Securities Law Considerations Part 2: SEC Registered Funds, Exemptions and Regulatory Considerations

The Investment Company Act of 1940, as amended (“40 Act”) defines an “investment company” as an issuer primarily involved in the business of investing, reinvesting, or trading securities. It explicitly prohibits any engagement in buying and selling securities without SEC registration or a valid exemption. Hedge funds and comparable pooled investment vehicles fall under this definition if they meet one of the two exemptions.

Section 3(c)(1) of the ‘40 Act provides an exemption from registration for funds whose securities are beneficially owned by no more than 100 individuals at any given time. In the case of a qualifying venture capital fund with aggregate capital contributions and uncalled capital commitments below $10 million, the limit extends to not more than 250 persons. Section 3(c)(1) is frequently relied upon by private fund managers to secure registration exemption.

On the other hand, Section 3(c)(7) of the ‘40 Act offers an exemption without restrictions on the number of beneficial owners, provided the securities are exclusively owned by “qualified purchasers.” However, funds with 2,000 or more investors are obligated to register their securities with the SEC.

Funds operating under an exemption pursuant to either Sections 3(c)(1) or 3(c)(7) of the ‘40 Act face restrictions, prohibiting them from making public offerings of their securities under the Securities Act of 1933. Moreover, stringent limitations on advertising and general solicitation are imposed on funds relying on these exemptions under Section 3(c)(1) or Section 3(c)(7).

1. The 100-Beneficial Owner Criterion

In the context of assessing the 100-person threshold stipulated by Section 3(c)(1) of the ‘40 Act, individuals are typically tallied separately, and joint ownership between spouses is consolidated into one beneficial owner. The term “person” encompasses both natural individuals and corporate entities. The SEC employs a “look-through” methodology for a company investing in a fund, treating each security holder of that company as an independent investor of the fund under certain conditions. These conditions include: (i) the investing company being a registered investment company or a private investment company organized under exemptions in Section 3(c)(1) or Section 3(c)(7) of the ‘40 Act, and (ii) the company holding 10% or more of the outstanding voting securities of the fund. Notably, for offshore funds relying on Section 3(c)(1) and accommodating U.S. tax-exempt investors, only U.S. investors contribute to the 100-person limit.

The Integration Doctrine
As a fund nears the threshold on the number of investors, such as 100 persons or 250 persons for a qualified venture fund, evading the limit by establishing an identical fund is not a viable strategy for managers.

To forestall the creation of identical funds each time the 100-person cap approaches, the SEC employs the “integration” doctrine. When two or more funds managed by the same sponsor exhibit substantial similarity, the SEC integrates these funds, treating them as a singular entity. In cases of integration, the SEC combines the total number of investors across the funds to assess whether, collectively, they surpass the 100-person mark.

It’s crucial to note that the SEC refrains from integrating two funds if one falls under Section 3(c)(1) and the other under Section 3(c)(7). Furthermore, the SEC typically avoids integration between domestic and offshore funds.

2. Qualifying Investors in a Section 3(c)(1) Fund

When a fund opts for the Section 3(c)(1) exemption, it taps into investor interest through Rule 506 under Regulation D of the Securities Act of 1933. Securities governed by Rule 506 are exclusively available for purchase by “accredited investors” and, under specific circumstances, up to 35 “sophisticated investors.”

Under Regulation D, eight categories of “accredited investors” are outlined, including but not limited to:

  • Individuals with a net worth exceeding $1,000,000, or joint net worth with a spouse, excluding the net value of their primary residence as per the Dodd-Frank Act.
  • Individuals with an individual annual gross income exceeding $200,000, or a combined annual gross income with a spouse exceeding $300,000, in each of the two most recent years, and with a reasonable expectation of a similar income in the current year.
  • Executives, directors, managing members, or general partners of the issuer.
  • Participants in an employee benefit plan under ERISA, either guided by a plan fiduciary from a bank, insurance company, or registered investment adviser, or holding total assets exceeding $5,000,000.
  • Trusts and other vehicles with total assets surpassing $5,000,000, not formed exclusively for acquiring an interest in the fund, and directed by a sophisticated investor.
  • Entities where every equity owner qualifies as an accredited investor.

A “sophisticated investor” is an individual, alone or with purchaser representative(s), possessing the financial and business acumen to evaluate the merits and risks of a fund investment effectively.

3. Investor Eligibility in Section 3(c)(7) Funds: Navigating the Criteria

Participation in a Section 3(c)(7) fund demands adherence to the “qualified purchaser” status, encompassing:

  • Individuals holding investments not below $5 million.
  • Individuals, including institutional investors, managing their accounts or those of other qualified purchasers, collectively wielding a discretionary investment authority exceeding $25 million.
  • “Family owned companies” with ownership of a minimum of $5 million in investments, directly or indirectly possessed by two or more individuals related as siblings or spouses, including former spouses, or direct lineal descendants by birth or adoption, spouses of such individuals, the estate of such individuals, or foundations/charitable organizations/trusts established for their benefit.
  • Other trusts not exclusively formed to acquire Section 3(c)(7) fund securities, where both the trustee and contributors to the trust qualify as purchasers.

Fund Manager Regulation: Investment Advisers Act
According to the Investment Advisers Act of 1940 (the “Advisers Act”) an “investment adviser” is an entity or person providing compensated advice on securities. Private fund managers, categorized as investment advisers, may leverage exclusions from SEC registration. Key exemptions include:

  • Intrastate Advisers: Exempt if clients reside solely in the manager’s state, avoiding advice on nationally traded securities.
  • S.-Based Private Fund Managers: Exempt if managing private funds, with assets under $150 million in the U.S., adhering to Sections 3(c)(1) or 3(c)(7) of the ‘40 Act.
  • Foreign Private Advisors: Exempt if lacking a U.S. office, having less than 15 U.S. clients in private funds, managing less than $25 million for U.S. clients, and not presenting as a U.S. investment adviser.
  • Venture Capital Advisors: Exempt if following venture capital strategies, lacking redemption rights, with specific asset allocation and borrowing limitations.
  • Small Business Investment Company Advisers: Exempt when advising solely Small Business Investment Companies (SBICs).
  • Exempt Investment Advisers: Compliance with Advisers Act’s other rules, despite exemption, is mandatory, covering disclosure, record-keeping, reporting, marketing, custody, and capital raising.
Limitation on Performance-Based Fees by Registered Advisers

Section 205(a)(1) of the Advisers Act limits registered advisers from receiving performance-based compensation. Exceptions apply if the contract involves exempt funds, non-U.S. residents, or “Qualified Clients.” Qualified Clients meet specific financial criteria:

  • Net worth over $2,000,000 or a “qualified purchaser” pre-contract.
  • At least $1,000,000 under management with the manager post-contract.
  • Certain managerial or employee categories.

For section 3(c)(1) and 3(c)(7) funds, individual investors or fund qualification determines “Qualified Client” status.

Recent Amendments to the Investment Advisers Act

In August 2023, the Investment Advisers Act of 1940 underwent significant updates, impacting both private fund advisers and registered investment advisers. Notable changes include:

Preferential Treatment Rule for Private Fund Advisers:

  • Disclosure requirements for economic preferential treatment among fund investors.
  • Prohibition on selective information sharing about portfolio investments.
  • Restrictions on granting preferential redemption abilities.

Compliance Date and Legacy Funds:

  • Compliance dates vary based on private fund assets.
  • Legacy funds face exclusions under specific circumstances.

Restricted Activities Rule for Private Fund Advisers:

  • Restrictions on regulatory/compliance expense reimbursement without disclosure.
  • Allocation rules for expenses associated with co-investments.
  • Clawback reduction disclosure for taxes.
  • Prohibition on adviser borrowing without disclosure and majority consent.

Compliance Date and Legacy Funds:

  • Compliance dates vary based on private fund assets.
  • Legacy funds have exclusions under specific circumstances.

New and Amended Rules for Registered Investment Advisers:

  • Annual Audit Rule: Annual audited financial statements within 120 days of fiscal year-end.
  • Quarterly Statement Rule: Quarterly disclosures within specified time frames.
  • Adviser-Led Secondaries Rule: Compliance with new transaction requirements.
  • Books and Records Rule/Compliance Procedures and Practices Rule: Amendments for written records and documented annual reviews.

Application to Non-U.S. Advisers:

  • Rules apply to advisers with their principal office in the U.S.

Legal Challenge:

  • Industry associations have legally challenged the rules.
  • Compliance obligations remain unaffected during litigation.

These updates emphasize the changing securities regulatory landscape, prompting investment fund managers to reassess practices and compliance protocols.

Commodity Exchange Act

A fund manager trading commodity futures contracts or options must register as a commodity pool operator (CPO) under the Commodity Exchange Act. CPOs are subject to Commodity Futures Trading Commission rules, including record-keeping, reporting, and disclosure requirements.

The National Futures Association must approve the fund’s offering document. Exemptions from regulatory requirements may be sought if, among other conditions, the fund’s commodity transactions’ initial margin and option premiums are below 10% of assets or if investors are “qualified eligible participants.”

A “qualified eligible participant” generally includes an individual with securities and investments valued at $2,000,000 or one who, within the prior six months, had at least $200,000 in exchange-specified initial margin and option premiums with a futures commission merchant.

Employee Retirement Income Security Act of 1974 (ERISA)

Investments from benefit plan investors, such as retirement and Keogh accounts, into a fund managed by a fund manager are subject to ERISA regulations. If these investments reach or exceed 25% of the fund’s aggregate equity, the fund manager becomes a “plan fiduciary” under ERISA.

As a fiduciary, the manager faces restrictions on transactions that may pose a conflict of interest with benefit plan investors. To avoid this status, the fund manager must calculate the percentage of assets from benefit plan investors during each investment or withdrawal.

The legal team at Jacko Law Group works with clients who are considering or are in the process of a formation and may need legal and regulatory compliance counsel to optimize their efforts and protect their business. If you have a private fund matter or other compliance questions, please call 619.298.2880 or email

Author: Eric M. Leander, Senior Attorney, Jacko Law Group, PC (“JLG). JLG works extensively with investment advisers, broker-dealers, investment companies, private equity and hedge funds, banks and corporate clients on securities and corporate counsel matters. For more information, please visit

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