The Knowledgeable Employee Exemption for Private Funds

UPDATE: See More Guidance on Knowledgeable Employee Exemption for Private Funds

When operating under the Section 3(c)(7) exemption from the Investment Company Act, the issue then becomes how a private investment fund can provide an equity ownership to key employees.

Its unlikely that your key employees will have the $5 million in investments needed to qualify as an investor. (Each investor in a 3(c)(7) private investment fund must be Qualified Purchaser.)

The SEC established Rule 3C-5 to allow “knowledgeable employees” to invest in their company’s private fund without having to be a qualified purchaser. The rule also exempts these knowledgeable employees from the 100 investor limit under the Section 3(c)(1) exemption from the Investment Company Act.

You will still need to determine if the employee’s acquisition of the interest is exempt from the registration requirements of the Securities Act. Most likely that will mean that the knowledgeable employee will need to be an accredited investor. Meeting that $200,000 per year / $300,000 per year if married income (and a reasonable expectation of that income continuing) threshold may be the biggest impediment to offering equity interests further down the company ladder.

The first category of “knowledgeable employees” is the management of the covered company, which covers these positions:

  • director [see Section 2(a)(12)]
  • trustee
  • general partner
  • advisory board member [see Section 2(a)(1)]
  • “executive officer”

Executive Officer is defined in Rule 3C-5 as:

  • president
  • vice president in charge of a principal business unit, division or function
  • any other officer who performs a policy-making function
  • any other person who performs a similar policy-making function

The second group of knowledgeable employees are those who participate in the investment activities. Those employees need to meet these requirements:

  • Participate in the investment activities in connection with his or her regular functions or duties,
  • has been performing such functions and duties for at least 12 months, and
  • is not performing solely clerical, secretarial or administrative functions.

The 12 month limit is not limited to 12 months at the employee’s current company. The SEC 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 and performed substantially similar functions or duties for another company during that 12 month period.

Whether an employee actively “participates in the investment activities” of a private fund will be a factual determination made on a case-by-case basis.  In a 1999 No Action letter sent to the ABA the SEC said the following would NOT be knowledge employees:

  • Marketing and investor relations professionals who explain potential and actual portfolio investments of a fund and the investment decision-making process and strategy being followed to clients and prospective investors and interface among the fund, the portfolio mangers and the fund’s clients.
  • Attorneys who
    • provide advice in the preparation of offering documents and the negotiation of related agreements,
    • who also are familiar with investment company management issues, and
    • respond to questions or give advice concerning ongoing fund investments, operations and compliance matters.
  • Brokers and traders of a broker-dealer related to the Fund who are Series 7 registered.
  • Financial, compliance, operational and accounting officers of a fund who have management responsibilities for compliance, accounting and auditing functions of funds.

The SEC also said that research analysts who investigate the potential investments for the fund may not be knowledgeable employees unless they research all potential portfolio investments and provide recommendations to the portfolio manager.


Photo is of the Board of Directors and Officers of the Industrial Exhibition Association of Toronto 1930 used under Creative Commons License from the Toronto Public Library Special Collections

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