10%
ownership, were to be applied only to investors which themselves were either registered investment
companies or which would be required to register under the definition of "Investment Company" in the '40
Act were they not qualified for the exemptions in Sections 3(c)(1) and 3(c)(7). Certain major investors,
e.g., pension and endowment funds, are investment companies in a sense but are exempt from the '40 Act
on the basis of provisions other than Sections 3(c)(1) and 3(c)(7), as are banks and insurance companies.
The reach of the 10% "look through" was significantly narrowed.
In 1996, the Congress created a new exemption, Section (3)(c)(7), which allows an unlimited number of
investors, at least for '40 Act purposes, as long as each is a "qualified purchaser"..... which means, under
Section 2(a)(51)(A), an individual with a $5 million investment portfolio, an entity with a $25 million
portfolio or an advisor to qualified purchasers who invests on a discretionary basis a portfolio of at least
$25 million. The leeway allowed by Section (3)(c)(7) is, in practical terms, between one hundred and five
hundred limited partners because, once one gets beyond the five hundred limited partner investor
threshold, the Internal Revenue Code concept of a "publicly traded partnership" (i.e., one taxable as a
corporation) becomes applicable.
Under Section 3(c)(7)(E), a fund relying on the (3)(c)(7) exemption and one relying on the 3(c)(1)
exemption will not be treated as a single issuer, even though the two funds are organized simultaneously
and perhaps for the same purpose; therefore, neither will have to count the investors in the other for
purposes of the hundred or fewer exemption in (3)(c)(1) or the qualified purchaser limit in (3)(c)(7). This
rule helps in the situation where the main fund relies on the (3)(c)(1) exemption and a side fund or
parallel fund is organized to invest to in lock step or pari passu with the main fund. If the side find is
limited to qualified purchasers, then neither fund contaminates the other for the purposes of the
exemption.
In short, and with, of course, the usual nuanced issues at the borderline of this or any other exemptive
scheme, the landscape..
[14]

Additional issues to address include the following:
First, what might be deemed the "incubator" exception ... the exemption in Section 3(a)(1)(C) of the '40
Act which, oversimplifying, entails a threshold 60/40 test in considering whether a firm is an "investment
company." If 60% of the securities owned by the ostensible or purported investment company represent
positions in "majority owned" subsidiaries ... i.e., the alleged investment company is in fact conglomerate
or a holding company ... then the company is entirely exempt ... it simply does not fit the definition of an
"investment company." Relying on the Section, several of the "incubators" (now due to the Nasdaq melt-
Page 3 of 7 10.1.24: Avoiding Registration under the '40 Acts - Encyclopedia - L...
down calling themselves " accelerators," styled themselves as other than investment companies. CMGI,
Idealabs, Internet Capital Group etc., made majority investments in early stage companies and tried to
incubate (or, better, accelerate) those companies to prosperity. The system ran into a hiccup when the
incubators themselves went public because their 51% or greater interests were necessarily diluted by the
effect of the public offering. Given , however, the definition of "control" in Section 12(a)(9) of the '40 Act,
which mentions a 25% or greater interest, many practitioners believe that the SEC is in effect relaxing the
reach of the Investment Company Act so that an incubator type company which is itself public (and,
therefore, has perforce over a hundred shareholders) may apply for an order under Section 3b-1 if 60% of
its assets are comprised of investments in portfolio companies in which it holds the 25% or greater
interest.
[15]
The question is somewhat mooted at this point since the incubators are no longer a popular
vehicle for public investment. Moreover, by definition the incubators are themselves taxable at the entity
level (although, in the past, none of them made much in the way current earnings from the portfolio
companies, even on a consolidated basis) and thus, do not have the second key element of a private
equity fund's strategy ... exemption from the '40 Act and exemption from entity level tax.
[16]
It may be a
while, therefore, before the "operating company" exemption under Section 3a-1(c) under the '40 Act
comes back as a major opportunity.
[17]

The second potential exemption from at least some of the provisions of '40 Act has to do with the addition
in Section 2(a)(48) (added in 1980 as part of the so-called Heizer amendments to the '40 Act, named for
Ned Heizer) of the notion of a Business Development Company, a registered investment company which,
however, is released from some of the more onerous prohibitions in the '40 Act, particularly the flat
prohibition on success-based performance compensation to the managers. There is a lengthy discussion of
business development companies starting in Halloran at 5-29, which will not be reduplicated here. The fact
is that the Business Development Company concept, the idea of public venture capital funds which would
let the revered "little guy" invest in venture capital, has proven to be largely a chimera. Only a few have
survived and, by and large, they have not done well. Accordingly, there will be no discussion of that animal
in these pages; interested parties are referred to Halloran's discussion for additional information.
Finally, as the venture capital industry matured, it became necessary to deal as well with the Investment
Advisors Act of 1940 which, again, imposed unacceptable constraints on the general partners of a venture
fund ... or, in today's universe, the partners of the GP which itself was a partner in the venture fund. It
was necessary, therefore, to find an exemption of the Investment Advisors Act and the obvious candidate
was Section 203(b)(3), which exempts an investment advisor with 14 or fewer advisees. If one counted all
the limited partners in a fund obviously, the 14 or fewer exemption would not be available. Accordingly, in
1985, after a good deal of backing and filling (again the history is outlined in Halloran, 5-22), the SEC
adopted Advisors Act Rule 203(b)3-1 which allows the general partner or partners to count only the
partnership itself, and not the limited partners therein, for purposes of the 14 or fewer exemption. Again,
the devil is in the details. One question has to do with a registered investment advisor... an entity clearly
subject to the Investment Advisors Act in that it advises, e.g., public pension funds on the purchase of
publicly traded securities. Assume that advisor, or an affiliate thereof, decides to sponsor and manage a
private equity fund and recruits as a limited partner therein one or more of its advisee clients ..., some of
the public pension funds that it advises away from the fund. How do you count, for purposes of the 14 or
fewer test? In Mark Capital Management, Inc. (avail. June 4, 1997), there is a suggestion that the advisor
under those circumstances may continue the count only the fund even though some of the limited partners
are, in another context, advise clients of the general partner.
If a fund, eligible for exemption from the Investment Company Act under Section 3(c)(1) and, therefore,
Page 4 of 7 10.1.24: Avoiding Registration under the '40 Acts - Encyclopedia - L...
limited to fewer than 100 investors, plans to convert to the exemption offered by Section 3(c)(7), Section
3(c)(7)(b) requires the fund management to notify each beneficial owner of the conversion, inform them
that the number of investors, under Section 3(c)(7). may go up to 500 (at which point it becomes a
publicly traded partnership and therefore, no longer taxed as a partnership) and redeem the interest of
any investor who is not eligible under 3(c)(7) as a qualified purchaser or a knowledgeable employee at
net asset value; indeed, any investor which or who is eligible to continue under 3(c)(7) must also be
offered the opportunity to redeem.
The integration issue is a thorny one. For the fund to come under the 100 or fewer investor limitation in 3
(c)(1), managers often try to cobble together two, three, four or five separate funds and claim that each
is to be judged on its own feet, thereby getting a total of investors well over the 100 limitation without
running afoul of 3(c)(1). The SEC takes a hard look at this device, as you might imagine. See Shoreline
Fund, L.P., SEC no-action letter (Apr. 11, 1994) and other no-action letters cited therein. The SEC looks at
the similarity of the strategies pursued by the funds, the make up of their portfolios, whether the funds are
intended for distinct groups of investors one a biotech fund and another an information technology fund,
for example. The SECs authority is based on Section 48(1) of the Investment Company Act, which
prohibits registrants from doing indirectly what cannot be done directly. The issue often arises when fund
sponsors are running parallel funds, for example grouping all the ERISA entities in one fund, the off-
shore investors in another, so as to separate those investors from investments which might create
unrelated business taxable income or income effectively connected with a U.S. trade or business.
Sometimes friends and family are allowed into a parallel fund which is non-promoted and does not bear
the burden of a management fee this for investors in a position to do good things for the primary funds
such as sourcing deals; providing managerial advice; etc. The Shoreline Fund no-action letter is helpful
because it focuses on funds intended for distinct groups of investors.
[1]
For a discussion of the 1980 "business development company" amendments to the Investment
Company and Investment Advisers Act of 1940, see 1 Halloran, Ch. 4.
[2]
Investment Company Act of 1940, 3(c)(1). It should be noted that the 100 "beneficial owner" test
applies to all outstanding securities (other than short-term paper); thus, long-term promissory notes might
be included, another reason to avoid leverage in a venture fund.
[3]
Id. 3(c)(1)(A).

[4]
The classic example is a seemingly precise rule which states that no "vehicles" are allowed in Central
Park. Does this mean bicycles, tricycles, pogo sticks, a little red wagon towed by a three-year old child? It
is important to keep in mind that the "rule of 100" in 3(c)(1) applies by its terms to the holder of any
security, voting or not.
[5]
See, e.g., C & S Investment Fund, SEC No-Action Letter (avail. July 13, 1977).

[6]
PBT' Covered Option Fund, SEC No-Action Letter (avail. Feb. 17, 1979) ("an important question is
whether [interests in the two partnerships) would be considered materially different by a reasonable
investor qualified to purchase both"). See also Oppenheimer Arbitrage Partners, SEC No-Action Letter
(avail. Dec. 26, 1985). In Oppenheimer, although both partnerships were engaged in risk arbitrage
transactions, one was designed for tax-exempt ERISA plans; it used no leverage and engaged in no short
Page 5 of 7 10.1.24: Avoiding Registration under the '40 Acts - Encyclopedia - L...
sales, uncovered options or "classic" arbitrage. The other was designed for individuals; it used the
maximum leverage possible, and engaged in short sales, uncovered options, classic arbitrage, futures
contracts and repurchase agreements. The staff agreed that the two need not be integrated.
[7]
An investment adviser is anyone who, for compensation, advises others "either directly or through
publications or writings, as to the value of securities or as to the advisability of investing in ... securities."
Investment Advisers Act, 202(a)(I 1). Some law firms have taken the view that the general partners are
not advising "others" when they invest the partnership's funds since they themselves are a part of the
partnership.
[8]
Investment Advisers Act, 203(b)(3).

[9]
Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977), cert. denied, 436 U.S. 913(1978).

[10]
Investment Advisers Act, Rule 203(b)(3)- I (a)(2). However, if the general partner advises the limited
partners directly on their investments or counsels them on transferring their assets from one fund to
another, such limited partners may be individually counted as clients. If the limited partners of a fund
enjoy co-investment rights-"window" rights as they are called-the GPGP should be careful not to render
independent investment advice to the investors on a particular security.
Moreover, there is a risk that a venture capital manager affiliated with a group of firms which include one
or more investment advisers could be integrated for purposes of counting clients. See Davis Skaggs & Co.,
SEC No-Action Letter (Avail. Aug. 21, 198 1)
[11]
Investment Advisers Act, 205(l).

[12]
Id. Rule 205-3.

[13]
A current SEC proposal, SEC Rel. 33-8766 (Dec.27, 2006), would increase the test for individual
investors qualifying under Section 3(1)(a) provision not only accredited but super accredited investors
i.e., $1,000,000 in net worth or $200,000 in income ($300,000 with spouse) and $2,500,000 in the
individuals investment portfolio, not including the residence. The proposal states it does not appear to
exempt funds qualifying as business development companies under Section 202(a)(22) of the Investment
Advisers Act, the thought being that will carve out venture funds 60% of the portfolio in private
domestic companies. The target? Hedge fund retaliation.
[14]
For example, if the sponsors go out to recruit one hundred or fewer investors in a fund, do they run
afoul of the additional qualification to both Sections 3(c)(1) and (3)(c)(7) that the fund (by soliciting, say,
two hundred to get one hundred) is "presently propos[ing] to make a public offering its securities". The
obvious answer is to qualify the offering under the safe harbor in Reg. D. If one is particularly anal about
these matters it should be noted that Rules 504 and 505 of Reg. D are safe harbors which are not based
on Section 4(2) of the Securities Act of 1933, the so-called private offering exemption, but on Section 3(b)
of the '33 Act. Therefore, theoretically could be exempt public offerings. Cutting to the chase as they say,
the answer is to make sure that the offering is qualified under Rule 506 of Reg. D.
[15]
See Internet Capital Group, Inc. Inv. Co. Act. Rel. Nos. 23923 (July 28, 1999) and 23961 (August 23,
1999); Yahoo! Inc. Inv. Co. Act. Rel. Nos. 24459 (May 18, 2000) and 244494 (June 13, 2000).
Page 6 of 7 10.1.24: Avoiding Registration under the '40 Acts - Encyclopedia - L...
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[16]
Registered investment companies are tax exempt if they qualify under subchapter M of the Internal
Revenue Code. Private equity funds are exempt from tax because they are partnerships under subchapter
K.
[17]
One can expand the limits in Section 3(c)(1) for one hundred or fewer investors or the limit in Section
3(c)(7) for, and, only for, qualified purchasers by adding so-called "knowledgeable employees," an
exemption which occasionally makes a difference. It should be noted that, even though the general partner
of an "investment company" has over a 10% interest in the fund, that entity would not otherwise be
classified as an "investment company," and therefore, the members of the LLC which comprises the GP, in
view of most practitioners are not to be counted. Moreover, the general partnership interest is itself (again
arguably) not a security and, therefore, is not counted for purposes of the 10% look through test and
finally one can argue that the members of the general partner are knowledgeable employees.
Document Last Updated: 9/6/2008
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