SECURITIES AND EXCHANGE COMMISSION

 

  17 CFR Part 270

 

  Release No. IC-22597, International Series Release No. 1071,

  File No. S7-30-96

 

  RIN 3235-AH09

 

  Privately Offered Investment Companies

 

  AGENCY:  Securities and Exchange Commission

 

  ACTION:  Final rules

 

  SUMMARY:  The Commission is adopting rules under the Investment

 

  Company Act of 1940 to implement provisions of the National

 

  Securities Markets Improvement Act of 1996 that apply to

 

  privately offered investment companies.  The rules define

 

  certain terms for purposes of the new exclusion from regulation

 

  under the Investment Company Act for privately offered

 

  investment companies whose investors are all highly

 

  sophisticated investors, termed "qualified purchasers."  The

 

  rules also address certain transition issues relating to

 

  existing privately offered investment companies that have no

 

  more than 100 investors and other matters concerning privately

 

  offered investment companies.

 

  EFFECTIVE DATE:  The rules become effective on June 9, 1997.

 

  FOR FURTHER INFORMATION CONTACT:  David P. Mathews, Senior

 

  Counsel, Nadya B. Roytblat, Assistant Office Chief, or Kenneth

 

  J. Berman, Assistant Director, at (202) 942-0690, Office of

 

  Regulatory Policy, Division of Investment Management, Mail Stop

 

  10-2, Securities and Exchange Commission, 450 Fifth Street,

==========================================START OF PAGE 2======

 

  N.W., Washington, D.C. 20549.  Requests for formal

 

  interpretative advice should be directed to the Office of Chief

 

  Counsel at (202) 942-0659, Division of Investment Management,

 

  Securities and Exchange Commission, 450 Fifth Street, N.W.,

 

  Mail Stop 10-6, Washington, D.C. 20549.

 

  SUPPLEMENTARY INFORMATION:  The Commission today is adopting

 

  rules 2a51-1, 2a51-2, 2a51-3, 3c-1, 3c-5 and 3c-6 [17 CFR

 

  270.2a51-1, .2a51-2, .2a51-3, .3c-1, .3c-5 and .3c-6] under the

 

  Investment Company Act of 1940 [15 USC 80a] (the "Investment

 

  Company Act" or "Act").

 

  EXECUTIVE SUMMARY

 

       The Commission is adopting rules to implement certain

 

  provisions of the National Securities Markets Improvement Act

 

  of 1996 (the "1996 Act").  The 1996 Act, among other things,

 

  added section 3(c)(7) to the Investment Company Act to create a

 

  new exclusion from regulation under the Act for privately

 

  offered investment companies that sell their securities solely

 

  to "qualified purchasers" owning or investing on a

 

  discretionary basis a specified amount of "investments"

 

  ("Section 3(c)(7) Funds").  The 1996 Act also amended section

 

  3(c)(1) of the Investment Company Act, which excludes from

 

  regulation under the Act privately offered investment companies

 

  with 100 or fewer "beneficial owners" ("Section 3(c)(1)

 

  Funds").  Reflecting a relationship between section 3(c)(1) and

 

  new section 3(c)(7), the 1996 Act contains provisions that

 

  permit an existing Section 3(c)(1) Fund to convert into a

==========================================START OF PAGE 3======

 

  Section 3(c)(7) Fund or invest in a Section 3(c)(7) Fund as a

 

  qualified purchaser, subject to certain requirements designed

 

  to protect the Section 3(c)(1) Fund's existing "beneficial

 

  owners."

 

       The 1996 Act requires the Commission to prescribe rules

 

  defining the terms "investments" and "beneficial owner"

 

  relevant to the new provisions by April 9, 1997.  Other changes

 

  to the provisions of the Investment Company Act relating to

 

  privately offered investment companies require Commission

 

  rulemaking as well.  The Commission is adopting rules under the

 

  Investment Company Act that:

  define the term "investments" for purposes of the qualified

  purchaser definition;

 

  define the term "beneficial owner" for purposes of the

  provisions that permit an existing Section 3(c)(1) Fund to

  convert into a Section 3(c)(7) Fund or to be treated as a

  qualified purchaser;

 

  clarify certain interpretative issues under section 3(c)(7);

 

  permit certain Section 3(c)(1) Funds to rely on the pre-1996

  Act provisions of section 3(c)(1) rather than restructure their

  existing relationships with investors;

 

  permit knowledgeable employees of a Section 3(c)(1) Fund or a

  Section 3(c)(7) Fund (referred to collectively in this Release

  as "privately offered funds" or "funds"), and knowledgeable

  employees of certain affiliates of these Funds, to invest in

  the Funds; and

 

  address transfers of securities in a privately offered fund

  when the transfer was a gift or caused by divorce or death.

 

  The rules reflect modifications suggested by commenters that

 

  are designed to make the rules less complex and easier to

 

  apply, consistent with the policies underlying the Investment

 

  Company Act and the 1996 Act's provisions relating to privately

==========================================START OF PAGE 4======

 

  offered funds.

 

  I.   BACKGROUND

 

       A.   Statutory Exclusions for Privately Offered Funds

 

       Section 3(c)(1) of the Investment Company Act excludes

 

  from regulation under the Act certain privately offered

 

  investment companies "whose outstanding securities (other than

 

  short-term paper) are beneficially owned by not more than one

 

  hundred persons."-[1]-  A wide variety of investment

 

  vehicles rely on section 3(c)(1), ranging from small groups of

 

  individual investors, such as investment clubs, to venture

 

  capital and other investment pools designed primarily for

 

  sophisticated investors.-[2]-

 

       The 1996 Act-[3]- added new section 3(c)(7) of the

 

  Investment Company Act to create an alternative exclusion for

 

  investment companies that sell their securities solely to

 

  investors who are "qualified purchasers."-[4]-  As is the

                     

 

       -[1]-     15 USC 80a-3(c)(1).  In addition, the Section

                 3(c)(1) Fund must be an issuer that "is not

                 making and does not presently propose to make a

                 public offering of its securities."  Id.

 

       -[2]-     See DIVISION OF INVESTMENT MANAGEMENT, SEC,

                 PROTECTING INVESTORS: A HALF CENTURY OF

                 INVESTMENT COMPANY REGULATION (hereinafter

                 PROTECTING INVESTORS REPORT) at 104 (1992).

 

       -[3]-     The National Securities Markets Improvement Act

                 of 1996, Pub. L. No. 104-290 (1996) (codified in

                 scattered sections of the United States Code).

 

       -[4]-     15 USC 80a-3(c)(7).  For the history of the

                 development of section 3(c)(7), see Private

                 Investment Companies, Investment Company Act

                 Release No. IC-22405 (Dec. 18, 1996) [61 FR

                                                   (continued...)

==========================================START OF PAGE 5======

 

  case for a Section 3(c)(1) Fund, a Section 3(c)(7) Fund cannot

 

  make, or propose to make, a public offering of its

 

  securities.-[5]-

 

       New section 2(a)(51)(A) of the Investment Company Act

 

  defines the term qualified purchaser as (i) any natural person

 

  who owns not less than $5 million in investments (as defined by

 

  the Commission),-[6]- (ii) a family-owned company ("Family

                     

 

       -[4]-(...continued)

                 68100 (Dec. 26, 1996)] (hereinafter Proposing

                 Release) at nn.3-9 and accompanying text.

 

       -[5]-     Section 3(c)(7) of the Act.  While the

                 legislative history of the 1996 Act does not

                 explicitly discuss section 3(c)(7)'s limitation

                 on public offerings by Section 3(c)(7) Funds,

                 the limitation appears to reflect Congress's

                 concerns that unsophisticated individuals not be

                 inadvertently drawn into a Section 3(c)(7) Fund.

 

                 See The Investment Company Act Amendments of

                 1995: Hearing on H.R. 1495 before the Subcomm.

                 on Telecommunications and Finance of the Comm.

                 on Commerce, House of Representatives, 104th

                 Cong., 1st Sess. 53 (1995) (hereinafter House

                 Hearings) (testimony of Matthew P. Fink,

                 President, Investment Company Institute, urging

                 that section 3(c)(7) include a public offering

                 limitation).  Section 3(c)(1)'s limitation on

                 public offerings has been interpreted to permit

                 "transactions by an issuer not involving any

                 public offering" under section 4(2) of the

                 Securities Act of 1933 ("Securities Act") [15

                 USC 77d(2)]. See, e.g., Engelberger Partnerships

                 (Dec. 7, 1981).  The Commission believes that

                 section 3(c)(7)'s public offering limitation

                 should be interpreted in the same manner as the

                 limitation in section 3(c)(1).

 

       -[6]-     Section 2(a)(51)(A)(i) of the Act [15 USC 80a-

                 2(a)(51)(A)(i)].  The 1996 Act directed the

                 Commission to prescribe rules defining the term

                 "investments" by April 9, 1997.  15 USC 80a-2

                 note.

==========================================START OF PAGE 6======

 

  Company") that owns not less than $5 million in

 

  investments,-[7]- (iii) certain trusts,-[8]- and (iv)

 

  any other person (e.g., an institutional investor) that owns

 

  and invests on a discretionary basis not less than $25 million

 

  in investments.-[9]-

 

       Section 3(c)(7)(B) includes a "grandfather" provision

 

  ("Grandfather Provision") that permits an existing Section

 

  3(c)(1) Fund to convert into a Section 3(c)(7) Fund

 

  ("Grandfathered Fund").-[10]-  The outstanding securities

 

  of a Grandfathered Fund may be beneficially owned by as many as

 

  100 persons that are not qualified purchasers, provided that

 

                     

 

       -[7]-     A Family Company is a company "that is owned

                 directly or indirectly by or for 2 or more

                 natural persons who are related as siblings or

                 spouse (including former spouses), or direct

                 lineal descendants by birth or adoption, spouses

                 of such persons, the estates of such persons, or

                 foundations, charitable organizations, or trusts

                 established by or for the benefit of such

                 persons . . . ."  Section 2(a)(51)(A)(ii) of the

                 Act [15 USC 80a-2(a)(51)(A)(ii)].

 

       -[8]-     A trust may be a qualified purchaser if (i) it

                 was not formed for the specific purpose of

                 acquiring the securities offered, and (ii) the

                 trustee or other person authorized to make

                 decisions with respect to the trust, and each

                 settlor or other person who has contributed

                 assets to the trust, are qualified purchasers.

                 Section 2(a)(51)(A)(iii) of the Act [15 USC

                 80a-2(a)(51)(A)(iii)].

 

       -[9]-     A qualified purchaser that meets the $25 million

                 threshold may act for its own account or for the

                 accounts of other qualified purchasers.  See

                 section 2(a)(51)(A)(iv) of the Act [15 USC 80a-

                 2(a)(51)(A)(iv)].

 

       -[10]-    15 USC 80a-3(c)(7)(B).

==========================================START OF PAGE 7======

 

  these persons acquired the securities of the Grandfathered Fund

 

  on or before September 1, 1996.-[11]-  The Grandfather

 

  Provision is designed to allow an existing Section 3(c)(1) Fund

 

  wishing to avail itself of section 3(c)(7) to continue its

 

  existing relationships with investors that are not qualified

 

  purchasers.-[12]-

 

       The Grandfather Provision requires the Grandfathered Fund,

 

  prior to the conversion, to provide each beneficial owner of

 

  its securities (i) notice of the Fund's intention to become a

 

  Section 3(c)(7) Fund and (ii) an opportunity to redeem the

 

  owner's interest in the Fund.-[13]-  The 1996 Act directs

 

  the Commission to define the term "beneficial owner" for this

 

  purpose.-[14]-  The 1996 Act also requires an existing

 

  privately offered fund that wishes to become a qualified

 

  purchaser to obtain the consent of certain beneficial owners of

 

  its securities and certain other persons (the "Consent

 

  Provision").-[15]-

                     

 

       -[11]-    Section 3(c)(7)(B)(i)(I) of the Act [15 USC 80a-

                 3(c)(7)(B)(i)(I)].

 

       -[12]-    See S. REP. NO. 293, 104th Cong., 2d Sess. 23

                 (1996) (hereinafter Senate Report); H.R. REP.

                 NO. 622, 104th Cong., 2d Sess. 51 (1996)

                 (hereinafter House Report).  These Reports

                 relate to bills that were eventually enacted as

                 the 1996 Act.

 

       -[13]-    Section 3(c)(7)(B)(ii) of the Act [15 USC 80a-

                 3(c)(7)(B)(ii)].

 

       -[14]-    15 USC 80a-3 note.

 

       -[15]-    Section 2(a)(51)(C) of the Act [15 USC 80a-

                 2(a)(51)(C)].

==========================================START OF PAGE 8======

 

       B.   Amendments to Section 3(c)(1)

 

       To prevent circumvention of the 100-investor limit,

 

  section 3(c)(1)(A) (the "Look-Through Provision") requires, in

 

  some instances, that a fund seeking to rely on section 3(c)(1)

 

  "look through" certain companies (e.g., corporations,

 

  partnerships and other investors that are not natural persons)

 

  that hold its voting securities and count the company's

 

  security holders as beneficial owners of the fund's

 

  securities.-[16]-  Prior to the 1996 Act,-[17]- the Look-

 

  Through Provision applied (i) if a company owned 10% or more of

 

  a Section 3(c)(1) Fund's voting securities ("First 10% Test")

 

  and (ii) more than 10% of the company's total assets consisted

 

  of securities of Section 3(c)(1) Funds generally ("Second 10%

Test").-[18]-

                     

 

       -[16]-    15 USC 80a-3(c)(1)(A).  Section 2(a)(42) of the

                 Investment Company Act [15 USC 80a-2(a)(42)]

                 defines a voting security as any security

                 "presently entitling the owner or holder thereof

                 to vote for the election of a company."  See

                 Thomas P. Lemke and Gerald T. Lins, Private

                 Investment Companies Under Section 3(c)(1), 44

                 BUS. LAW. 401, 416-18 (Feb. 1989) (discussing

                 the types of non-voting interests that have been

                 treated as voting securities).

 

       -[17]-    The 1996 Act was signed into law by President

                 Clinton on October 11, 1996.  The provisions

                 relating to privately offered funds do not

                 become effective until the earlier of April 9,

                 1997 or the date on which the rule defining the

                 term investments is published in the Federal

                 Register.  For purposes of convenience, this

                 Release assumes that the amendments to section

                 3(c)(1) are now effective. 

 

       -[18]-    To illustrate the operation of the pre-1996 Act

                 Look-Through Provision, assume Company A is

                 seeking to rely on section (3)(c)(1).  If one of

                                                   (continued...)

==========================================START OF PAGE 9======

 

       The 1996 Act's amendments to section 3(c)(1) were

 

  designed, in part, to simplify the way in which the number of

 

  investors in a fund is calculated for purposes of the

 

  100-investor limit.  The amended Look-Through Provision does

 

  not apply to an investor that is an operating company.  In

 

  other words, a Section 3(c)(1) Fund must only look through an

 

  investor to count its shareholders if the investor is an

 

  investment company or a privately offered fund.-[19]-  In

 

  addition, the Second 10% Test has been eliminated.  As a

 

  result, a Section 3(c)(1) Fund must count all of the

 

  shareholders of an investment company or fund investor that

                     

 

       -[18]-(...continued)

                 Company A's security holders, Company B,

                 beneficially owned 10% or more of Company A's

                 voting securities (the First 10% Test), then the

                 security holders of Company B would have been

                 counted as security holders of Company A, unless

                 no more than 10% of Company B's assets consisted

                 of securities of Section 3(c)(1) Funds (the

                 Second 10% Test).

 

       The operation of the pre-1996 Act Look-Through Provision

       also is relevant to determining who is a beneficial owner

       of a Section 3(c)(1) Fund's securities for purposes of the

       Grandfather and Consent Provisions.  See section II.B. of

       this Release.

 

       -[19]-    This approach recognizes that an investment in a

                 Section 3(c)(1) Fund by a company that is not

                 itself an investment company generally does not

                 implicate the concerns that the Look-Through

                 Provision was intended to address -- that the

                 investor may be a conduit that was created to

                 enable a Section 3(c)(1) Fund to have indirectly

                 more than 100 investors.  See The Securities

                 Investment Promotion Act of 1996: Hearing on S.

                 1815 before the Senate Comm. on Banking, Housing

                 and Urban Affairs, 104th Cong., 2d Sess. 40

                 (1995) (testimony of Arthur Levitt, Chairman,

                 SEC).

==========================================START OF PAGE 10======

 

  owns 10% or more of the Section 3(c)(1) Fund's voting

 

  securities even if the investor does not have more than 10% of

 

  its assets invested in Section 3(c)(1) Funds.-[20]-

 

  These revisions, while generally narrowing the scope of the

 

  Look-Through Provision, have raised questions regarding the

 

  regulatory status of existing Section 3(c)(1) Funds that have

 

  relied on the Second 10% Test.

 

       C.   The Commission's Rule Proposals

 

       On December 26, 1996, the Commission published a release

 

  proposing several rules under the Investment Company Act to

 

  implement the provisions of the 1996 Act relating to privately

 

  offered funds ("Proposing Release").-[21]-  Proposed rule

 

  2a51-1 would define the term "investments" for purposes of the

 

  qualified purchaser definition.  Proposed rule 2a51-2 would

 

  define the term "beneficial owner" for purposes of the

 

  Grandfather and Consent Provisions.  Proposed rule 2a51-3 would

 

  provide that a company could not be a qualified purchaser if it

 

  was formed for the specific purpose of acquiring the securities

 

  of a Section 3(c)(7) Fund unless each beneficial owner of the

 

                     

 

       -[20]-    This change reflects the view that the private

                 nature of a Section 3(c)(1) Fund may be brought

                 into question when an investment company has a

                 substantial investment in the Section 3(c)(1)

                 Fund.  See, e.g., PROTECTING INVESTORS REPORT,

                 supra note 2, at 106-09.  See section III.A.2 of

                 this Release for a discussion of when a Section

                 3(c)(1) Fund should determine whether an

                 investor is subject to the amended Look-Through

                 Provision.   

 

       -[21]-    Proposing Release, supra note 4.

==========================================START OF PAGE 11======

 

  company's securities is a qualified purchaser.  Proposed rule

 

  3c-7 would address certain issues related to a Grandfathered

 

  Fund and an affiliated Section 3(c)(1) Fund.

 

       The Commission also proposed two other rules that the 1996

 

  Act directed the Commission to adopt.  The 1996 Act directed

 

  the Commission to prescribe rules permitting "knowledgeable

 

  employees" of a privately offered fund (or knowledgeable

 

  employees of the fund's affiliates) to invest in the fund

 

  without causing the fund to lose its exclusion from regulation

 

  under the Investment Company Act.-[22]-  The Commission

 

  proposed rule 3c-5 to permit knowledgeable employees to make

 

  such investments.

 

       The 1996 Act also directed the Commission to prescribe

 

  rules implementing section 3(c)(1)(B) of the Act.-[23]-

 

  Section 3(c)(1)(B) provides that beneficial ownership of

 

  securities of a Section 3(c)(1) Fund by any person who acquires

 

  the securities as a result of "a legal separation, divorce,

 

  death, or other involuntary event" will be deemed to be

 

  beneficial ownership by the person from whom the transfer was

 

                     

 

       -[22]-    15 USC 80a-3 note.  The purpose of this

                 provision appears to be to allow privately

                 offered funds to offer persons who participate

                 in the funds' management the opportunity to

                 invest in the fund as a benefit of employment.

                 See House Hearings, supra note 5, at 22-23

                 (testimony of Barry P. Barbash, Director,

                 Division of Investment Management, SEC).

 

       -[23]-    15 USC 80a-3 note.

==========================================START OF PAGE 12======

 

  made, pursuant to such rules and regulations as the Commission

 

  prescribes.-[24]-  The Commission proposed rule 3c-6 to

 

  implement section 3(c)(1)(B) of the Act.  The proposed rule

 

  also would address similar transfers of securities issued by

 

  Section 3(c)(7) Funds.-[25]-

 

       The Commission received letters from 48 commenters

 

  concerning the proposals.  While commenters generally supported

 

  the proposed rules, many suggested changes designed to simplify

 

  the rules, make them more flexible or resolve technical issues.

 

 

  The Commission is adopting the proposed rules with several

 

  modifications that reflect, in part, many of the commenters'

 

  suggestions.

 

  II.  RULES RELATING TO SECTION 3(c)(7) FUNDS

 

       A.   Investments and Other Matters

 

       Rule 2a51-1 under the Investment Company Act defines the

 

  term investments for purposes of determining whether a

 

  prospective investor in a Section 3(c)(7) Fund ("Prospective

 

  Qualified Purchaser") meets the $5 million/$25 million

 

  thresholds.-[26]-  Rule 2a51-1 also contains provisions

                     

       -[24]-    15 USC 80a-3(c)(1)(B).

 

       -[25]-    See section 3(c)(7)(A) of the Act [15 USC 80a-

                 3(c)(7)(A)] (permitting certain transfers by

                 qualified purchasers).

 

       -[26]-    The 1996 Act provides that the term investments

                 is to be defined by Commission rule.  15 USC

                 80a-2 note.  Section 2(a)(51)(B) of the Act [15

                 USC 80a-2(a)(51)(B)] also gives the Commission

                 authority to prescribe such rules and

                 regulations governing qualified purchasers as

                                                   (continued...)

==========================================START OF PAGE 13======

 

  designed to clarify how the amount of a Prospective Qualified

 

  Purchaser's investments should be determined.

 

            1.   Qualified Institutional Buyers as Qualified

 

                 Purchasers

 

       Many commenters suggested that the determination of

 

  qualified purchaser status could be made significantly easier

 

  if qualified institutional buyers ("QIBs"), as defined in rule

 

  144A under the Securities Act of 1933 ("Securities Act"), were

 

  deemed to be qualified purchasers.  Rule 144A generally defines

 

  QIBs as certain institutions (including registered investment

 

  companies) that own and invest on a discretionary basis $100

 

  million of securities of issuers that are not affiliated with

 

  the institution ("QIB Securities"); banks that own and invest

 

  on a discretionary basis $100 million of QIB Securities and

 

  that have an audited net worth of at least $25 million; and

 

  certain registered dealers.-[27]-  The Commission

 

  believes that it is generally appropriate to treat QIBs as

 

  qualified purchasers for purposes of section 3(c)(7) in light

 

  of the high threshold of securities ownership that these

 

  institutions must meet under rule 144A, a threshold much higher

 

  than the investment ownership threshold required for qualified

 

                     

 

       -[26]-(...continued)

                 the Commission determines are necessary or

                 appropriate in the public interest or for the

                 protection of investors. 

 

       -[27]-    17 CFR 230.144A(a).  In each case, the QIB must

                 be acting for its own account or the account of

                 another QIB.

==========================================START OF PAGE 14======

 

  purchasers under section 2(a)(51)(A) of the Act.

 

       Rule 2a51-1 therefore provides that, with two exceptions,

 

  a QIB is deemed to be a qualified purchaser.-[28]-   The

 

  first exception relates to dealers.  Under rule 144A, a dealer

 

  (other than a dealer acting for a QIB in a riskless principal

 

  transaction) must own and invest on a discretionary basis $10

 

  million of QIB Securities.-[29]-  In order to coordinate

 

  the definition of QIB with the statutory definition of

 

  qualified purchaser, rule 2a51-1 requires the dealer to own and

 

  invest on a discretionary basis $25 million of QIB

 

  Securities.-[30]-

 

       The second exception relates to employee benefit plans.

 

  Rule 144A includes in its QIB definition certain employee

 

  benefit plans, as well as certain trusts that hold assets of

 

  employee benefit plans.-[31]-  A self-directed employee

                     

 

       -[28]-    Rule 2a51-1(g)(1) [17 CFR 270.2a51-1(g)(1)].

                 The QIB must be acting for its own account, the

                 account of another QIB or the account of a

                 qualified purchaser.  A person's status as a QIB

                 would be determined based on QIB Securities, not

                 investments as defined by rule 2a51-1.

 

       -[29]-    Rule 144A(a)(1)(ii) [17 CFR 230.144A(a)(1)(ii)].

 

       -[30]-    Rule 2a51-1(g)(1)(i) [17 CFR 270.2a51-

                 1(g)(1)(i)].  A dealer that does not own and

                 invest on a discretionary basis $25 million of

                 QIB Securities could still be a qualified

                 purchaser if the dealer owns and invests on a

                 discretionary basis $25 million of investments,

                 determined in accordance with rule 2a51-1.

 

       -[31]-    Rule 144A(a)(1)(i)(D) (government employee benefit

                 plans), (E) (any employee benefit plan within

                 the meaning of Title I of the Employee

                                                   (continued...)

==========================================START OF PAGE 15======

 

  benefit plan (such as a "401(k)" plan) generally would not be

 

  considered to be a qualified purchaser for purposes of rule

 

  2a51-1; rather, an employee could invest in a Section 3(c)(7)

 

  Fund through a self-directed plan only if the employee is a

 

  qualified purchaser.-[32]-  This provision therefore is

 

  not available to a self-directed plan.-[33]-

 

            2.   Definition of Investments

 

       Rule 2a51-1, as proposed, would have defined investments

 

  broadly to include securities (other than controlling interests

 

  in certain issuers), and real estate, futures contracts,

 

  physical commodities, and cash and cash equivalents held for

 

  investment purposes.  The Commission believes that this

 

  approach is consistent with the legislative history of the 1996

 

  Act, which suggests that Congress expected that the definition

 

  of investments would be broader than securities, but that not

                     

 

       -[31]-(...continued)

                 Retirement Income Security Act of 1974), and (F)

                 (trust funds whose participants are exclusively

                 plans of the types identified in paragraphs (D)

                 and (E)) [17 CFR 230.144A(a)(1)(i)(D),(E), and

                 (F)].

 

       -[32]-    See infra section II.A.8 of this Release

                 (discussing the circumstances under which

                 pension and retirement plans can be treated as

                 qualified purchasers).

 

       -[33]-    Rule 2a51-1(g)(1)(ii) [17 CFR 270.2a51-

                 1(g)(1)(ii)] provides that a plan will not be

                 deemed to be acting for its own account if

                 investment decisions with respect to the plan

                 are made by the beneficiaries of the plan.  In

                 other words, the investment decision must be

                 made by a qualified purchaser.  

==========================================START OF PAGE 16======

 

  every asset be treated as an investment.-[34]-  Rather,

 

  the legislative history suggests that the asset should be held

 

  for investment purposes and that the nature of the asset should

 

  indicate that its holder has the investment experience and

 

  sophistication necessary to evaluate the risks of investing in

 

  unregulated investment pools.-[35]-

 

       Commenters generally supported the approach of the

 

  proposal, although many commenters suggested alternative

 

  approaches to addressing particular issues.  The Commission is

 

  adopting the definition of investments substantially as

 

  proposed, with modifications made in view of the commenters'

 

  suggestions, as discussed below.

 

                     

 

       -[34]-    See Proposing Release, supra note 4, at nn.29-31

                 and accompanying text.

 

       -[35]-    Id.  The legislative history was confined to

                 addressing new section 3(c)(7), and should not

                 be viewed as suggesting how issues of investor

                 sophistication should be analyzed in other

                 contexts under the federal securities laws.

                 Although Section 3(c)(7) Funds are not subject

                 to regulation under the Investment Company Act,

                 these Funds and persons who sell their

                 securities are subject to the antifraud, civil

                 liability, and other applicable provisions of

                 the federal securities laws.  Persons who sell

                 the securities issued by Section 3(c)(7) Funds

                 should also consider the applicability of the

                 broker-dealer registration provisions of the

                 Securities Exchange Act of 1934 [15 USC 78a-

                 78jj] ("Exchange Act"). 

==========================================START OF PAGE 17======

 

                 a.   Securities

 

       Rule 2a51-1(b)(1) includes securities within the

 

  definition of investments.-[36]-  This approach should

 

  result in a broad range of assets being treated as investments

 

  for purposes of the qualified purchaser definition.  Many

 

  investment opportunities, such as limited partnerships and

 

  limited liability companies, are offered in the form of

 

  securities.-[37]-

 

       Under the rule, securities that constitute a "control

 

  interest" in an issuer generally do not come within the

 

  definition of investments.-[38]-  Limiting the definition

 

  in this manner is designed to exclude, among other things,

 

  controlling ownership interests in family-owned and other

 

  closely-held businesses.  These holdings may not demonstrate

 

  the degree of financial sophistication necessary to invest in

 

                     

 

       -[36]-    17 CFR 270.2a51-1(b)(1). 

 

       -[37]-    See section 2(a)(1) of the Securities Act [15

                 USC 77b(a)(1)].

 

       -[38]-    The rule excludes from the definition of

                 investments securities of an issuer that

                 "controls, is controlled by, or is under common

                 control with, the person that owns the

                 securities."  The term "control" is defined in

                 section 2(a)(9) of the Act [15 USC 80a-2(a)(9)]

                 as "the power to exercise a controlling

                 influence over the management or policies of a

                 company, unless such power is solely the result

                 of an official position with such company."

                 Section 2(a)(9) also provides that a person who

                 owns beneficially, "either directly or through

                 one or more controlled companies, more than 25

                 per centum of the voting securities of a company

                 shall be presumed to control such company."  Id.

==========================================START OF PAGE 18======

 

  unregulated investment pools.

 

       The Commission proposed certain exceptions from the

 

  control interest exclusion.  The Commission is broadening these

 

  exceptions in certain respects, in light of the suggestions of

 

  commenters as discussed below.

 

       Investment Vehicles.  The rule permits control interests

 

  in "investment vehicles" excluded or exempted from the

 

  definition of investment company by sections 3(c)(1) through

 

  3(c)(9) of the Act or rule 3a-6 or 3a-7 under the Act to be

 

  treated as investments.-[39]-  Sections 3(c)(1) through

 

  3(c)(9) and rules 3a-6 and 3a-7 except from the definition of

 

  investment company, in addition to privately offered funds,

 

  certain types of issuers that engage in significant investment-

 

  related activities (i.e., brokers and other financial

 

  intermediaries, banks, insurance companies, finance companies,

 

  and certain structured finance vehicles).-[40]-

 

       A control interest in these types of companies generally

 

  suggests a significant degree of investment experience.  In a

 

  change from the proposal, the rule also specifies that a

 

  control interest in a commodity pool may be treated as an

 

  investment.-[41]-  As in the case of a control interest

                     

 

       -[39]-    Rule 2a51-1(a)(3) [17 CFR 270.2a51-1(a)(3)]

                 (defining the term "investment vehicle"). 

 

       -[40]-    15 USC 80a-3(c)(1) through (9); 17 CFR 270.3a-6

                 (exemption for foreign banks and insurance

                 companies) and .3a-7 (exemption for certain

                 structured finance vehicles).

 

       -[41]-    Rule 2a51-1(a)(3).

==========================================START OF PAGE 19======

 

  in an investment company, a control interest in a commodity

 

  pool may suggest a significant degree of investment experience

 

  on the part of the Prospective Qualified Purchaser.

 

       Public Companies.  The rule, as proposed, would have

 

  included in the definition of investments a control interest in

 

  a "listed" company that is not a majority-owned subsidiary of

 

  the Prospective Qualified Purchaser.  A listed company would

 

  have been defined as a company whose equity securities are

 

  listed on a national securities exchange, traded on the

 

  National Association of Securities Dealers Automated Quotation

 

  System (NASDAQ), or listed on a designated offshore securities

 

  market.  Commenters generally supported treating control

 

  interests in listed companies as investments, but suggested

 

  that the category should be broadened to include control

 

  interests (including majority ownership interests) in any

 

  public company.

 

       The Commission agrees, and has revised the rule to include

 

  in the definition of investments a control interest in a

 

  company that files periodic reports in accordance with the

 

  Securities Exchange Act of 1934.-[42]-  The Commission

 

  has concluded that a person that holds a control interest in a

 

  reporting company is likely to have significant experience in

 

  financial matters and investments.  The fact that the control

                     

 

       -[42]-    Rule 2a51-1(b)(1)(ii) [17 CFR 270.2a51-

                 1(b)(1)(ii)].  A control interest in an issuer

                 may be treated as an investment if the issuer

                 files reports pursuant to section 13 or 15(d) of

                 the Exchange Act [15 USC 78m and 78o(d)].

==========================================START OF PAGE 20======

 

  interest is a majority interest should not affect this

 

  analysis.  As proposed, a control interest in an issuer whose

 

  securities are listed on a designated offshore securities

 

  market (as defined by Regulation S under the Securities Act)

 

  also may be treated as an investment.-[43]-

 

       Large Private Companies.  Many commenters suggested that a

 

  control interest in a large private operating company should be

 

  treated as an investment.  These commenters asserted that the

 

  very size of such a company suggests that a person who controls

 

  it is sophisticated and has significant financial

 

  acumen.-[44]-  The commenters also pointed out that

 

  sophisticated investors, such as venture capital investors,

 

  often hold control interests in private companies, and that not

 

  treating these holdings as investments could result in these

 

  investors not being treated as qualified purchasers.

 

       Under the rule as adopted, a control interest in a company

 

  that has shareholders' equity of $50 million or more may be

 

 

                     

 

       -[43]-    Rule 2a51-1(a)(7)(ii) [17 CFR 270.2a51-

                 1(a)(7)(ii)]; 17 CFR 230.901 through .904.

 

       -[44]-    Commenters did not agree, however, on how to

                 identify such a company.  Several commenters

                 suggested that the definition be based on the

                 company's shareholders' equity (e.g., $25

                 million or $50 million).  Other commenters

                 suggested that the definition be based on the

                 company's revenues, assets or going concern

                 value.  Still other commenters suggested that a

                 control interest should be included if its value

                 was in excess of a specified amount.

==========================================START OF PAGE 21======

 

  treated as an investment.-[45]-  The Commission believes

 

  that this change should respond to the concerns of the

 

  commenters in a manner consistent with the legislative history

 

  indicating Congress' view that control interests in family-

 

  owned and other small businesses may not evidence investment

 

  sophistication.

 

                 b.   Real Estate

 

       Rule 2a51-1(b)(2) includes real estate held for investment

 

  purposes within the definition of investments.-[46]-

 

  Most commenters strongly supported treating real estate as an

 

  investment.

 

       Consistent with the examples provided by the legislative

 

  history of the 1996 Act, real estate is not considered to be

 

  held for investment purposes if the real estate is used by the

 

  Prospective Qualified Purchaser or a member of the Prospective

 

  Qualified Purchaser's family ("Related Person") for personal

 

  purposes (e.g., as a personal residence).-[47]-  The term

 

                     

 

       -[45]-    Rule 2a51-1(b)(1)(iii) [17 CFR 270.2a51-

                 1(b)(1)(iii)].  The company must have had $50

                 million of shareholders' equity on its most

                 recent financial statements (whether annual or

                 quarterly).  Id.

 

       -[46]-    17 CFR 270.2a51-1(b)(2).

 

       -[47]-    Rule 2a51-1(c)(1) [17 CFR 270.2a51-1(c)(1)].

                 Rule 2a51-1(a)(8) [17 CFR 270.2a51-1(a)(8)]

                 defines "related person" as a sibling, spouse or

                 former spouse of the prospective qualified

                 purchaser, or a direct lineal descendant or

                 ancestor by birth or adoption of the Prospective

                 Qualified Purchaser, or a spouse of the

                 descendant or ancestor.

==========================================START OF PAGE 22======

 

  "personal purposes" is derived from the Internal Revenue Code

 

  provision that addresses circumstances under which a taxpayer

 

  is allowed deductions with respect to certain "dwelling

 

  units."-[48]-  Thus, residential property may be treated

 

  as an investment if it is not treated as a residence for tax

 

  purposes.  Many commenters agreed that the reference to the

 

  Internal Revenue Code provisions is appropriate because it

 

  would allow a Prospective Qualified Purchaser to determine

 

  whether residential real estate is an investment based on the

 

  same provisions he or she would apply in determining whether

 

  certain expenses related to the property are deductible for

 

  purposes of his or her tax returns. 

 

       Property owned by a Prospective Qualified Purchaser that

 

  has been used by the Prospective Qualified Purchaser or a

 

  Related Person as a place of business or in connection with the

 

  conduct of a trade or business ("Business-Related Property")

 

  also is not considered to be held for investment

 

                     

 

       -[48]-    Internal Revenue Code ("IRC") section 280A(d)

                 [26 USC 280A(d)].  Rule 2a51-1(c) [17 CFR

                 270.2a51-1(c)] treats residential real estate as

                 an investment if it is not treated as a dwelling

                 unit used as a residence in determining whether

                 deductions for depreciation and other items are

                 allowable under the IRC.  Section 280A provides,

                 among other things, that a taxpayer uses a

                 dwelling unit during the taxable year as a

                 residence if he or she uses such unit for

                 personal purposes for a number of days that

                 exceeds the greater of 14 days or 10 percent of

                 the number of days during which the unit is

                 rented at a fair market value. 

==========================================START OF PAGE 23======

 

  purposes.-[49]-  While Business-Related Property may have

 

  been acquired with an investment goal in mind, these holdings

 

  may not be indicative of extensive experience in the financial

 

  or real estate markets and may have been acquired for reasons

 

  other than the potential investment merits of the

 

  property.-[50]-

 

                 c.   Commodity Interests, Commodities and

 

                      Financial Contracts

 

       Rule 2a51-1(b)(3) includes contracts for the purchase or

 

  sale of a commodity for future delivery ("Commodity Interests")

 

  held for investment purposes within the definition of

 

  investments.-[51]-  Most commenters agreed that Commodity

 

                      

 

       -[49]-    Rule 2a51-1(c)(1). 

 

       -[50]-    Real property held by a Prospective Qualified

                 Purchaser primarily engaged in the real estate

                 investment and development business as part of

                 that business may be treated as an investment.

                 Id. 

 

       -[51]-    17 CFR 270.2a51-1(b)(3).  Paragraph (a)(1) of

                 rule 2a51-1 [17 CFR 270.2a51-1(a)(1)] defines

                 Commodity Interests to mean commodity futures

                 contracts, options on commodity futures

                 contracts, and options on physical commodities

                 traded on or subject to the rules of (a) any

                 contract market designated for trading such

                 transactions under the Commodity Exchange Act

                 (the "CEA") [7 USC 1] and the rules thereunder;

                 or (b) any board of trade or exchange outside

                 the United States, as contemplated in Part 30 of

                 the rules under the CEA.  17 CFR 30.1 through

                 30.11.  Commodity Interests held as part of a

                 business by a Prospective Qualified Purchaser

                 that is primarily engaged in the business of

                 investing or trading in Commodity Interests may

                 be treated as investments.  Rule 2a51-1(c)(2)

                 [17 CFR 270.2a51-1(c)(2)].

==========================================START OF PAGE 24======

 

  Interests should be treated as investments.

 

       The rule also includes in the definition of investments

 

  commodities that are held in physical form and for investment

 

  purposes.-[52]-  This provision recognizes that many

 

  investors hold gold, silver or other commodities as part of

 

  their investment portfolios.  While some commenters suggested

 

  that the definition include any commodity, other commenters

 

  stated that the rule's definition would include most

 

  commodities held as investments.

 

 

 

                     

 

       -[52]-    Rule 2a51-1(b)(4) [17 CFR 270.2a51-1(b)(4)].

                 Physical commodities, for purposes of the rule,

                 are defined as any commodity with respect to

                 which a Commodity Interest is traded on a

                 domestic or foreign commodities exchange.  Rule

                 2a51-1(a)(5) [17 CFR 270.2a51-1(a)(5)].

==========================================START OF PAGE 25======

 

       The rule has been revised from the proposal to include

 

  "swaps" and similar financial contracts in the definition of

 

  investments.-[53]-  The Commission agrees with the

 

  commenters that, because these instruments often are used in

 

  connection with investments, it is appropriate to treat them as

 

  investments.-[54]-

                     

 

       -[53]-    Rule 2a51-1(b)(5) [17 CFR 270.2a51-1(b)(5)]

                 includes in the definition of investments

                 "financial contracts" as defined by section

                 3(c)(2) of the Act [15 USC 80a-3(c)(2)].  This

                 definition was added to section 3(c)(2) by the

                 1996 Act in order to expand the exclusion from

                 the definition of investment company applicable

                 to securities brokers to include certain other

                 market intermediaries (e.g., "swap" dealers).

                 Section 3(c)(2) provides, in pertinent part,

                 that a financial contract is any arrangement

                 that --

 

            (I)  takes the form of an individually negotiated

            contract, agreement, or option to buy, sell, lend,

            swap, or repurchase, or other similar individually

            negotiated transaction commonly entered into by

            participants in the financial markets;

 

            (II) is in respect of securities, commodities,

            currencies, interest or other rates, other measures

            of value, or any other financial or economic interest

            similar in purpose or function to any of the

            foregoing; and

 

            (III)     is entered into in response to a request

            from a counter party for a quotation, or is otherwise

            entered into and structured to accommodate the

            objectives of the counter party to such arrangement.

 

       Some "financial contracts" are also securities, and thus

       investments under rule 2a51-1(b)(1).  See In re BT

       Securities Corp., Exchange Act Release No. 35136 (Dec. 22,

       1994).

 

       -[54]-    As with other investments, a financial contract

                 can be valued at its fair market value or cost.

                 See section II.A.3.a of this Release.  The rule

                                                   (continued...)

==========================================START OF PAGE 26======

 

                 d.   Cash and Cash Equivalents

 

       Rule 2a51-1(b)(7) includes cash and cash equivalents held

 

  for investment purposes ("Cash") in the definition of

 

  investments.-[55]-  Most commenters agreed that treating

 

  Cash as an investment was appropriate because many investors

 

  are likely at any given time to have a component of their

 

  investment portfolio in Cash.-[56]-  In response to a

 

  request for comment in the Proposing Release whether the

 

  "investment purposes" test for Cash needed further elaboration,

 

  many commenters responded that the "investment purposes" test

 

  was an appropriate formulation.

 

       The rule clarifies certain issues related to Cash that

 

  were addressed in the Proposing Release or raised by

 

  commenters.  The rule specifies that the net cash surrender

 

  value of an insurance policy may be considered to be

 

  Cash.-[57]-  The rule also specifies that, for purposes

 

                     

 

       -[54]-(...continued)

                 does not permit a financial contract to be

                 valued at its notional amount (e.g., the

                 principal amount upon which the interest

                 payments in a swap transaction are based).

 

       -[55]-    17 CFR 270.2a51-1(b)(7).

 

       -[56]-    For example, an investor may have a significant

                 amount of Cash as a result of a recent sale of

                 an investment or because market conditions

                 resulted in the investor taking a "defensive"

                 position.  Cash also may be integral to certain

                 sophisticated investment strategies (such as

                 hedging).

 

       -[57]-    Rule 2a51-1(b)(7).  See also Proposing Release,

                 supra note 4, at n.48.

==========================================START OF PAGE 27======

 

  of the rule, bank deposits, certificates of deposit, bankers

 

  acceptances and similar bank instruments may be treated as

 

  Cash.-[58]-

 

       The rule also provides that a Prospective Qualified

 

  Purchaser that is a privately offered fund or a commodity pool

 

  may treat as investments unfunded capital commitments (i.e.,

 

  firm agreements by investors to provide these Prospective

 

  Qualified Purchasers with cash upon request).-[59]-

 

  Several commenters noted that privately offered funds often do

 

  not require their investors to provide the moneys the investors

 

  have committed to invest in the fund until investment

 

  opportunities become available to the fund.  The fund therefore

 

  has access to cash that will be used for investment purposes,

 

  through commitments that reflect investors' assessment of the

 

  fund sponsor's investment expertise.  The Commission thus

 

  considers it appropriate to treat these capital commitments in

 

  a manner similar to Cash.

                     

 

       -[58]-    Rule 2a51-1(b)(7).  One commenter suggested that

                 the rule be specific on this point because

                 certain bank instruments with longer maturities

                 might not be considered to be either cash

                 equivalents or securities.  The rule does not

                 specify that securities of a money market fund

                 are Cash because they are securities and would

                 be investments under rule 2a51-1(b)(1).

 

       -[59]-    Rule 2a51-1(b)(6) [17 CFR 270.2a51-1(b)(6)].

==========================================START OF PAGE 28======

 

                 e.   Other Types of Investments

 

       The Commission requested comment whether certain assets

 

  (such as jewelry, artwork, antiques and other collectibles)

 

  that may be held by some for investment purposes should be

 

  treated as investments.  While several commenters suggested

 

  that such assets should be included in the definition of

 

  investments, others agreed that they should be excluded because

 

  these holdings do not necessarily suggest any experience in the

 

  financial markets or investing in unregulated investment

 

  pools.-[60]-  The Commission agrees with this analysis

 

  and the rule therefore does not include such assets in the

 

  definition of investments.

 

            3.   Determining the Amount of Investments

 

       Rule 2a51-1 permits the amount of a Prospective Qualified

 

  Purchaser's investments to be based either on the market value

 

  of the investments or on their cost.  In either case, the rule

 

  requires indebtedness incurred to acquire investments to be

 

  deducted from the amount of investments owned as discussed

 

  below.

 

                     

 

       -[60]-    See also AMERICAN BAR ASSOCIATION, SECTION OF

                 BUSINESS LAW, COMMITTEE ON FEDERAL REGULATION OF

                 SECURITIES, TASK FORCE ON HEDGE FUNDS, REPORT ON

                 SECTION 3(C)(1) OF THE INVESTMENT COMPANY ACT OF

                 1940 AND PROPOSALS TO CREATE AN EXCEPTION FOR

                 QUALIFIED PURCHASERS, 51 Bus. Law. 773, 778

                 (Dec. 5, 1995) (hereinafter HEDGE FUNDS TASK

                 FORCE REPORT) (suggesting that automobiles,

                 jewelry and art be excluded from investments for

                 purposes of measuring financial sophistication).

==========================================START OF PAGE 29======

 

                 a.   Value of Investments

 

       Rule 2a51-1(d) specifies that the value of an investment

 

  may be either its market value on the most recent practicable

 

  date or its cost.-[61]-  Most commenters supported this

 

  approach.  The rule as adopted has been reformulated to state

 

  that the value of an investment may be either its cost or "fair

 

  market value" on the most recent practicable date.  This change

 

  is designed to clarify that, in the absence of a recent market

 

  value, an investment's value could be determined by an

 

  appraisal by an independent third party.-[62]-

 

       The rule does not specify which valuation methodology

 

  should be used in a particular circumstance.  A Section 3(c)(7)

 

  Fund could allow Prospective Qualified Purchasers to provide

 

  the amount of their investments based on either methodology,

 

  since either methodology is an appropriate way to measure a

 

  Prospective Qualified Purchaser's investment experience.

 

                 b.      Deductions from Amount of Investments

 

                      i.   Certain Indebtedness

 

       The rule, as proposed, would have required the deduction

 

  from the amount of a Prospective Qualified Purchaser's

 

  investments (i) of any indebtedness incurred to acquire the

 

  investments and (ii) of certain mortgage-related indebtedness

 

                     

 

       -[61]-    17 CFR 270.2a51-1(d).  In the case of a

                 security, market value could be determined in

                 the manner described in rule 17a-7(b) under the

                 Investment Company Act [17 CFR 270.17a-7(b)].

 

       -[62]-    See Proposing Release, supra note 4, at n.53.

==========================================START OF PAGE 30======

 

  incurred during the preceding 12 months ("Mortgage Deduction").

 

 

  These provisions, (collectively, the "Indebtedness Deduction

 

  Provision") reflected the Commission's belief that, in

 

  establishing the $5 million/$25 million investment thresholds,

 

  Congress intended that qualified purchasers generally be

 

  limited to persons who own a specified amount of investments.

 

  This intention would appear to be inconsistent with permitting

 

  a Prospective Qualified Purchaser to accumulate the requisite

 

  amount of investments through borrowing or similar means.

 

       Most commenters objected to the Indebtedness Deduction

 

  Provision as unnecessary and inconsistent with Congress's

 

  intent.  Some commenters, however, believed that the provision

 

  was appropriate and consistent with the policies underlying

 

  section 3(c)(7).  Many commenters, whether opposing or

 

  supporting the provision, suggested that it be revised in

 

  certain respects to make it easier to apply.

 

       After considering all of the comments received and the

 

  1996 Act's legislative history, the Commission continues to

 

  believe that the Indebtedness Deduction Provision appropriately

 

  implements Congress's intent.  The Commission is therefore

 

  adopting this provision substantially as proposed with one

 

  change designed to simplify its application.  The rule, as

 

  adopted, does not include the Mortgage Deduction.  This

 

  deduction was designed to preclude a personal residence or a

 

  vacation home from, in effect, being converted into Cash or

 

  another type of investment for purposes of meeting the $5

==========================================START OF PAGE 31======

 

  million threshold.  Some commenters suggested that this

 

  provision was overly complex and would be difficult to

 

  administer.  Other commenters suggested generally that the

 

  Indebtedness Deduction Provision, if included in the rule, be

 

  limited to indebtedness incurred to acquire investments.  These

 

  commenters noted that indebtedness secured by a mortgage could

 

  be incurred for various reasons other than to acquire

 

  investments and that the provision was therefore overbroad.

 

       Upon reflection, the Commission has concluded that the

 

  Mortgage Deduction is unnecessary.  As discussed above, the

 

  rule requires that indebtedness incurred to acquire an

 

  investment be deducted.-[63]-  If a mortgage loan (or any

 

  other type of loan) is incurred to acquire, or for the purpose

 

  of acquiring, an investment, the outstanding amount of such

 

  loan would have to be deducted.-[64]-

 

       Consistent with these changes to the Indebtedness

 

  Deduction Provision, the rule's provision with respect to

 

  indebtedness deductions by Family Companies has been

 

  significantly simplified.  Certain proposed deductions relating

 

  to indebtedness incurred by a Family Company or its owners are

 

 

                     

 

       -[63]-    Rule 2a51-1(e) [17 CFR 270.2a51-1(e)].

 

       -[64]-    It also should be noted that Cash held for

                 investment purposes is an investment.

                 Therefore, if the cash proceeds of a loan are

                 treated as an investment, the outstanding amount

                 of the loan must be deducted.

==========================================START OF PAGE 32======

 

  not required by the adopted rule.-[65]-  The rule, as

 

  adopted, requires a Family Company to deduct the amount of any

 

  outstanding indebtedness incurred by the Family Company or any

 

  of the Family Company's owners to acquire the investments held

 

  by the Family Company.-[66]-

 

                 ii.  Other Payments

 

       The rule, as proposed, would have required a Prospective

 

  Qualified Purchaser who is a natural person to deduct certain

 

  payments that he or she received during the preceding 12 months

 

  relating to, among other things, lawsuits, insurance policies,

 

  divorce and separation agreements, and gifts and bequests.

 

  This provision ("Other Payments Provision") was designed to

 

  assure that Prospective Qualified Purchasers who are natural

 

  persons would be required to deduct from the amount of their

 

  investments certain amounts received during the preceding 12

 

  months that could inflate the amount of their investments

                     

 

       -[65]-    Under the proposed rule, a Family Company also

                 would have been required to deduct (i) the

                 amount of any real estate loans that any owner

                 of the Family Company would have had to deduct

                 if the owner were the Prospective Qualified

                 Purchaser; (ii) the amount of any indebtedness

                 incurred by the Family Company during the

                 preceding 12 months to the extent that the

                 principal amount of the indebtedness exceeded

                 the fair market value of any assets of the

                 Family Company other than investments; and (iii)

                 the amount of any indebtedness incurred during

                 the preceding 12 months by an owner of the

                 Family Company or by a related person of an

                 owner of the Family Company and guaranteed by

                 the Family Company.  See Proposing Release,

                 supra note 4, at nn.59-61 and accompanying text.

 

 

       -[66]-    Rule 2a51-1(f) [17 CFR 270.2a51-1(f)].

==========================================START OF PAGE 33======

 

  (particularly Cash) without reflecting any investment

 

  experience.

 

       As with the Indebtedness Deduction Provision, most

 

  commenters objected to the Other Payments Provision as overly

 

  complex and potentially difficult to administer.  One

 

  commenter, however, believed that the Other Payments Provision

 

  was consistent with the policies underlying section 3(c)(7) and

 

  suggested that the Commission consider additional deductions

 

  (such as the proceeds from the sale of a family-owned

business).

 

       After considering the comments received, the Commission

 

  has determined not to adopt the Other Payments Provision at

 

  this time.  Similarly, the provision that would have required

 

  Other Payments received by owners of a Family Company to be

 

  deducted by the Family Company is not being adopted.  At this

 

  time, the burdens that might be associated with the Other

 

  Payments Provision appear to outweigh its benefits to

 

  investors.  The Commission may revisit this issue in the future

 

  if experience with section 3(c)(7) suggests that a provision

 

  similar to the Other Payments Provision is necessary or

 

  appropriate in the public interest or for the protection of

 

  investors.

 

            4.   Jointly Held Investments

 

       The rule provides that, in determining whether a natural

 

  person is a qualified purchaser, the person may include in the

 

  amount of his or her investments any investments held jointly

==========================================START OF PAGE 34======

 

  with the person's spouse ("Joint Investments").-[67]-

 

  Thus, a person who owns $3 million of investments individually

 

  and $2 million of Joint Investments would be a qualified

 

  purchaser.  The spouse also would be a qualified purchaser if

 

  he or she owned, individually, an additional $3 million of

 

  investments.

 

       A spouse who is not a qualified purchaser can hold a joint

 

  interest in a Section 3(c)(7) Fund with his or her qualified

 

  purchaser spouse.-[68]-  The Commission requested comment

 

  whether spouses who hold $5 million in investments in the

 

  aggregate (regardless of whether the investments are held

 

  jointly) should be treated as qualified purchasers if they make

 

  a joint investment in a Section 3(c)(7) Fund.  All the

 

  commenters that addressed this issue agreed that permitting

 

  such investments would be appropriate.  The rule as adopted

 

  reflects this approach.-[69]-  The Commission believes

                     

 

       -[67]-    Rule 2a51-1(g)(2) [17 CFR 270.2a51-1(g)(2)].

                 Joint Investments also include investments in

                 which the person shares with his or her spouse a

                 community property or similar shared ownership

                 interest.  Id.  In determining the amount of

                 Joint Investments, the Prospective Qualified

                 Purchaser must deduct from the amount of any

                 Joint Investments any outstanding indebtedness

                 incurred by the spouse to acquire the

                 investments.  Id.

 

       -[68]-    Section 2(a)(51)(A)(i) of the Act.

 

       -[69]-    Rule 2a51-1(g)(2).  Consistent with this

                 approach, the Commission believes that, for

                 purposes of determining the number of beneficial

                 owners of voting securities of a Section 3(c)(1)

                 Fund, securities of the Section 3(c)(1) Fund

                                                   (continued...)

==========================================START OF PAGE 35======

 

  that this approach will simplify the determination of whether

 

  spouses making a joint investment are qualified purchasers.

 

            5.   Investments Held by Certain Affiliated Entities

 

       The rule, as proposed, would have permitted a parent

 

  company that is a Prospective Qualified Purchaser to aggregate

 

  investments it owns with those owned by its majority-owned

 

  subsidiaries, provided that the subsidiaries' investments were

 

  managed under the direction of the parent company.-[70]-

 

  Most commenters agreed with this approach, but suggested that

 

  the provision should address a broader range of corporate and

 

  other inter-company structures.  Commenters suggested, for

 

  example, that when a company that is part of a group of related

 

  companies is making an investment in a Section 3(c)(7) Fund, it

 

  is not necessary to focus on which of these companies actually

 

  owns or manages the investments.

 

       The Commission agrees with this analysis.  The rule as

 

                     

 

       -[69]-(...continued)

                 jointly owned by both spouses should be

                 considered to be owned by one beneficial owner.

                 This approach is a departure from an earlier

                 staff position on this issue.  See, e.g., Joseph

                 H. Moss (Feb. 27, 1984).

 

       -[70]-    This approach is designed to recognize, for

                 example, holding company structures necessitated

                 by legal, tax or other factors that may require

                 or make advantageous the holding of investments

                 in separate corporate entities.  See, e.g.,

                 Resale of Restricted Securities; Changes To

                 Method of Determining Holding Period of

                 Restricted Securities Under Rules 144 and 145,

                 Securities Act Release No. 6862 (Apr. 23, 1990)

                 [55 FR 17933 (Apr. 30, 1990)] (describing bank

                 holding company structures).

==========================================START OF PAGE 36======

 

  adopted permits the investments of a parent company and its

 

  majority-owned subsidiaries to be aggregated, regardless of

 

  which company is the Prospective Qualified

 

  Purchaser.-[71]-

 

            6.   Reasonable Belief

 

       The rule, as proposed, would have permitted a Section

 

  3(c)(7) Fund or a person acting on its behalf, when determining

 

  whether a Prospective Qualified Purchaser is a qualified

 

  purchaser, to rely upon audited financial statements, brokerage

 

  account statements and other appropriate information and

 

  certifications provided by the Prospective Qualified Purchaser

 

  or its representatives, as well as upon publicly available

 

  information as of a recent date.-[72]-  The rule would

 

  have required that reliance on this information be reasonable

 

  and that the Section 3(c)(7) Fund or its representatives, after

 

  reasonable inquiry, have no basis for believing that the

 

  information is incorrect in any material respect.

 

       Commenters generally agreed that the proposed rule was

 

  consistent with the suggestion in the 1996 Act's legislative

 

  history that the Commission use its rulemaking authority to

 

                     

 

       -[71]-    Rule 2a51-1(g)(3) [17 CFR 270.2a51-1(g)(3)].

                 Several commenters noted that the rule, as

                 proposed, would not have extended to non-

                 corporate structures.  The rule as adopted

                 refers generally to "companies" rather than

                 "corporations."  Id.

 

       -[72]-    Proposed rule 2a51-1(j).

==========================================START OF PAGE 37======

 

  adopt rules with respect to "reasonable care

 

  defenses."-[73]-  The commenters suggested, however, that

 

  the rule should conform to the provisions of other Commission

 

  rules under the Securities Act that address transactions

 

  involving certain categories of sophisticated investors, such

 

  as rule 506 of Regulation D (offerings to "accredited

 

  investors" and "sophisticated investors") and rule 144A (sales

 

  to QIBs).-[74]-  These rules focus on whether an issuer

 

  "reasonably believes" that a purchaser of securities satisfies

 

  certain criteria for investors specified in the

 

  rules.-[75]-  Rule 2a51-1, as adopted, reflects this

 

  approach.-[76]-

 

       The Commission requested comment whether the rule should

 

  contain a list of the types of documents (similar to the list

 

  included in rule 144A) that a Section 3(c)(7) Fund could rely

                     

 

       -[73]-    The legislative history of the 1996 Act

                 indicates that the Commission can use its

                 rulemaking authority provided in section

                 2(a)(51) of the Act [15 USC 80a-2(a)(51)] to

                 "develop reasonable care defenses when an issuer

                 relying on the qualified purchaser exception in

                 good faith sells securities to a purchaser that

                 does not meet the qualified purchaser

                 definition."  House Report, supra note 12, at

                 53.

 

       -[74]-    17 CFR 230.144A, .506.

 

       -[75]-    17 CFR 230.144A(d)(1), .501(a).

 

       -[76]-    Rule 2a51-1(h) [17 CFR 270.2a51-1(h)] provides,

                 in relevant part, that the term "qualified

                 purchaser" as used in section 3(c)(7) of the Act

                 includes a person who a Section 3(c)(7) Fund or

                 its representative "reasonably believes" is a

                 qualified purchaser. 

==========================================START OF PAGE 38======

 

  on in determining whether a Prospective Qualified Purchaser was

 

  a qualified purchaser.  Commenters had mixed reactions to this

 

  approach.  Some commenters objected to the inclusion of a list,

 

  while others argued that the types of documents set forth in

 

  rule 144A were not sufficiently inclusive.  Although the

 

  Commission understands that the list provided in rule 144A has

 

  been useful in that context, that list reflects the type of

 

  information that usually is publicly available concerning

 

  institutional investors (the only type of investor that can be

 

  a QIB).  Commenters suggested that similar information

 

  typically is not available for individual investors.  Because a

 

  list similar to that included in rule 144A would be of limited

 

  use, it is not included in rule 2a51-1.

 

            7.   Retirement Plans and Other Forms of Holding

 

  Investments

 

       The Commission requested comment whether there are other

 

  structures for holding ownership interests in investments that

 

  should be addressed by the rule.  Many commenters requested

 

  clarification on various issues related to assets held in

 

  individual retirement accounts ("IRAs") and employee benefit

 

  plans.  The rule provides that a Prospective Qualified

 

  Purchaser who is a natural person may include investments held

 

  in his or her IRA or in other retirement accounts (such as a

 

  "401(k)" plan) when the Prospective Qualified Purchaser makes

==========================================START OF PAGE 39======

 

  all of the investment decisions for the account.-[77]-

 

       The Commission understands that there are other forms of

 

  holding investments that may raise interpretative issues

 

  concerning whether a Prospective Qualified Purchaser "owns" an

 

  investment.-[78]-  For instance, when an entity that

 

  holds investments is the "alter ego" of a Prospective Qualified

 

  Purchaser (as in the case of an entity that is wholly owned by

 

  a Prospective Qualified Purchaser who makes all the decisions

 

  with respect to such investments), it would be appropriate to

 

  attribute the investments held by such entity to the

 

  Prospective Qualified Purchaser.

 

            8.   Pension and Retirement Plans as Qualified

 

                 Purchasers

 

       A number of commenters raised interpretative questions

 

  concerning the circumstances under which a pension or other

 

  type of employee benefit plan that holds $25 million of

 

  investments in the aggregate could be treated as a qualified

 

                     

 

       -[77]-    Rule 2a51-1(g)(4) [17 CFR 270.2a51-1(g)(4)].  A

                 401(k) plan is established in accordance with

                 section 401(k) of the IRC [26 USC 401(k)].  If a

                 401(k) plan provides several options in which an

                 employee can choose to invest his or her

                 account, the employee would be making the

                 investment decision with respect to the account

                 even though the plan's trustee or sponsor

                 selects the range of options from which the

                 employee can choose.

 

       -[78]-    Many of the issues raised by commenters have

                 been addressed by the provision of the rule

                 dealing with ownership of investments by certain

                 affiliated companies.  See rule 2a51-1(g)(3);

                 supra section II.A.5 of this Release.

==========================================START OF PAGE 40======

 

  purchaser.  Most of these questions concerned 401(k) plans that

 

  allow an employee to direct the investment of his or her

 

  account balance (which may consist of amounts contributed by

 

  the employee, the employer, or both) to specified investment

 

  alternatives available through the plan.  Some commenters

 

  suggested that if such a plan holds $25 million of investments

 

  in the aggregate, participants in the plan should have an

 

  opportunity to invest in a Section 3(c)(7) Fund offered as an

 

  investment option.  Other commenters argued that the Section

 

  3(c)(7) Fund should "look through" the 401(k) plan to its

 

  participants for purposes of determining whether each investor

 

  in the Fund is a qualified purchaser.

 

       The latter approach reflects the Commission's

 

  interpretation of section 3(c)(7).  The legislative history of

 

  the 1996 Act indicates that Section 3(c)(7) Funds are to be

 

  limited to investors who own a specified amount of

 

  investments.-[79]-  The critical issue, therefore, is not

                     

 

       -[79]-    See Senate Report, supra note 12, at 10.  The

                 Commission staff has taken a similar position

                 under section 3(c)(1) of the Act, with which the

                 Commission agrees, with respect to how to

                 "count" 401(k) plans for purposes of determining

                 whether a Section 3(c)(1) Fund has 100 or fewer

                 investors.  Thus, each participant in the plan

                 who chooses to invest in the Fund, as opposed to

                 the plan itself, should be treated as a separate

                 investor in the Section 3(c)(1) Fund for

                 purposes of determining the number of beneficial

                 owners of the Fund's securities.  See The

                 PanAgora Group Trust (Apr. 29, 1993).

 

       The Commission is aware that the staff has taken the

       position under section 3(c)(1) that a self-directed

                                                   (continued...)

==========================================START OF PAGE 41======

 

  whether the employee is directing his or her investments

 

  through a 401(k) plan or a similar intermediary, but whether

 

  the employee owns the requisite amount of investments.

 

  Congress determined generally that the person making the

 

  investment decision to invest in a Section 3(c)(7) Fund had to

 

  own a requisite amount of investments; the Act generally does

 

  not permit a person who does not own the requisite amount of

 

  investments to be treated as a qualified purchaser even if he

 

  or she received advice from a third party concerning the

 

  investment.

 

       The approach described above would not apply to a defined

 

  benefit or other retirement plan that owns $25 million of

 

  investments and does not permit participants to decide whether

 

  or how much to invest in particular investment alternatives.

 

  If the decision to invest in a Section 3(c)(7) Fund is made by

 

  the plan trustee or other plan fiduciary that makes investment

 

  decisions for the plan, and the plan owns at least $25 million

                     

 

       -[79]-(...continued)

       employee benefit plan can be considered to be a single

       investor under certain circumstances.  In particular, the

       staff has indicated that such a plan would be a single

       investor for purposes of section 3(c)(1) if the plan

       operates in a manner resembling that of a defined benefit

       plan.  See The Standish Ayer & Wood, Inc. Stable Value

       Group Trust (Dec. 28, 1995).  In adopting the analysis set

       forth in the PanAgora letter, the Commission is not

       endorsing the analysis set forth in the Standish Ayer

       letter for purposes of section 3(c)(7).  The Commission

       has requested the staff to consider whether the position

       taken in the Standish Ayer letter is appropriate in the

       context of section 3(c)(7) and to reconsider whether the

       position taken in the Standish Ayer letter is consistent

       with that reflected in the PanAgora letter for purposes of

       section 3(c)(1).

==========================================START OF PAGE 42======

 

  of investments that is not subject to participant direction,

 

  the plan would be a qualified purchaser with respect to

 

  investments made by the plan trustee.

 

            9.   Other Issues Relating to Qualified Purchasers

 

       Section 3(c)(7)(A) of the Act provides that the

 

  outstanding securities of a Section 3(c)(7) Fund must be owned

 

  "exclusively by persons who, at the time of acquisition of such

 

  securities, are qualified purchasers."  The Commission believes

 

  that, as a general matter, this provision requires the

 

  determination whether a person is a qualified purchaser to be

 

  made or reaffirmed each time the person acquires securities of

 

  a Section 3(c)(7) Fund.

 

       Commenters noted that privately offered funds often allow

 

  investors to make their investment in a fund in installments or

 

  as the fund's manager needs capital to make investments.  These

 

  commenters requested that the Commission clarify whether

 

  section 3(c)(7) requires the investor to be a qualified

 

  purchaser at the time each installment is paid.  The Commission

 

  would interpret section 3(c)(7) as not requiring a Section

 

  3(c)(7) Fund to determine whether the investor is a qualified

 

  purchaser each time the investor makes additional investments

 

  in the Fund pursuant to a binding commitment to make such

 

  payments, provided the investor was a qualified purchaser at

 

  the time the investor made the commitment.  The Commission

 

  believes that this approach is consistent with section 3(c)(7).

 

       Commenters also requested guidance whether affiliates of a

==========================================START OF PAGE 43======

 

  Section 3(c)(7) Fund's sponsor that hold interests in the Fund

 

  are required to be qualified purchasers.  A privately offered

 

  fund is often organized as a limited partnership with the

 

  fund's sponsor or investment adviser (or one of their

 

  affiliates) serving as the general partner.  In these

 

  circumstances, if the general partnership interest is not a

 

  security-[80]- and is not being used as a device to evade

 

  the provisions of section 3(c)(7) limiting security holders of

 

  the Section 3(c)(7) Fund to qualified purchasers, the general

 

  partner need not be a qualified purchaser.-[81]-

 

       B.   Definitions of Beneficial Ownership and Other Issues

            Relating to the Grandfather and Consent Provisions

 

       Rule 2a51-2 defines the term "beneficial owner" for

 

  purposes of the Grandfather Provision governing Section 3(c)(1)

 

  Funds that wish to convert into Section 3(c)(7) Funds and the

 

  Consent Provision governing Section 3(c)(1) and Section 3(c)(7)

 

  Funds that wish to become qualified purchasers.  The rule also

 

  addresses what types of ownership constitute "indirect"

 

  beneficial ownership for purposes of the Consent Provision.

 

                     

 

       -[80]-    See, e.g., Williamson v. Tucker, 645 F.2d 404

                 (5th Cir.), cert. denied, 454 U.S. 897 (1981).

 

       -[81]-    See, e.g., Shoreline Fund, L.P and Condor Fund

                 International, Inc. (Nov. 14, 1994) (taking a

                 similar approach under section 3(c)(1)).

==========================================START OF PAGE 44======

 

            1.   The Grandfather Provision

 

                 a.   Background

 

       Under the Grandfather Provision, a Grandfathered Fund may

 

  convert into a Section 3(c)(7) Fund without requiring investors

 

  that are not qualified purchasers to dispose of their interests

 

  in the Fund.-[82]-  The Grandfather Provision requires

 

  the Grandfathered Fund, prior to the conversion, (i) to

 

  disclose to each "beneficial owner" that future investors will

 

  be limited to qualified purchasers, and that ownership in the

 

  Grandfathered Fund will no longer be limited to 100 persons,

 

  and (ii) concurrently with or after the disclosure, to provide

 

  each beneficial owner with a reasonable opportunity to redeem

 

  any part or all of its interests in the Fund for that

 

  beneficial owner's proportionate share of the Fund's "net

assets."-[83]-

                     

 

       -[82]-    See 142 CONG. REC. at E1929 (Oct. 4, 1996)

                 (Remarks of Hon. Thomas J. Bliley, Jr.). These

                 non-qualified purchasers must have acquired all

                 or a portion of their investment in the

                 Grandfathered Fund on or before September 1,

                 1996.  The Grandfather Provision was designed to

                 enable existing Section 3(c)(1) Funds to

                 preserve their arrangements with these non-

                 qualified purchasers, and does not limit

                 additional purchases by these non-qualified

                 purchasers of the Grandfathered Fund's

                 securities.  Any person owning a security of the

                 Grandfathered Fund who acquired the security

                 after September 1, 1996 must be, either on the

                 date of the acquisition or on the date that the

                 Fund avails itself of section 3(c)(7), a

                 qualified purchaser. 

 

       -[83]-    The opportunity must be provided

                 "notwithstanding any agreement to the contrary

                 between the [Grandfathered Fund] and such

                 beneficial owner."  Section 3(c)(7)(B)(ii)(II)

                 of the Act [15 USC 80a-3(c)(7)(B)(ii)(II)].

==========================================START OF PAGE 45======

 

       The 1996 Act directs the Commission to define the term

 

  "beneficial owner" for purposes of the Grandfather Provision.

 

  The legislative history of the 1996 Act suggests that the

 

  Commission was to use this authority to alleviate any

 

  unnecessary burdens that might arise as a result of the

 

  application of section 3(c)(1)'s Look-Through

 

  Provision.-[84]-  Specifically, Congress appears not to

 

  have intended to require a Grandfathered Fund to provide the

 

  notice and redemption opportunity to security holders of its

 

  institutional investors, even when those security holders would

 

  be deemed beneficial owners of the Grandfathered Fund's voting

 

  securities under the Look-Through Provision.-[85]-

 

  Rather, the notice and redemption opportunity generally are

 

  intended to be provided only to the institutional investor,

 

  unless the institutional investor is controlled by or under

 

  common control with the Grandfathered Fund.-[86]-

 

       Consistent with the purposes indicated in the legislative

 

  history of the 1996 Act, the Commission believes that the

 

  grandfather notice and redemption opportunity requirements were

 

  intended not only for the purposes described above, but for the

 

  benefit of certain persons who were deemed to be beneficial

 

                     

 

       -[84]-    See supra note 18 and accompanying text

                 (describing section 3(c)(1)(A) of the Investment

                 Company Act).

 

       -[85]-    See Remarks of Hon. Thomas J. Bliley, supra note

                 82.

 

       -[86]-    Id.

==========================================START OF PAGE 46======

 

  owners prior to the 1996 Act's amendments to the Look-Through

 

  Provision.-[87]-  These persons may have relied on the

 

  then-existing Look-Through Provision as a way to limit the

 

  Grandfathered Fund's ability to sell its securities to

 

  additional investors.-[88]-  Allowing the Grandfathered Fund to

 

  raise substantial new capital from an unlimited number of

 

  qualified purchasers could significantly alter the nature of an

 

  investment in the Grandfathered Fund.  Most commenters agreed

 

  that the manner in which the proposed rule defined beneficial

 

  ownership for purposes of the Grandfather Provision is

 

  consistent with the 1996 Act's legislative history and

 

  supported the rule.

 

                     

 

       -[87]-    See supra note 19 and accompanying text

                 (discussing the elimination of the Second 10%

                 Test).

 

       -[88]-    This reliance can be illustrated by the

                 following example.  An investor invested in a

                 Section 3(c)(1) Fund ("Fund A") through another

                 Section 3(c)(1) Fund ("Fund B") that was subject

                 to the Look-Through Provision as then in effect.

 

                 The investor may have made its investment in

                 Fund B (or Fund B may have made its investment

                 in Fund A) recognizing that under section

                 3(c)(1)(A) as then in effect, each security

                 holder of Fund B was deemed to be a beneficial

                 owner of Fund A's voting securities.  In this

                 way, the Look-Through Provision would have

                 limited the number of additional persons that

                 could invest in Fund A.  As noted above,

                 however, even in these circumstances, Congress

                 appears to have intended that investors in Fund

                 B not be deemed beneficial owners of Fund A's

                 securities for purposes of the Grandfather

                 Provision unless there is a control relationship

                 between Fund A and Fund B.  

==========================================START OF PAGE 47======

 

                 b.   Operation of the Rule

 

       Paragraph (a) of rule 2a51-2 provides generally that

 

  beneficial ownership is to be determined in accordance with

 

  section 3(c)(1) of the Act.-[89]-  Paragraph (b) of the

 

  rule provides a special rule for determining beneficial

 

  ownership of securities held by a company.-[90]-

 

  Paragraph (b) provides that securities of a Grandfathered Fund

 

  beneficially owned by a company (without giving effect to the

 

  Look-Through Provision) are deemed to be beneficially owned by

 

  one person (the "Owning Company") unless (i) on October 11,

 

  1996, under section 3(c)(1)(A) of the Act as then in effect,

 

  the voting securities of the Grandfathered Fund were deemed to

 

  be beneficially owned by the holders of the Owning Company's

 

  outstanding securities,-[91]- (ii) the Owning Company has

 

  a control relationship with the Grandfathered Fund,-[92]-

 

  and (iii) the Owning Company is itself an investment company or

 

                     

 

       -[89]-    17 CFR 270.2a51-2(a).

 

       -[90]-    17 CFR 270.2a51-2(b).

 

       -[91]-    The applicability of the Look-Though Provision

                 is determined as of October 11, 1996 to assure

                 that the Grandfathered Fund did not engage in

                 transactions subsequent to the enactment of the

                 1996 Act designed to limit the applicability of

                 the Look-Through Provision (such as the issuance

                 of additional voting securities so that the

                 percentage of voting securities owned by an

                 Owning Company falls below 10%).

 

       -[92]-    See supra note 38 (describing the Act's

                 definition of control).

==========================================START OF PAGE 48======

 

  a privately offered fund.-[93]-  If these conditions do

 

  not apply, the grandfather notice and redemption opportunity

 

  should be provided to the Owning Company.  If the conditions do

 

  apply, the grandfather notice and redemption opportunity should

 

  be provided to the Owning Company's security holders as the

 

  beneficial owners of the Grandfathered Fund's securities. 

 

       The application of the rule can best be illustrated by the

 

  following example.  Assume Company A is a Grandfathered Fund

 

  and that Company B, a Section 3(c)(1) Fund, owned more than 10%

 

  of the voting securities of Company A on October 11, 1996.  If

 

  Company B does not have a control relationship with Company A,

 

  the grandfather notice and redemption opportunity can be

 

  provided directly to Company B.  If a control relationship does

 

  exist, and on October 11, 1996, the security holders of Company

 

  B were deemed to be the beneficial owners of Company A's voting

 

  securities (because of the Second 10% Test),-[94]-

 

  Company A must provide the grandfather notice and redemption

 

  opportunity to each of Company B's security holders.

 

                     

 

       -[93]-    Limiting the application of the Look-Through

                 Provision in this context to Owning Companies

                 that are investment companies or privately

                 offered funds is consistent with amended section

                 3(c)(1)(A).  If the Owning Company is not an

                 investment company or a privately offered fund,

                 its security holders are unlikely to have a

                 sufficient interest in its investment in the

                 Grandfathered Fund to justify providing them

                 with the grandfather notice and redemption

                 opportunity.  See supra note 19 and accompanying

                 text. 

 

       -[94]-    See supra section I.B. of this Release.

==========================================START OF PAGE 49======

 

                 c.   Interpretative Issues Relating to the

 

                      Grandfather Provision

 

                      i.   Scope of the Grandfather Provision

 

       The Commission believes that the notice and redemption

 

  opportunity requirements of the Grandfather Provision were

 

  intended for the benefit of all persons who are beneficial

 

  owners of the securities of a Grandfathered Fund.  The

 

  Commission noted in the Proposing Release that, consistent with

 

  this legislative intent, it believed that the conditions in the

 

  Grandfather Provision must be complied with by any Section

 

  3(c)(1) Fund that wishes to rely on the Grandfather Provision,

 

  even if each beneficial owner of the Fund meets the definition

 

  of qualified purchaser.  While several commenters objected to

 

  this interpretation, the Commission believes that it clearly

 

  reflects the legislative history of the Grandfather Provision.

 

  If the notice and redemption opportunity requirements had been

 

  intended only for the benefit of beneficial owners who are not

 

  qualified purchasers, Congress could have limited the

 

  Grandfather Provision accordingly.-[95]-

 

                     

 

       -[95]-    Compare House Report, supra note 12, at 51

                 (describing original provision in H.R. 3005, as

                 reported by the Committee on Commerce, which

                 limited the notice and redemption opportunity to

                 investors that were not qualified purchasers)

                 and Senate Report, supra note 12, at 23 ("The

                 issuer must allow section 3(c)(1) fund owners

                 `of record' to redeem their interests in the

                 fund in either cash or a proportionate share of

                 the fund's assets."); see also supra note 82.

==========================================START OF PAGE 50======

 

                      ii.  "Net Assets"

 

       The Grandfather Provision states that a redeeming

 

  beneficial owner of a Grandfathered Fund is entitled to receive

 

  its proportionate share of the Fund's "net assets."-[96]-

 

  The Act does not define the term "net assets."  In the

 

  Proposing Release, the Commission noted that the term "current

 

  net assets" is used in the Investment Company Act and defined

 

  by Commission rule.-[97]-  The Commission requested

 

  comment whether "net assets," for purposes of the Grandfather

 

  Provision, should be determined based upon the methods used to

 

  determine "current net assets," or the methods that would have

 

  been used to determine the amount that the beneficial owner

 

  would have received in accordance with existing withdrawal

 

  provisions in the Grandfathered Fund's governing documents.

 

  Most commenters suggested that "net assets" be determined in

                     

 

       -[96]-    Section 3(c)(7)(B)(ii)(II) of the Act.  Each

                 person electing to redeem must receive its

                 proportionate share of the Grandfathered Fund's

                 net assets in cash, unless the person agrees to

                 accept such amount in kind (i.e., in assets of

                 the Grandfathered Fund).  If the Grandfathered

                 Fund elects to provide investors with an

                 opportunity to receive an in-kind distribution,

                 this election must be disclosed in the

                 grandfather disclosure.

 

       -[97]-    See, e.g., section 2(a)(32) of the Investment

                 Company Act [15 USC 80a-2(a)(32)] (defining the

                 term redeemable security as a "security . . .

                 under the terms of which the holder . . . is

                 entitled (whether absolutely or only out of

                 surplus) to receive approximately his

                 proportionate share of the issuer's current net

                 assets, or the cash equivalent thereof") and

                 rule 2a-4 [17 CFR 270.2a-4] (definition of

                 current net asset value for certain purposes).

==========================================START OF PAGE 51======

 

  accordance with the latter approach.

 

       The Commission does not believe that the term "net assets"

 

  as used in the Grandfather Provision was intended to be

 

  identical to the term "current net assets" as used in the Act.

 

  The Commission believes that the term "net assets" should be

 

  interpreted in a manner consistent with the legislative

 

  purposes of the notice and redemption opportunity requirements

 

  of the Grandfather Provision.  The Grandfather Provision was

 

  designed to afford investors in the Grandfathered Fund an

 

  opportunity to redeem their investment, without penalty, before

 

  the Grandfathered Fund raises substantial new capital by

 

  increasing the number of the Fund's security holders above the

 

  limit in section 3(c)(1), thereby possibly altering the nature

 

  of an investment in the Grandfathered Fund.-[98]-

 

       It would be consistent with the Grandfather Provision for

 

  a Grandfathered Fund to conclude that it could redeem a

 

  beneficial owner's pro rata share of the net asset value of the

 

  Fund in accordance with the methods specified in the Fund's

 

  governing documents.  Valuation methods that "hold back"

 

  certain amounts (e.g., reserves for contingent liabilities) may

 

  be consistent with the Grandfather Provision to the extent that

 

  they do not act as a penalty for exercising the redemption

 

  right afforded by section 3(c)(7).  If a fund is unable to

 

  conclude that the hold back is not a penalty, the fund could

                     

 

       -[98]-    See Proposing Release, supra note 4, at n.76 and

                 accompanying text.

==========================================START OF PAGE 52======

 

  continue to comply with section 3(c)(1) until all amounts due

 

  to redeeming beneficial owners have been paid.

 

       Commenters requested guidance concerning how to determine

 

  the pro rata share of net assets to which debt and senior

 

  securities redeemed in accordance with the Grandfather

 

  Provision would be entitled.  The Commission believes that the

 

  "net assets" attributable to these securities would generally

 

  be determined by the repayment or redemption provisions

 

  governing such instruments.  In most cases, this amount could

 

  be the principal amount of the securities (or, in the case of

 

  preferred stock, the liquidation preference or other amount

 

  payable upon redemption), any accrued and unpaid interest or

 

  dividends, and any premium due upon prepayment or redemption.

 

       The Commission also notes that the Grandfather Provision

 

  does not override provisions in fund documents, other

 

  agreements or applicable law that could have the effect of

 

  preventing a fund from converting into a Section 3(c)(7)

 

  Fund.-[99]-  For example, if a fund's partnership

 

  agreement prohibits the fund from having more than 100

 

                     

 

       -[99]-    The Grandfather Provision requires that a

                 Grandfathered Fund afford its beneficial owners

                 a redemption opportunity "notwithstanding any

                 agreement to the contrary between" the Fund and

                 its investors.  Section 3(c)(7)(B)(ii)(II) of

                 the Act.  This provision is designed to assure

                 that the Grandfathered Fund affords the

                 redemption opportunity prior to admitting

                 qualified purchasers in accordance with section

                 3(c)(7), notwithstanding contractual provisions

                 that only require redemption opportunities to be

                 provided periodically.

==========================================START OF PAGE 53======

 

  investors, the fund may have to seek to amend the agreement

 

  before selling its securities to qualified purchasers (if the

 

  fund already has 100 investors).-[100]-

 

       Many commenters observed that in the case of certain

 

  privately offered funds, providing the redemption opportunity

 

  required by the Grandfather Provision could have significant

 

  adverse effects on a fund's investment strategy.-[101]-

 

  The Grandfather Provision does not override the fiduciary

 

  duties that a sponsor of a Grandfathered Fund may have to the

 

  beneficial owners of the Fund's securities under the Fund's

 

  governing documents or applicable law.  Thus, the general

 

  partner or other fiduciary of a privately offered fund may have

 

  to consider whether effecting the notice and redemption

 

  required by the Grandfather Provision in order to be able to

 

  open the fund to new investors (and increase the amount of

 

  assets in the fund and the general partner's fee) is in the

 

  best interests of the fund's security holders.

 

            2.   The Consent Provision

 

       Section 2(a)(51)(C) of the Act requires that a privately

 

                     

 

       -[100]-   Similarly, if a Grandfathered Fund has issued

                 debt securities pursuant to an indenture that

                 requires a prepayment premium if the debt

                 securities are repaid before a specified date

                 (or precludes prepayment), the Grandfather

                 Provision does not override these provisions.

 

       -[101]-   For example, commenters suggested that in order

                 to meet redemption requests, a fund might be

                 required to sell illiquid portfolio positions at

                 a loss or when it would not otherwise be in the

                 best interests of the fund's investors to do so.


 

==========================================START OF PAGE 54======

 

  offered fund that wishes to become a qualified purchaser

 

  ("Purchasing Fund") obtain the consent of all of its beneficial

 

  owners that had invested in the Purchasing Fund on or before

 

  April 30, 1996.-[102]-  The beneficial owners of the

 

  securities of any privately offered fund that is a direct or

 

  indirect beneficial owner of the securities of the Purchasing

 

  Fund also must consent to the treatment of the Purchasing Fund

 

  as a qualified purchaser.-[103]-

 

                 a.   Definition of Beneficial Owner

 

       Paragraph (c) of rule 2a51-2 clarifies the meaning of the

 

  term "beneficial owner" for purposes of the Consent

 

  Provision.-[104]-  The rule provides that securities of

 

  a Purchasing Fund beneficially owned by a company ("Owning

 

  Company"), without giving effect to the Look-Through Provision,

 

  are deemed to be beneficially owned by one person unless (i) on

 

  April 30, 1996, under section 3(c)(1)(A) of the Act as then in

 

  effect, the voting securities of the Purchasing Fund were

 

  deemed to be beneficially owned by the holders of the Owning

 

  Company's outstanding securities, (ii) the Owning Company has a

                     

 

       -[102]-   The legislative history of the 1996 Act does not

                 explain the purpose of the Consent Provision.

 

       Section 2(a)(51)(C) uses the term "excepted company" to

       refer to Section 3(c)(1) and Section 3(c)(7) Funds.  The

       inclusion of Section 3(c)(7) Funds in this provision was

       presumably designed to require the consent to be obtained

       by any Grandfathered Fund that wished to be a qualified

       purchaser.

 

       -[103]-   Id.

 

       -[104]-   17 CFR 270.2a51-2(c).

==========================================START OF PAGE 55======

 

  control relationship with either the Purchasing Fund or the

 

  Section 3(c)(7) Fund with respect to which the Purchasing Fund

 

  will be a qualified purchaser ("Target Fund"), and (iii) the

 

  Owning Company itself is a privately offered fund.  If these

 

  conditions do not apply, the consent must be obtained from the

 

  Owning Company.  If the conditions do apply, the consent must

 

  be obtained from the Owning Company's security holders as the

 

  beneficial owners of the Purchasing Fund's securities under the

 

  rule. 

 

       As in the case of the definition of beneficial owner for

 

  purposes of the Grandfather Provision, the rule relating to the

 

  Consent Provision is intended to allow an institutional

 

  investor to provide the required consent even if, under the

 

  Look-Through Provision, the security holders of the

 

  institutional investor are deemed to be beneficial owners of

 

  the Purchasing Fund's securities.  If there is a control

 

  relationship between the Purchasing Fund and either the Owning

 

  Company or the Target Fund, and the Owning Company is a

 

  privately offered fund whose security holders were deemed

 

  beneficial owners of the Purchasing Fund on April 30, 1996,

 

  then the consent must be obtained from those security holders.

 

                      b.   Required Consent

 

       As proposed, paragraph (d) of the rule clarifies what

 

  constitutes "indirect" ownership with regard to the requirement

 

  in section 2(a)(51)(C) of the Act that the consent be obtained

 

  from the security holders of a privately offered fund that is

==========================================START OF PAGE 56======

 

  an indirect beneficial owner of the Purchasing

 

  Fund.-[105]-  The rule provides that the privately

 

  offered fund would not be considered to own the securities of

 

  the Purchasing Fund indirectly unless the privately offered

 

  fund has a control relationship with either the Purchasing Fund

 

  or the Target Fund.  Commenters generally supported this

 

  approach.

 

       Several commenters also suggested that the rule generally

 

  should limit the circumstances under which a Purchasing Fund

 

  must obtain the consent of the beneficial owners of the

 

  securities of a privately offered fund that directly owns the

 

  securities of the Purchasing Fund ("Owning

 

  Fund").-[106]-  These commenters stated that if the rule

 

  did not contain such a limitation, consent would have to be

 

  obtained from security holders who would not be entitled to

 

  receive the notice and redemption opportunity required by the

 

  Grandfather Provision.

 

       As noted in the Proposing Release, the Consent Provision

 

  appears to be designed to prohibit an existing Section 3(c)(1)

 

  Fund from avoiding the notice and redemption opportunity

 

  requirements of the Grandfather Provision by investing its

 

  assets in a Section 3(c)(7) Fund, either directly or indirectly

 

                     

 

       -[105]-   17 CFR 270.2a51-2(d).

 

       -[106]-   Many of these commenters believed that such

                 consent was not required under the provision of

                 the proposed rule defining indirect beneficial

                 ownership.

==========================================START OF PAGE 57======

 

  through another privately offered fund.-[107]-  This

 

  purpose is served if the scope of the Consent Provision is the

 

  same as that of the Grandfather Provision.-[108]-

 

  Paragraph (e) of the rule, as adopted, clarifies that the

 

  consent of the beneficial owners of the Owning Fund is not

 

  required unless the Owning Fund directly or indirectly

 

  controls, is controlled by, or is under common control with,

 

  the Purchasing Fund or the Target Fund.-[109]-

                     

 

       -[107]-   Such conduct also may raise issues under section

                 48(a) of the Investment Company Act [15 USC 80a-

                 47(a)] (prohibiting violations of the Act's

                 provisions by indirect means).

 

       -[108]-   The Consent Provision also may have been

                 designed to give investors in an existing

                 privately offered fund the opportunity to review

                 what could be a significant change in the manner

                 in which the fund makes investments as a result

                 of the regulatory changes effected by the 1996

                 Act.  In the absence of a control relationship,

                 however, it is unlikely that the investors in

                 the Owning Fund would have a significant

                 interest in the Purchasing Fund's decision to

                 invest in a Section 3(c)(7) Fund. 

 

       -[109]-   17 CFR 270.2a51-2(e).  The following example

                 illustrates the operation of the rule.  Assume

                 Company A is a Purchasing Fund that wishes to

                 invest in Company B as a qualified purchaser,

                 and that Companies C and D are beneficial owners

                 of Company A's voting securities.  Company C is

                 an operating company that does not have a

                 control relationship with Company A, but whose

                 security holders were deemed to be beneficial

                 owners of Company A's voting securities on April

                 30, 1996.  Company D is a privately offered fund

                 that was deemed to own beneficially Company A's

                 voting securities on April 30, 1996 (in other

                 words, the Look-Through Provision did not

                 apply).  Each of Company D's investors

                 (Companies E through G) are themselves privately

                 offered funds, but none has a control

                                                   (continued...)

==========================================START OF PAGE 58======

 

       Under the rule, the Purchasing Fund could obtain a general

 

  consent with respect to most transactions in which it will be a

 

  qualified purchaser.  Whether a specific consent would be

 

  required when there is a control relationship between the

 

  Purchasing Fund or certain of its beneficial owners and the

 

  Target Fund would depend upon whether the general consent

 

  provided sufficient information to elicit an informed consent

 

  from the appropriate investors.

 

                     

 

       -[109]-(...continued)

                 relationship with Company D or Company A.

 

       Company C would have to consent to Company A being a

       qualified purchaser.  Because Company C is not a privately

       offered fund, Company C's shareholders would not be

       treated as beneficial owners of Company A's voting

       securities, and their consent would not be required.  (The

       consent of Company C's shareholders would not be required

       even if Company C had a control relationship with Company

       A.)

 

       Company D would have to consent to Company A being a

       qualified purchaser.  Even though Company D is a privately

       offered fund, the beneficial owners of its outstanding

       securities (i.e., Companies E through G) would not have to

       consent to Company A being a qualified purchaser unless

       there was a control relationship between Company D and

       either Company A or Company B.  Security holders of

       Companies E through G would not be required to consent

       even if they are considered to be beneficial owners of

       Company D's securities under the Look-Through Provision

       because there is no control relationship.  Similarly,

       Companies E through G would not be deemed to indirectly

       own voting securities of Company A.

==========================================START OF PAGE 59======

 

       C.   Conforming Rule

 

       Rule 2a51-3(a) under the Investment Company Act clarifies

 

  an interpretative issue concerning companies that are qualified

 

  purchasers.-[110]-  The statutory definition of

 

  qualified purchaser specifies that a trust that is a qualified

 

  purchaser must not have been formed "for the specific purpose

 

  of acquiring the securities offered."-[111]-  The rule

 

  makes the same condition applicable to any other company that

 

  is a Prospective Qualified Purchaser (whether a Family Company

 

  or another type of company) unless each beneficial owner of the

 

  company's securities is a qualified purchaser.  The rule thus

 

  limits the possibility that a company will be able to do

 

  indirectly what it is prohibited from doing directly (i.e.,

 

  organize a "qualified purchaser" entity for the purpose of

 

  making an investment in a particular Section 3(c)(7) Fund

 

  available to investors that themselves did not meet the

 

  definition of qualified purchaser).-[112]-

                     

 

       -[110]-   17 CFR 270.2a51-3(a).

 

       -[111]-   Section 2(a)(51)(A)(iii) of the Act.

 

       -[112]-   See supra note 107 and accompanying text

                 (discussing section 48(a) of the Act).  The

                 rule, as proposed, would have required all

                 interests in the company to be owned by

                 qualified purchasers.  The rule, as adopted,

                 recognizes that such a company may be organized

                 as a limited partnership, with a person or

                 company serving as the general partner.  In

                 these circumstances, if the general partnership

                 interest is not being used as a device to evade

                 the provisions of section 3(c)(7) limiting

                 security holders of the Section 3(c)(7) Fund to

                                                   (continued...)

==========================================START OF PAGE 60======

 

       As suggested by several commenters, the scope of the rule

 

  has been expanded to permit a company to be a qualified

 

  purchaser (even if the company did not own $5 million of

 

  investments, in the case of a Family Company, or $25 million of

 

  investments in the case of any other type of company) if each

 

  beneficial owner of the company's securities is a qualified

 

  purchaser.-[113]-

 

       D.   Non-Exclusive Safe Harbor for Certain Section 3(c)(7)

 

            Funds

 

       The legislative history of the 1996 Act indicates that a

 

  sponsor of an existing Section 3(c)(1) Fund could establish a

 

  new Section 3(c)(7) Fund.-[114]-  Section 3(c)(7)(E) of

 

  the Act (the "Non-Integration Provision) provides that the

 

  Commission may not "integrate" the two Funds -- that is, treat

 

  the two Funds as a single issuer for purposes of determining

 

  the number of beneficial owners of the Section 3(c)(1) Fund or

 

  whether the outstanding securities of the Section 3(c)(7) Fund

 

 

                     

 

       -[112]-(...continued)

                 qualified purchasers, the general partner need

                 not be a qualified purchaser.  See supra notes

                 78-79 and accompanying text.

 

       -[113]-   Rule 2a51-3(b) [17 CFR 270.2a51-3(b)]; see supra

                 note 112.

 

       -[114]-   See 142 CONG. REC. at E1938 (Oct. 21, 1996)

                 (Remarks of Hon. John D. Dingell); House

                 Hearings, supra note 5, at 71 (prepared

                 statement of Marianne Smythe); see also HEDGE

                 FUNDS TASK FORCE REPORT, supra note 60, at 779.


 

==========================================START OF PAGE 61======

 

  are owned by anyone who is not a qualified

 

  purchaser.-[115]-  The Non-Integration Provision,

 

  however, is not intended to allow a sponsor of an existing

 

  Section 3(c)(1) Fund nominally to convert that fund into a

 

  Section 3(c)(7) Fund, and then to create another Section

 

  3(c)(1) Fund ("Related Section 3(c)(1) Fund") thereby avoiding

 

  the 100-investor limit.-[116]-  The Non-Integration

 

  Provision, thus, was not designed to preclude the Commission

 

  from treating a nominally converted Section 3(c)(1) Fund and a

 

  Section 3(c)(1) Fund organized by the same sponsor as a single

 

  issuer for certain purposes.

 

       Prior to the publication of the Proposing Release,

 

  representatives of hedge funds and other investment pools

 

                     

 

       -[115]-   The Non-Integration Provision states, in part,

                 that an issuer that is otherwise excepted under

                 section 3(c)(7) and an issuer that is otherwise

                 excepted under section 3(c)(1) are not to be

                 treated by the Commission as being a single

                 issuer for purposes of determining the number of

                 beneficial owners of the Section 3(c)(1) Fund or

                 whether the outstanding securities of the

                 Section 3(c)(7) Fund are owned by anyone who is

                 not a qualified purchaser.  The Commission staff

                 has addressed the possibility of integrating

                 Section 3(c)(1) Funds established by the same

                 sponsor for purposes of determining whether they

                 constitute the same issuer and have exceeded the

                 100-investor limit of section 3(c)(1).  See,

                 e.g., Shoreline Fund (Apr. 11, 1994) (the staff

                 considers several factors in determining whether

                 funds should be integrated and generally will

                 require integration if "a reasonable purchaser

                 would view an interest in an offering as not

                 materially different from another").

 

       -[116]-   See Remarks of Hon. John D. Dingell, supra note

                 114.

==========================================START OF PAGE 62======

 

  raised concerns regarding the ability of a sponsor of a Section

 

  3(c)(1) Fund that undergoes a bona fide conversion into a

 

  Section 3(c)(7) Fund (i.e., provides the grandfather notice and

 

  redemption opportunity and sells its securities to new

 

  investors that are qualified purchasers) to then create a new

 

  Section 3(c)(1) Fund.  The Commission proposed rule 3c-7 to

 

  respond to these concerns.  The rule would have provided that a

 

  Grandfathered Fund will be treated as an issuer excluded under

 

  section 3(c)(7) of the Act if, at the time the new Section

 

  3(c)(1) Fund offers its securities, 25% or more of the value of

 

  all securities of the Grandfathered Fund is held by qualified

 

  purchasers that acquired these securities after October 11,

 

  1996.

 

       Commenters had mixed reactions to the proposed rule.

 

  Several commenters supported the rule as proposed or with

 

  modifications that would base availability of the safe harbor

 

  on securities held by qualified purchasers regardless of when

 

  acquired.  Other commenters believed that the proposed rule was

 

  unnecessary, that the percentage threshold for qualified

 

  purchasers investing in the fund would preclude bona fide

 

  conversions, and that the Commission could rely on its anti-

 

  fraud authority to address "sham" grandfathering transactions.

 

       Upon further consideration of the issue, and after

 

  considering the views of the commenters, the Commission does

 

  not believe that a safe harbor rule is necessary.  In the

 

  Commission's view, the Non-Integration Provision was not

==========================================START OF PAGE 63======

 

  designed to permit a fund to rely on section 3(c)(7) if the

 

  fund's compliance with the Grandfather Provision was designed

 

  to evade the 100-investor limitation of section 3(c)(1).  A

 

  fund that purports to rely on section 3(c)(7) based on the

 

  Grandfather Provision must have the bona fide purpose of

 

  selling its securities to qualified purchasers.  At this time,

 

  the Commission does not believe that it is necessary to set

 

  forth a test based on the percentage of securities owned by

 

  qualified purchasers to establish the bona fides of a

 

  conversion for purposes of determining compliance with the Act.

 

 

  Whether a conversion to a Grandfathered Fund is bona fide and

 

  undertaken in good faith would depend upon the facts and

 

  circumstances.  The relevant facts would include, among others,

 

  whether the fund has taken steps to sell its securities to

 

  qualified purchasers, and whether the fund is subject to legal

 

  or other impediments that would preclude it from selling its

 

  securities to qualified purchasers.

 

  III. OTHER RULES RELATING TO PRIVATELY OFFERED FUNDS

 

       A.   Section 3(c)(1) Funds

 

            1.   Transition Rule

 

       The 1996 Act amended section 3(c)(1)(A) of the Investment

 

  Company Act, the Look-Through Provision, which governs the way

 

  in which a Section 3(c)(1) Fund calculates the number of its

 

  beneficial owners for purposes of complying with the 100-

 

  investor limit.  Under amended section 3(c)(1)(A), a Section

 

  3(c)(1) Fund must include among its beneficial owners the

==========================================START OF PAGE 64======

 

  underlying security holders of any investment company or

 

  privately offered fund that owns 10% or more of the Section

 

  3(c)(1) Fund (collectively, "10%+ Security Holders").  The pre-

 

  1996 Act Look-Through Provision did not apply unless the 10%+

 

  Security Holder also had more than 10% of its assets invested

 

  in Section 3(c)(1) Fund securities generally.  The amendment,

 

  in effect, limits the ability of certain types of investors to

 

  own more than 10% of a Section 3(c)(1) Fund.-[117]-

 

       Some existing Section 3(c)(1) Funds have 10%+ Security

 

  Holders in reliance on the pre-amendment application of the

 

  Look-Through Provision.  As a result of the 1996 Act, such a

 

  fund may be required to treat a 10% Security Holder as more

 

  than one beneficial owner for purposes of the 100-investor

 

  limit.  The Commission believes that the amendment to the Look-

 

  Through Provision was designed primarily to simplify the

 

  application of the Provision and was not intended to disrupt

 

  existing investment arrangements.  The Commission, therefore,

 

  proposed rule 3c-1 under the Investment Company Act to provide

 

  that the amended Look-Through Provision will not apply in the

 

  case of a pre-1996 Act 10%+ Security Holder, provided that the

                     

 

       -[117]-   The amended Look-Through Provision applies only

                 when an investment company or a privately

                 offered fund invests in a Section 3(c)(1) Fund.

                 The 1996 Act expands the ability of corporate,

                 non-investment company investors to participate

                 in Section 3(c)(1) Funds by no longer requiring

                 Section 3(c)(1) Funds to count the underlying

                 shareholders of these investors under any

                 circumstances.

==========================================START OF PAGE 65======

 

  10%+ Security Holder continues to satisfy the Second 10%

 

  Test.-[118]-

 

       The rule is adopted with one change.  The rule, as

 

  proposed, would have applied only to a 10%+ Security Holder

 

  that acquired its interest in the fund before the 1996 Act was

 

  signed by the President.  Several commenters suggested that the

 

  rule should apply to any 10%+ Security Holder that acquired its

 

  securities prior to the effective date of the amendments to the

 

  Look-Through Provision.  These commenters noted that Section

 

  3(c)(1) Funds that admitted new investors near the end of 1996

 

  may not have known, or appreciated the significance, of the

 

  1996 Act's amendments.  In view of the commenters' suggestions,

 

  the rule as adopted applies to 10%+ Security Holders that

 

  acquired their securities on or before April 1, 1997.

 

                     

 

       -[118]-   The rule does not limit additional acquisitions

                 of securities by a 10%+ Security Holder, as long

                 as it satisfies the Second 10% Test on the date

                 of acquisition.  For the purpose of the rule,

                 securities of Section 3(c)(7) Funds would be

                 included in applying the Second 10% Test, since

                 a Section 3(c)(7) Fund probably would have been

                 a Section 3(c)(1) Fund but for the new exclusion

                 created by the 1996 Act.  The rule also applies

                 to ownership interests of 10% or more that are

                 acquired as a result of a conversion of

                 convertible non-voting securities.  

==========================================START OF PAGE 66======

 

            2.   Applicability of the Amended Look-Through

 

                 Provision

 

       The Commission believes that, as a general matter, the

 

  determination of whether an investor is subject to the amended

 

  Look-Through Provision must be made each time the investor

 

  acquires a voting security of a Section 3(c)(1) Fund.  Thus, an

 

  investor would not become subject to the Look-Through Provision

 

  if its proportionate ownership of the Fund's voting securities

 

  increased solely because another investor redeemed its

 

  securities in the Fund.  This analysis would not apply if the

 

  redemption (or other transaction) were part of a series of

 

  transactions designed to avoid the Look-Through

 

  Provision.-[119]-

 

       B.   Investments by Knowledgeable Employees

 

       As directed by Congress, the Commission is adopting rule

 

  3c-5 under the Investment Company Act to permit "knowledgeable

 

  employees" of a fund and certain of its affiliates to acquire

 

  securities issued by the fund without being counted for

 

  purposes of section 3(c)(1)'s 100-investor limit.-[120]-

 

  In addition, as directed by Congress, the rule permits

 

                     

 

       -[119]-   See supra note 107 (discussing section 48(a) of

                 the Act).

 

       -[120]-   The rule specifies that these persons must be

                 knowledgeable employees at the time they acquire

                 the fund's securities.  They do not have to

                 dispose of these securities (or be counted as

                 security holders for purposes of section

                 3(c)(1)'s 100-investor limit) upon termination

                 of employment.

==========================================START OF PAGE 67======

 

  knowledgeable employees to invest in a Section 3(c)(7) Fund

 

  even though they do not meet the definition of qualified

 

  purchaser.-[121]-  Commenters generally supported the

 

  rule, although several commenters suggested that the scope of

 

  the rule's definition of knowledgeable employees be expanded.

 

       Rule 3c-5 defines knowledgeable employees as the

 

  directors, executive officers, and general partners of the fund

 

  or an affiliated person of the fund that oversees the fund's

 

  investments ("Management Affiliate").-[122]-  The rule

 

  also encompasses persons who serve in capacities similar to

 

  directors, such as trustees and advisory board

 

  members.-[123]-

 

       The rule as proposed also would have included as

 

  knowledgeable employees other employees of the fund or its

 

  Management Affiliate who, in connection with their regular

 

  functions or duties, participate in, or obtain information

 

  regarding, the investment activities of the fund or other

 

  investment companies managed by the Management Affiliate.  One

 

                     

 

       -[121]-   The fund will have to determine whether a

                 knowledgeable employee's acquisition of the

                 securities is a transaction exempt from the

                 registration requirements of the Securities Act.

 

                 See, e.g., Regulation D under the Securities Act

                 [17 CFR 230.501 through .508].

 

       -[122]-   Rule 3c-5(a)(4) [17 CFR 270.3c-5(a)(4)].  The

                 rule specifies that a fund's investment adviser

                 is considered to be an affiliated person of the

                 fund for purposes of the rule.  Rule 3c-5(a)(1)

                 [17 CFR 270.3c-5(a)(1)].

 

       -[123]-   Rule 3c-5(a)(4)(i) [17 CFR 270.3c-5(a)(4)(i)].

==========================================START OF PAGE 68======

 

  commenter suggested that including employees who "obtain

 

  information" regarding the investment activities could include

 

  employees, such as compliance personnel, who may not have any

 

  investment experience.  The Commission agrees, and the rule as

 

  adopted includes only employees who "participate in" the

 

  investment activities of the fund or other investment companies

 

  managed by the fund's Management Affiliate.-[124]-

 

       The rule, as proposed, would have required employees who

 

  are knowledgeable employees by virtue of their participation in

 

  investment activities to have been engaged in these activities

 

  on behalf of the fund or the Management Affiliate for a period

 

  of at least 12 months.  Several commenters suggested that the

 

  12 month period would unnecessarily limit the ability of new

 

  employees who had equivalent experience with their previous

 

  employer to invest in the fund.  The Commission has 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.

 

  The rule, as adopted, therefore includes as knowledgeable

 

  employees those employees who performed substantially similar

 

  functions or duties for or on behalf of another person during

 

  the preceding 12 months.-[125]-

 

       The rule permits the acquisition of privately offered fund

                     

 

       -[124]-   Rule 3c-5(a)(4)(ii) [17 CFR 270.3c-5(a)(4)(ii)].

 

       -[125]-   Id.

==========================================START OF PAGE 69======

 

  securities by a company all of whose owners are knowledgeable

 

  employees.-[126]-  This change is consistent with rule

 

  2a51-3, which permits a company all of whose securities are

 

  owned by qualified purchasers to itself be treated as a

 

  qualified purchaser.  In addition, the rule permits

 

  knowledgeable employees to transfer their securities of a

 

  privately offered fund on the same terms as those governing

 

  transfers by other owners of fund securities in rule 3c-6

 

  discussed below.-[127]-

 

       Several commenters suggested that the rule permit

 

  purchases by broader categories of employees.  The provision in

 

  the 1996 Act directing Commission rulemaking with regard to

 

  investments in privately offered funds by knowledgeable

 

  employees appears to be intended to encompass persons who

 

  actively participate in the management of a fund's investments.

 

 

  At this time, the Commission believes that the rule as adopted

 

  is consistent with this legislative purpose.

 

       C.   Involuntary Transfers

 

       Section 3(c)(1)(B) of the Act provides that beneficial

 

  ownership of securities of a Section 3(c)(1) Fund by any person

 

  who acquires the securities as a result of a "legal separation,

 

  divorce, death, or other involuntary event" will be deemed to

 

  be beneficial ownership by the person from whom the transfer

 

  was made, pursuant to such rules and regulations as the

                     

 

       -[126]-   Rule 3c-5(b)(2) [17 CFR 270.3c-5(b)(2)].

 

       -[127]-   Rule 3c-5(b)(3) [17 CFR 270.3c-5(b)(3)].

==========================================START OF PAGE 70======

 

  Commission prescribes.  This provision was designed to address

 

  situations in which section 3(c)(1)'s 100-investor limit is

 

  exceeded "because of transfers which are neither within the

 

  issuer's control nor are voluntary on the part of the present

 

  beneficial owner."-[128]-

 

       The 1996 Act directed the Commission to prescribe rules to

 

  implement section 3(c)(1)(B).-[129]-  The Commission is

 

  adopting rule 3c-6 under the Investment Company Act to provide

 

  that beneficial ownership by a person ("Transferee") who

 

  acquired securities of a Section 3(c)(1) Fund pursuant to a

 

  gift, bequest, or an agreement relating to a legal separation

 

  or divorce will be deemed to be beneficial ownership by the

 

  person from whom the transfer was made

 

  ("Transferor").-[130]-  Rule 3c-6, as proposed, would

 

  have permitted such transfers of fund securities only to

 

  certain persons, generally family members.  Commenters

 

  suggested that the categories of Transferees were unnecessarily

 

  limited.  These commenters also noted that, as long as the

 

  transfer is in the form of a gift, the relationship of the

 

  Transferee to the Transferor was not particularly important for

 

  purposes of the policies underlying section 3(c)(1).  The rule

 

                     

 

       -[128]-   H.R. REP. NO. 1341, 96th Cong., 2d Sess. at 36

                 (1980).

 

       -[129]-   15 USC 80a-3 note.

 

       -[130]-   Transferees are not limited to natural persons.

                 Donative transfers to charitable organizations

                 are therefore permitted by the rule.

==========================================START OF PAGE 71======

 

  as adopted reflects this approach.-[131]-

 

       Unlike the proposed rule, the rule as adopted does not

 

  limit subsequent transfers by Transferees that are in the form

 

  of a gift or bequest.  Several commenters suggested that this

 

  limitation would be unnecessarily restrictive.  As noted by

 

  commenters, it is not necessary for the rule to contain

 

  restrictions on non-donative transfers since the effect of the

 

  transfer may be to cause the Section 3(c)(1) Fund to lose its

 

  exclusion from Investment Company Act regulation.-[132]-

 

       Rule 3c-6 also deals with transfers of securities by

 

  qualified purchasers under section 3(c)(7)(A) of the Act.  That

 

  section provides that securities of a Section 3(c)(7) Fund that

 

  are owned by persons who received them from a qualified

 

  purchaser as a gift or bequest, or when the transfer was caused

 

  by legal separation, divorce, death or other involuntary event,

 

  will be deemed to be owned by a qualified purchaser, subject to

 

  such rules as the Commission may prescribe.  Rule 3c-6 permits

 

                      

 

       -[131]-   The rule, as proposed, would have permitted

                 transfers to the specified categories of

                 Transferees pursuant to "other involuntary

                 events."  Given the breadth of the rule and the

                 elimination of restrictions on the classes of

                 Transferees, the Commission does not believe

                 that it is necessary at this time to address

                 other involuntary transfers of Section 3(c)(1)

                 Fund securities.

 

       -[132]-   A person that acquires securities from a

                 Transferee for consideration or from the Section

                 3(c)(1) Fund would have to be counted toward the

                 100-investor limitation as a beneficial owner

                 (or more than one beneficial owner, if the

                 amended Look-Through Provision is applicable).

==========================================START OF PAGE 72======

 

  transfers of securities of a Section 3(c)(7) Fund under

 

  essentially the same conditions as those governing transfers

 

  under section 3(c)(1)(B).-[133]-  The rule treats a

 

  person who acquires securities of a Section 3(c)(7) Fund in

 

  accordance with the rule as qualified purchasers only for

 

  purposes of those securities.  If the person acquires

 

  additional securities of the Fund other than in accordance with

 

  the rule, the person would have to meet the definition of

 

  qualified purchaser (without regard to the rule) at that time.

 

  IV.  COST/BENEFIT ANALYSIS AND EFFECTS ON COMPETITION,

       EFFICIENCY AND CAPITAL FORMATION

 

       Consistent with legislative intent and the protection of

 

  investors, the rules benefit privately offered funds and their

 

  investors in a number of ways.  The rules define certain terms

 

  necessary to effectuate the new exclusion from regulation under

 

  the Investment Company Act for Section 3(c)(7) Funds; enable

 

  Section 3(c)(1) Funds that wish to convert into Section 3(c)(7)

 

  Funds or become qualified purchasers to do so without being

 

  subject to unduly burdensome notice and consent requirements;

                     

 

       -[133]-   Other involuntary transfers of Section 3(c)(7)

                 Fund securities may occur even if they are not

                 covered by rule 3c-6.  See section 3(c)(7)(A) of

                 the Act ("securities that are owned by persons

                 who received the securities from a qualified

                 purchaser . . . in a case in which the transfer

                 was caused by . . . other involuntary event,

                 shall be deemed to be owned by a qualified

                 purchaser, subject to such rules, regulations

                 and orders as the Commission may prescribe . .

                 .").  The Commission does not contemplate

                 adopting additional rules concerning involuntary

                 transfers under section 3(c)(7) at the present

                 time.

==========================================START OF PAGE 73======

 

  enable knowledgeable employees of a privately offered fund to

 

  invest in the fund without causing the fund to relinquish its

 

  exclusion from regulation under the Act; permit certain

 

  transfers of privately offered fund securities; and clarify

 

  certain interpretative issues for privately offered funds.  The

 

  Commission believes that the rules would not impose any

 

  additional costs on privately offered funds.  Rather, the rules

 

  would clarify the statutory requirements for privately offered

 

  funds in order to reduce any unnecessary burdens without

 

  jeopardizing investor protection.

 

       Section 2(c) of the Investment Company Act provides that

 

  whenever the Commission is engaged in rulemaking and is

 

  required to consider or determine whether an action is

 

  necessary or appropriate in the public interest, the Commission

 

  also shall consider, in addition to the protection of

 

  investors, whether the action will promote efficiency,

 

  competition, and capital formation.-[134]-  The

 

  Commission believes that the rules will promote efficiency,

 

  competition and capital formation.  The rules define terms and

 

  clarify certain provisions of the new statutory exclusion for

 

  Section 3(c)(7) Funds and clarify other statutory requirements

 

  applicable to privately offered funds.  The Commission believes

 

  that the rules do so in a way that will reduce unnecessary

 

  burdens and provide greater flexibility, consistent with

 

  investor protection.

                     

 

       -[134]-   15 USC 80a-2(c).

==========================================START OF PAGE 74======

 

  V.   SUMMARY OF REGULATORY FLEXIBILITY ANALYSIS

 

       A summary of the Initial Regulatory Flexibility Act

 

  Analysis ("IRFA"), which was prepared in accordance with 5 USC

 

  603, was published in Investment Company Act Release No. 22405.

 

 

  No comments were received on the IRFA.

 

       The Commission has prepared a Final Regulatory Flexibility

 

  Analysis ("FRFA") in accordance with 5 USC 604 regarding rules

 

  2a51-1, 2a51-2, 2a51-3, 3c-1, 3c-5 and 3c-6 under the

 

  Investment Company Act.  The FRFA indicates that the rules

 

  comply with the provisions of the 1996 Act directing the

 

  Commission to prescribe certain rules concerning privately

 

  offered funds, and address certain interpretive issues raised

 

  by the 1996 Act's amendments relating to privately offered

 

  funds.  The FRFA states that the rules, among other things, are

 

  designed to assure that investors in Section 3(c)(7) Funds are

 

  the types of investors that Congress determined do not need the

 

  protections of the Investment Company Act.  The FRFA further

 

  states that the rules give privately offered funds greater

 

  flexibility as well as minimize certain compliance burdens

 

  imposed by the applicable provisions of the Investment Company

 

  Act.

 

       The FRFA also discusses the effect of the rules on small

 

  entities that are Section 3(c)(7) or Section 3(c)(1) Funds.

 

  For purposes of the rules, small entities are those with assets

 

  of $50 million or less at the end of their most recent fiscal

 

  year.  The FRFA states that the rules make possible the

==========================================START OF PAGE 75======

 

  creation of small entities that are Section 3(c)(7) Funds, and

 

  provide greater flexibility and minimize certain compliance

 

  burdens imposed by the provisions of the Investment Company Act

 

  on small entities that are Section 3(c)(1) Funds.  It is

 

  estimated that there are approximately 600 U.S. venture capital

 

  pools that are Section 3(c)(1) Funds, of which about 50% may be

 

  considered small entities.  The number of U.S. hedge funds has

 

  been estimated as being between 800 and 3,000.  Based on a

 

  sample of 250 hedge funds, it is estimated that approximately

 

  75% may be small entities.

 

       The FRFA states that the rules do not impose any new

 

  reporting, recordkeeping or compliance requirements, and that

 

  the Commission believes that there are no rules that duplicate,

 

  overlap or conflict with the adopted rules.

 

       The FRFA discusses the various alternatives considered by

 

  the Commission in connection with the rules that might minimize

 

  the effect on small entities, including: (a) the establishment

 

  of differing compliance or reporting requirements or timetables

 

  that take into account the resources of small entities; (b) the

 

  clarification, consolidation or simplification of compliance

 

  and reporting requirements under the rule for small entities;

 

  (c) the use of performance rather than design standards; and

 

  (d) an exemption from coverage of the rule or any part of the

 

  rule, for small entities.  The Commission believes that it

 

  would be inconsistent with the purposes of the Act to exempt

 

  small entities from the rules or to use performance standards

==========================================START OF PAGE 76======

 

  to specify different requirements for small entities.

 

  Different compliance or reporting requirements for small

 

  entities are not necessary because the rules do not establish

 

  any new reporting, recordkeeping or compliance requirements.

 

  The Commission has determined that it is not feasible to

 

  further clarify, consolidate or simplify the rules for small

 

  entities.

 

       Cost-benefit information reflected in the "Cost/Benefit

 

  Analysis" section of this Release also is reflected in the

 

  FRFA.  A copy of the FRFA may be obtained by contacting David

 

  P. Mathews, Securities and Exchange Commission, 450 5th Street,

 

  N.W., Mail Stop 10-2, Washington, D.C. 20549.

 

  VI.  STATUTORY AUTHORITY

 

       The Commission is adopting rules 2a51-1, 2a51-2 and 2a51-3

 

  pursuant to the authority set forth in sections 2(a)(51)(B),

 

  6(c) and 38(a) of the Investment Company Act [15 USC

 

  80a-2(a)(51)(B), -6(c) and -37(a)] and sections 209(d)(2) and

 

  (4) of the 1996 Act [15 USC 80a-2 note and -3 note).  The

 

  Commission is adopting rule 3c-1 pursuant to the authority set

 

  forth in sections 6(c) and 38(a) of the Investment Company Act

 

  [15 USC 80a-6(c) and -37(a)].  The Commission is adopting rule

 

  3c-5 pursuant to the authority set forth in sections 6(c) and

 

  38(a) of the Investment Company Act [15 USC 80a-6(c) and -

 

  37(a)] and section 209(d)(3) of the 1996 Act [15 USC 80a-3

 

  note].  The Commission is adopting rule 3c-6 pursuant to the

 

  authority set forth in sections 3(c)(1), 3(c)(7), 6(c) and

==========================================START OF PAGE 77======

 

  38(a) of the Investment Company Act [15 USC 80a-3(c)(1),

 

  -3(c)(7), -6(c) and -37(a)] and section 209(d)(1) of the 1996

 

  Act [15 USC 80a-3 note].

 

  TEXT OF RULES

 

  List of subjects in 17 CFR Part 270

 

       Investment companies, Securities

 

       For the reasons set out in the preamble, Title 17, Chapter

 

  II of the Code of Federal Regulations is amended as follows:

 

  PART 270 - RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF

 

  1940

 

       1.  The authority citation for Part 270 continues to read

 

  as follows:

 

       Authority:  15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless

 

  otherwise noted;

 

  *    *    *    *    *

 

       2.  Section 270.2a51-1 is added to read as follows:

 

   270.2a51-1.  Definition of investments for purposes of

  section 2(a)(51) (definition of "qualified purchaser"); certain

  calculations.

 

       (a)  Definitions.  As used in this section:

 

       (1)  The term Commodity Interests means commodity futures

 

  contracts, options on commodity futures contracts, and options

 

  on physical commodities traded on or subject to the rules of:

 

       (i)  Any contract market designated for trading such

 

  transactions under the Commodity Exchange Act and the rules

 

  thereunder; or

==========================================START OF PAGE 78======

 

       (ii) Any board of trade or exchange outside the United

 

  States, as contemplated in Part 30 of the rules under the

 

  Commodity Exchange Act [17 CFR 30.1 through .11].

 

       (2)  The term Family Company means a company described in

 

  paragraph (A)(ii) of section 2(a)(51) of the Act [15 U.S.C.

 

  80a-2(a)(51)].

 

       (3)  The term Investment Vehicle means an investment

 

  company, a company that would be an investment company but for

 

  the exclusions provided by sections 3(c)(1) through 3(c)(9) of

 

  the Act [15 U.S.C. 80a-3(c)(1) through 3(c)(9)] or the

 

  exemptions provided by  270.3a-6 or 270.3a-7, or a commodity

 

  pool.

 

       (4)  The term Investments has the meaning set forth in

 

  paragraph (b) of this section.

 

       (5)  The term Physical Commodity means any physical

 

  commodity with respect to which a Commodity Interest is traded

 

  on a market specified in paragraph (a)(1) of this section.

 

       (6)  The term Prospective Qualified Purchaser means a

 

  person seeking to purchase a security of a Section 3(c)(7)

 

  Company.

 

       (7)  The term Public Company means a company that:

 

       (i)  Files reports pursuant to section 13 or 15(d) of the

 

  Securities Exchange Act of 1934 [15 U.S.C. 78m or 78o(d)]; or

 

       (ii) Has a class of securities that are listed on a

 

  "designated offshore securities market" as such term is defined

 

  by Regulation S under the Securities Act of 1933 [17 CFR

==========================================START OF PAGE 79======

 

  230.901 through 230.904].

 

       (8)  The term Related Person means a person who is related

 

  to a Prospective Qualified Purchaser as a sibling, spouse or

 

  former spouse, or is a direct lineal descendant or ancestor by

 

  birth or adoption of the Prospective Qualified Purchaser, or is

 

  a spouse of such descendant or ancestor, provided that, in the

 

  case of a Family Company, a Related Person includes any owner

 

  of the Family Company and any person who is a Related Person of

 

  such owner.

 

       (9)  The term Relying Person means a Section 3(c)(7)

 

  Company or a person acting on its behalf.

 

       (10)  The term Section 3(c)(7) Company means a company

 

  that would be an investment company but for the exclusion

 

  provided by section 3(c)(7) of the Act [15 U.S.C. 80a-3(c)(7)].

 

       (b)  Types of Investments.  For purposes of section

 

  2(a)(51) of the Act [15 U.S.C. 80a-2(a)(51)], the term

 

  Investments means:

 

       (1)  Securities (as defined by section 2(a)(1) of the

 

  Securities Act of 1933 [15 U.S.C. 77b(a)(1)]), other than

 

  securities of an issuer that controls, is controlled by, or is

 

  under common control with, the Prospective Qualified Purchaser

 

  that owns such securities, unless the issuer of such securities

 

  is:

 

       (i)  An Investment Vehicle;

 

       (ii) A Public Company; or

 

       (iii)     A company with shareholders' equity of not less

==========================================START OF PAGE 80======

 

  than $50 million (determined in accordance with generally

 

  accepted accounting principles) as reflected on the company's

 

  most recent financial statements, provided that such financial

 

  statements present the information as of a date within 16

 

  months preceding the date on which the Prospective Qualified

 

  Purchaser acquires the securities of a Section 3(c)(7) Company;

 

       (2)  Real estate held for investment purposes;

 

       (3)  Commodity Interests held for investment purposes;

 

       (4)  Physical Commodities held for investment purposes;

 

       (5)  To the extent not securities, financial contracts (as

 

  such term is defined in section 3(c)(2)(B)(ii) of the Act [15

 

  U.S.C. 80a-3(c)(2)(B)(ii)] entered into for investment

 

  purposes;

 

       (6)  In the case of a Prospective Qualified Purchaser that

 

  is a Section 3(c)(7) Company, a company that would be an

 

  investment company but for the exclusion provided by section

 

  3(c)(1) of the Act [15 U.S.C. 80a-3(c)(1)], or a commodity

 

  pool, any amounts payable to such Prospective Qualified

 

  Purchaser pursuant to a firm agreement or similar binding

 

  commitment pursuant to which a person has agreed to acquire an

 

  interest in, or make capital contributions to, the Prospective

 

  Qualified Purchaser upon the demand of the Prospective

 

  Qualified Purchaser; and

==========================================START OF PAGE 81======

 

       (7)  Cash and cash equivalents (including foreign

 

  currencies) held for investment purposes.  For purposes of this

 

  section, cash and cash equivalents include:

 

       (i)  Bank deposits, certificates of deposit, bankers

 

  acceptances and similar bank instruments held for investment

 

  purposes; and

 

       (ii) The net cash surrender value of an insurance policy.

 

       (c)  Investment Purposes.  For purposes of this section:

 

       (1)  Real estate shall not be considered to be held for

 

  investment purposes by a Prospective Qualified Purchaser if it

 

  is used by the Prospective Qualified Purchaser or a Related

 

  Person for personal purposes or as a place of business, or in

 

  connection with the conduct of the trade or business of the

 

  Prospective Qualified Purchaser or a Related Person, provided

 

  that real estate owned by a Prospective Qualified Purchaser who

 

  is engaged primarily in the business of investing, trading or

 

  developing real estate in connection with such business may de

 

  deemed to be held for investment purposes.  Residential real

 

  estate shall not be deemed to be used for personal purposes if

 

  deductions with respect to such real estate are not disallowed

 

  by section 280A of the Internal Revenue Code [26 U.S.C. 280A].

 

       (2)  A Commodity Interest or Physical Commodity owned, or

 

  a financial contract entered into, by the Prospective Qualified

 

  Purchaser who is engaged primarily in the business of

 

  investing, reinvesting, or trading in Commodity Interests,

==========================================START OF PAGE 82======

 

  Physical Commodities or financial contracts in connection with

 

  such business may be deemed to be held for investment purposes.

 

       (d)  Valuation.  For purposes of determining whether a

 

  Prospective Qualified Purchaser is a qualified purchaser, the

 

  aggregate amount of Investments owned and invested on a

 

  discretionary basis by the Prospective Qualified Purchaser

 

  shall be the Investments' fair market value on the most recent

 

  practicable date or their cost, provided that:

 

       (1)  In the case of Commodity Interests, the amount of

 

  Investments shall be the value of the initial margin or option

 

  premium deposited in connection with such Commodity Interests;

 

  and

 

       (2)  In each case, there shall be deducted from the amount

 

  of Investments owned by the Prospective Qualified Purchaser the

 

  amounts specified in paragraphs (e) and (f) of this section, as

 

  applicable.

 

       (e)  Deductions.  In determining whether any person is a

 

  qualified purchaser there shall be deducted from the amount of

 

  such person's Investments the amount of any outstanding

 

  indebtedness incurred to acquire or for the purpose of

 

  acquiring the Investments owned by such person.

 

       (f)  Deductions: Family Companies.  In determining whether

 

  a Family Company is a qualified purchaser, in addition to the

 

  amounts specified in paragraph (e) of this section, there shall

 

  be deducted from the value of such Family Company's Investments

 

  any outstanding indebtedness incurred by an owner of the Family

==========================================START OF PAGE 83======

 

  Company to acquire such Investments.

 

       (g)  Special Rules for Certain Prospective Qualified

 

  Purchasers.

 

       (1)  Qualified Institutional Buyers.  Any Prospective

 

  Qualified Purchaser who is, or who a Relying Person reasonably

 

  believes is, a qualified institutional buyer as defined in

 

  paragraph (a) of  230.144A of this chapter, acting for its

 

  own account, the account of another qualified institutional

 

  buyer, or the account of a qualified purchaser, shall be deemed

 

  to be a qualified purchaser provided:

 

       (i)  That a dealer described in paragraph (a)(1)(ii) of 

 

  230.144A of this chapter shall own and invest on a

 

  discretionary basis at least $25 million in securities of

 

  issuers that are not affiliated persons of the dealer; and

 

       (ii) That a plan referred to in paragraph (a)(1)(i)(D) or

 

  (a)(1)(i)(E) of  230.144A of this chapter, or a trust fund

 

  referred to in paragraph (a)(1)(i)(F) of  230.144A of this

 

  chapter that holds the assets of such a plan, will not be

 

  deemed to be acting for its own account if investment decisions

 

  with respect to the plan are made by the beneficiaries of the

 

  plan, except with respect to investment decisions made solely

 

  by the fiduciary, trustee or sponsor of such plan.

 

       (2)  Joint Investments.  In determining whether a natural

 

  person is a qualified purchaser, there may be included in the

 

  amount of such person's Investments any Investments held

 

  jointly with such person's spouse, or Investments in which such

==========================================START OF PAGE 84======

 

  person shares with such person's spouse a community property or

 

  similar shared ownership interest.  In determining whether

 

  spouses who are making a joint investment in a Section 3(c)(7)

 

  Company are qualified purchasers, there may be included in the

 

  amount of each spouse's Investments any Investments owned by

 

  the other spouse (whether or not such Investments are held

 

  jointly).  In each case, there shall be deducted from the

 

  amount of any such Investments the amounts specified in

 

  paragraph (e) of this section incurred by each spouse.

 

       (3)  Investments by Subsidiaries.  For purposes of

 

  determining the amount of Investments owned by a company under

 

  section 2(a)(51)(A)(iv) of the Act [15 U.S.C.

 

  80a-2(a)(51)(A)(iv)], there may be included Investments owned

 

  by majority-owned subsidiaries of the company and Investments

 

  owned by a company ("Parent Company") of which the company is a

 

  majority-owned subsidiary, or by a majority-owned subsidiary of

 

  the company and other majority-owned subsidiaries of the Parent

 

  Company.

 

       (4)  Certain Retirement Plans and Trusts.  In determining

 

  whether a natural person is a qualified purchaser, there may be

 

  included in the amount of such person's Investments any

 

  Investments held in an individual retirement account or similar

 

  account the Investments of which are directed by and held for

 

  the benefit of such person.

==========================================START OF PAGE 85======

 

       (h)  Reasonable Belief.  The term "qualified purchaser" as

 

  used in section 3(c)(7) of the Act [15 U.S.C. 80a-3(c)(7)]

 

  means any person that meets the definition of qualified

 

  purchaser in section 2(a)(51)(A) of the Act [15 U.S.C. 80a-

 

  2(a)(51)(A)]) and the rules thereunder, or that a Relying

 

  Person reasonably believes meets such definition. 

 

       3.  Section 270.2a51-2 is added to read as follows:

 

   270.2a51-2.  Definitions of beneficial owner for certain

  purposes under sections 2(a)(51) and 3(c)(7) and determining

  indirect ownership interests.

 

       (a)  Beneficial Ownership: General.  Except as set forth

 

  in this section, for purposes of sections 2(a)(51)(C) and 3(c)(7)(B)(ii)

 

  of the Act [15 U.S.C. 80a-2(a)(51)(C) and -3(c)(7)(B)(ii)], the

 

  beneficial owners of securities of an excepted investment

 

  company (as defined in section 2(a)(51)(C) of the Act [15

 

  U.S.C. 80a-2(a)(51)(C)]) shall be determined in accordance with

 

  section 3(c)(1) of the Act [15 U.S.C. 80a-3(c)(1)].

 

       (b)  Beneficial Ownership: Grandfather Provision.  For

 

  purposes of section 3(c)(7)(B)(ii) of the Act [15 U.S.C. 80a-

 

  3(c)(7)(B)(ii)], securities of an issuer beneficially owned by

 

  a company (without giving effect to section 3(c)(1)(A) of the

 

  Act [15 U.S.C. 80a-3(c)(1)(A)]) ("owning company") shall be

 

  deemed to be beneficially owned by one person unless:

 

       (1)  The owning company is an investment company or an

 

  excepted investment company;

 

       (2)  The owning company, directly or indirectly, controls,

 

  is controlled by, or is under common control with, the issuer;

==========================================START OF PAGE 86======

 

  and

 

       (3)  On October 11, 1996, under section 3(c)(1)(A) of the

 

  Act as then in effect, the voting securities of the issuer were

 

  deemed to be beneficially owned by the holders of the owning

 

  company's outstanding securities (other than short-term paper),

 

  in which case, such holders shall be deemed to be beneficial

 

  owners of the issuer's outstanding voting securities.

 

       (c)  Beneficial Ownership: Consent Provision.  For

 

  purposes of section 2(a)(51)(C) of the Act [15 U.S.C. 80a-

 

  2(a)(51)(C)], securities of an excepted investment company

 

  beneficially owned by a company (without giving effect to

 

  section 3(c)(1)(A) of the Act [15 U.S.C. 80a-3(c)(1)(A)])

 

  ("owning company") shall be deemed to be beneficially owned by

 

  one person unless:

 

       (1)  The owning company is an excepted investment company;

 

       (2)  The owning company directly or indirectly controls,

 

  is controlled by, or is under common control with, the excepted

 

  investment company or the company with respect to which the

 

  excepted investment company is, or will be, a qualified

 

  purchaser; and

 

       (3)  On April 30, 1996, under section 3(c)(1)(A) of the

 

  Act as then in effect, the voting securities of the excepted

 

  investment company were deemed to be beneficially owned by the

 

  holders of the owning company's outstanding securities (other

 

  than short-term paper), in which case the holders of such

 

  excepted company's securities shall be deemed to be beneficial

==========================================START OF PAGE 87======

 

  owners of the excepted investment company's outstanding voting

 

  securities.

 

       (d)  Indirect Ownership: Consent Provision.  For purposes

 

  of section 2(a)(51)(C) of the Act [15 U.S.C. 80a-2(a)(51)(C)],

 

  an excepted investment company shall not be deemed to

 

  indirectly own the securities of an excepted investment company

 

  seeking a consent to be treated as a qualified purchaser

 

  ("qualified purchaser company") unless such excepted investment

 

  company, directly or indirectly, controls, is controlled by, or

 

  is under common control with, the qualified purchaser company

 

  or a company with respect to which the qualified purchaser

 

  company is or will be a qualified purchaser.

 

       (e)  Required Consent: Consent Provision.  For purposes of

 

  section 2(a)(51)(C) of the Act [15 U.S.C. 80a-2(a)(51)(C)], the

 

  consent of the beneficial owners of an excepted investment

 

  company ("owning company") that beneficially owns securities of

 

  an excepted investment company that is seeking the consents

 

  required by section 2(a)(51)(C) ("consent company") shall not

 

  be required unless the owning company directly or indirectly

 

  controls, is controlled by, or is under common control with,

 

  the consent company or the company with respect to which the

 

  consent company is, or will be, a qualified purchaser.

==========================================START OF PAGE 88======

 

  NOTES to  270.2a51-2:

 

       1.  On both April 30, 1996 and October 11, 1996, section

 

  3(c)(1)(A) of the Act as then in effect provided that:  (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, the beneficial ownership shall be

 

  deemed to be that of the holders of such company's outstanding

 

  securities (other than short-term paper) unless, as of the date

 

  of the most recent acquisition by such company of securities of

 

  that issuer, the value of all securities owned by such company

 

  of all issuers which are or would, but for the exception set

 

  forth in this subparagraph, be excluded from the definition of

 

  investment company solely by this paragraph, does not exceed 10

 

  per centum of the value of the company's total assets. Such

 

  issuer nonetheless is deemed to be an investment company for

 

  purposes of section 12(d)(1).

 

       2.  Issuers seeking the consent required by section

 

  2(a)(51)(C) of the Act should note that section 2(a)(51)(C)

 

  requires an issuer to obtain the consent of the beneficial

 

  owners of its securities and the beneficial owners of

 

  securities of any "excepted investment company" that directly

 

  or indirectly owns the securities of the issuer.  Except as set

 

  forth in paragraphs (d) (with respect to indirect owners) and

 

  (e) (with respect to direct owners) of this section, nothing in

 

  this section is designed to limit this consent requirement.

==========================================START OF PAGE 89======

 

       4.  Section 270.2a51-3 is added to read as follows:

 

   270.2a51-3.  Certain companies as qualified purchasers.

 

       (a)  For purposes of section 2(a)(51)(A)(ii) and (iv) of

 

  the Act [15 U.S.C. 80a-2(a)(51)(A)(ii) and (iv)], a company

 

  shall not be deemed to be a qualified purchaser if it was

 

  formed for the specific purpose of acquiring the securities

 

  offered by a company excluded from the definition of investment

 

  company by section 3(c)(7) of the Act [15 U.S.C. 80a-3(c)(7)]

 

  unless each beneficial owner of the company's securities is a

 

  qualified purchaser.

 

       (b)  For purposes of section 2(a)(51) of the Act [15

 

  U.S.C. 80a-2(a)(51)], a company may be deemed to be a qualified

 

  purchaser if each beneficial owner of the company's securities

 

  is a qualified purchaser.

 

       5.  Section 270.3c-1 is added to read as follows:

 

   270.3c-1.  Definition of beneficial ownership for certain

  section 3(c)(1) funds.

 

       (a)  As used in this section:

 

       (1)  The term Covered Company means a company that is an

 

  investment company, a Section 3(c)(1) Company or a Section

 

  3(c)(7) Company.

 

       (2)  The term Section 3(c)(1) Company means a company that

 

  would be an investment company but for the exclusion provided

 

  by section 3(c)(1) of the Act [15 U.S.C. 80a-3(c)(1)].

 

       (3)  The term Section 3(c)(7) Company means a company that

 

  would be an investment company but for the exclusion provided

 

  by section 3(c)(7) of the Act [15 U.S.C. 80a-3(c)(7)].

==========================================START OF PAGE 90======

 

       (b)  For purposes of section 3(c)(1)(A) of the Act [15

 

  U.S.C. 80a-3(c)(1)(A)], beneficial ownership by a Covered

 

  Company owning 10 percent or more of the outstanding voting

 

  securities of a Section 3(c)(1) Company shall be deemed to be

 

  beneficial ownership by one person, provided that:

 

       (1)  On April 1, 1997, the Covered Company owned 10

 

  percent or more of the outstanding voting securities of the

 

  Section 3(c)(1) Company or non-voting securities that, on such

 

  date and in accordance with the terms of such securities, were

 

  convertible into or exchangeable for voting securities that, if

 

  converted or exchanged on or after such date, would have

 

  constituted 10 percent or more of the outstanding voting

 

  securities of the Section 3(c)(1) Company; and

 

       (2)  On the date of any acquisition of securities of the

 

  Section 3(c)(1) Company by the Covered Company, the value of

 

  all securities owned by the Covered Company of all issuers that

 

  are Section 3(c)(1) or Section 3(c)(7) Companies does not

 

  exceed 10 percent of the value of the Covered Company's total

 

  assets.

 

       6.  Section 270.3c-5 is added to read as follows:

 

   270.3c-5.  Beneficial ownership by knowledgeable employees

  and certain other persons.

 

       (a)  As used in this section:

 

       (1)  The term Affiliated Management Person means an

 

  affiliated person, as such term is defined in section 2(a)(3)

 

  of the Act [15 U.S.C. 80a-2(a)(3)], that manages the investment

 

  activities of a Covered Company.  For purposes of this

==========================================START OF PAGE 91======

 

  definition, the term "investment company" as used in section

 

  2(a)(3) of the Act includes a Covered Company.

 

       (2)  The term Covered Company means a Section 3(c)(1)

 

  Company or a Section 3(c)(7) Company.

 

       (3)  The term Executive Officer means the president, any

 

  vice president in charge of a principal business unit, division

 

  or function (such as sales, administration or finance), any

 

  other officer who performs a policy-making function, or any

 

  other person who performs similar policy-making functions, for

 

  a Covered Company or for an Affiliated Management Person of the

 

  Covered Company.

 

       (4)  The term Knowledgeable Employee with respect to any

 

  Covered Company means any natural person who is:

 

       (i)  An Executive Officer, director, trustee, general

 

  partner, advisory board member, or person serving in a similar

 

  capacity, of the Covered Company or an Affiliated Management

 

  Person of the Covered Company; or

 

       (ii) An employee of the Covered Company or an Affiliated

 

  Management Person of the Covered Company (other than an

 

  employee performing solely clerical, secretarial or

 

  administrative functions with regard to such company or its

 

  investments) who, in connection with his or her regular

 

  functions or duties, participates in the investment activities

 

  of such Covered Company, other Covered Companies, or investment

 

  companies the investment activities of which are managed by

 

  such Affiliated Management Person of the Covered Company,

==========================================START OF PAGE 92======

 

  provided that such employee has been performing such functions

 

  and duties for or on behalf of the Covered Company or the

 

  Affiliated Management Person of the Covered Company, or

 

  substantially similar functions or duties for or on behalf of

 

  another company for at least 12 months.

 

       (5)  The term Section 3(c)(1) Company means a company that

 

  would be an investment company but for the exclusion provided

 

  by section 3(c)(1) of the Act [15 U.S.C. 80a-3(c)(1)].

 

       (6)  The term Section 3(c)(7) Company means a company that

 

  would be an investment company but for the exclusion provided

 

  by section 3(c)(7) of the Act [15 U.S.C. 80a-3(c)(7)].

 

       (b)  For purposes of determining the number of beneficial

 

  owners of a Section 3(c)(1) Company, and whether the

 

  outstanding securities of a Section 3(c)(7) Company are owned

 

  exclusively by qualified purchasers, there shall be excluded

 

  securities beneficially owned by:

 

       (1)  A person who at the time such securities were

 

  acquired was a Knowledgeable Employee of such Company;

 

       (2)  A company owned exclusively by Knowledgeable

 

  Employees;

 

       (3)  Any person who acquires securities originally

 

  acquired by a Knowledgeable Employee in accordance with this

 

  section, provided that such securities were acquired by such

 

  person in accordance with  270.3c-6.

 

       7.  Section 270.3c-6 is added to read as follows:

 

   270.3c-6.  Certain transfers of interests in section 3(c)(1)

==========================================START OF PAGE 93======

 

  and section 3(c)(7) funds.

 

       (a)  As used in this section:

 

       (1)  The term Donee means a person who acquires a security

 

  of a Covered Company (or a security or other interest in a

 

  company referred to in paragraph (b)(3) of this section) as a

 

  gift or bequest or pursuant to an agreement relating to a legal

 

  separation or divorce.

 

       (2)  The term Section 3(c)(1) Company means a company that

 

  would be an investment company but for the exclusion provided

 

  by section 3(c)(1) of the Act [15 U.S.C. 80a-3(c)(1)].

 

       (3)  The term Section 3(c)(7) Company means a company that

 

  would be an investment company but for the exclusion provided

 

  by section 3(c)(7) of the Act [15 U.S.C. 80a-3(c)(7)].

 

       (4)  The term Transferee means a Section 3(c)(1)

 

  Transferee or a Qualified Purchaser Transferee, in each case as

 

  defined in paragraph (b) of this section.

 

       (5)  The term Transferor means a Section 3(c)(1)

 

  Transferor or a Qualified Purchaser Transferor, in each case as

 

  defined in paragraph (b) of this section.

 

       (b)  Beneficial ownership by any person ("Section 3(c)(1)

 

  Transferee") who acquires securities or interests in securities

 

  of a Section 3(c)(1) Company from a person other than the

 

  Section 3(c)(1) Company shall be deemed to be beneficial

 

  ownership by the person from whom such transfer was made

 

  ("Section 3(c)(1) Transferor"), and securities of a Section

 

  3(c)(7) Company that are owned by persons who received the

==========================================START OF PAGE 94======

 

  securities from a qualified purchaser other than the Section

 

  3(c)(7) Company ("Qualified Purchaser Transferor") or a person

 

  deemed to be a qualified purchaser by this section shall be

 

  deemed to be acquired by a qualified purchaser ("Qualified

 

  Purchaser Transferee"), provided that the Transferee is:

 

       (1)  The estate of the Transferor;

 

       (2)  A Donee; or

 

       (3)  A company established by the Transferor exclusively

 

  for the benefit of (or owned exclusively by) the Transferor and

 

  the persons specified in paragraphs (b)(1) and (b)(2) of this

 

  section.

 

       By the Commission.

 

                                Jonathan G. Katz

                                Secretary

 

  April 3, 1997