Almost all hedge funds which trade securities are deemed to be “investment companies” under the Investment Company Act of 1940. All “investment companies” are required to register under the Investment Company Act (like all mutual funds must do) unless the “investment company” falls within an exemption from the registration provisions.
There are two separate exemptions from the registration provisions of the Investment Company Act. This post deals with the more common Section 3(c)(1) exemption which generally requires that the hedge fund have 100 or fewer investors.
Not Owned by More Than 100 Investors
A 3(c)(1) hedge fund is exempt under the Investment Company Act provided that the fund is beneficially owned by not more than 100 investors and is not making a public offering of its securities. The actual text of Section 3(c)(1) provides:
None of the following persons is an investment company within the meaning of this title: Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:
(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, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company’s outstanding securities (other than short-term paper).
(B) Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.
Certain Look Through Rules
Part A above provides “look through” provisions for certain entity investors. This rule provides that if another 3(c)(1) hedge fund (the “Investor Fund”) owns more than 10% of another 3(c)(1) hedge fund (the “Investee Fund”) then the Investee Fund would count all of the investors of the Investor Fund as investors as well. This rule is designed to prevent the pyramiding of 3(c)(1) funds to avoid the application of the mutual fund registration rules. Through various no-action letters the SEC has provided further guidance in this area which we will be writing about shortly.
Types of 3(c)(1) Investors
Generally speaking investors in Section 3(c)(1) hedge funds will be both accredited investors and qualified clients. A 3(c)(1) fund must limit its investors to qualified clients if it wants to charge a performance fee.
Other related articles include:
- Investment Company Act of 1940
- Section 3(c)(7) Hedge Funds
- Hedge Fund Investors
- Hedge Fund Performance Fees
For more information on mutual funds in general, mutual fund investment programs and investing in mutual funds, please see investing in no load mutual funds. No load mutual funds are funds which do not have a front or back end load because the distribution fees are usually paid through section 12b-1 fees.
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