February 18, 1997
VIA FEDERAL EXPRESS AND E-MAIL firstname.lastname@example.org
Mr. Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: File No. S7-30-96
Dear Mr. Katz:
This comment letter is submitted in triplicate in response to Release No. IC-22405 (the "Release"). In the Release, the Securities and Exchange Commission (the "SEC") proposed for comment rules (the "Proposed Rules") under the Investment Company Act of 1940, as amended (the "Act"), to implement provisions of the National Securities Markets Improvement Act of 1996 (the "1996 Act").
As background, our firm represents approximately 275 investment advisers that manage more than 220 investment pools. These pools are exempt from registration as investment companies under the Act, and their interests are held by both onshore and off-shore investors.Of the forty attorneys at our firm, ten devote substantial time to counseling investment advisers. Our practice group includes two former SEC enforcement attorneys. John P. Broadhurst of this office is a member of the American Bar Association Task Force on Hedge Funds. The views expressed in this letter, however, are those of our firm and are not being submitted on behalf of that Task Force or any of our clients.
We have the following comments on the Release and the Proposed Rules.
A. Definition of "Qualified Purchaser": General Comments .
As noted in the Release, the legislative history of the 1996 Act indicates that section 3(c)(7) funds are to be limited to investors with a high degree of financial sophistication who are in a position to appreciate the risks associated with investment pools that do not have the protections afforded by the Act.
The SEC has attempted to define investments with this principle in mind, trying to determine whether different types of assets indicate the investment sophistication of the owner. While the SEC's efforts in this regard are laudable, we believe that it is important to bear in mind that anyone with $5,000,000 in investments is very likely to use professional advisers, such as tax consultants, attorneys or investment counselors, who counsel them regarding asset allocation and selecting specific investments within asset classes.
Given this fact, we believe Proposed Rule 2a51-1 is in many respects excessively complex. The attempt to divine sophistication from a person's investment portfolio will not advance any public policy, given the likelihood that such wealthy investors will be able (and have ample incentive) to fend for themselves by hiring experts when deciding how to allocate their investments about which they feel they have insufficient personal expertise. The practicality of the rule should be given substantial weight. The burdens of compliance should not be excessive relative to the benefits that will flow from the rule. We propose that a number of areas of Proposed Rule 2a51-1 be simplified to facilitate compliance by both investors and issuers.
As an alternative to the complexities of Proposed Rule 2a51-1, we suggest that the "qualified purchaser" test consist of two simple parts. First, a qualified purchaser must have $5,000,000 of investments of any kind, excluding only his or her principal residence. Second, if the SEC considers it essential and believes statutory authority exists, a requirement could be added that a qualified purchaser must have a minimum net worth, such as $8,000,000, again excluding only his or her principal residence. We believe that this second net worth test assures the SEC that an investor is not using an unreasonable amount of debt to misrepresent the investor's aggregate investments. It is reasonable to assume that investors with such high net worth are highly sophisticated, able to appreciate the risks of an investment in a section 3(c)(7) pool, and have access to professional investment advice as discussed above. We believe that the vast majority of prospective 3(c)(7) investors will have a very high net worth and will not be left unprotected by a simplified "qualified purchaser" test.
B. Definition of "Qualified Purchaser": Specific Comments . If the SEC rejects the "net worth" proposal described above, we have the following specific comments to the definition of "Qualified Purchaser."
1. "Securities" - Control Person Exclusion .
a. Private Companies . Proposed Rule 2a51-1(b)(1) would exclude from the types of securities that may be considered investments securities of an issuer with which the prospective qualified purchaser has a control relationship. The effect of the exclusion is to exclude securities of controlled private companies, since subsection (b)(1)(ii) would except securities of listed companies from this exclusion.
This exclusion makes the unwarranted assumption that a control person of a private business is unsophisticated in investment matters. We believe that just the opposite is more likely to be true. A person who has a $5,000,000 control interest in a business or venture in which that person is actively engaged should certainly be assumed to be experienced in making financial decisions about that business and his or her investment therein. We believe it is reasonable to assume that person is sophisticated enough to understand the risks involved with investing in a section 3(c)(7) pool or to obtain professional advice regarding that investment. Similarly, there is no reason to assume that a passive investor who has made the investment decision to finance a private business is less sophisticated than a person who has decided to invest in publicly traded securities. For example, the exclusion might well comprehend some of the most sophisticated investors, such as venture capitalists.
We propose that this exclusion be eliminated. In the alternative, the exclusion should be limited to private companies with revenues in the last fiscal year of less than $10,000,000. A controlling interest in a company with revenues of that amount should demonstrate sufficient financial expertise for this purpose. We suggest that revenues, and not shareholders' equity, would be a more accurate indicator for many or most companies, particularly service and distribution businesses.
The rule should also recognize that privately-held companies frequently serve as conduits for other types of investments. We believe that if a private company itself holds "investments," as defined by the SEC pursuant to sectionof the Act, its control persons should be able to include their interests in the company's portfolio as investments for purposes of determining whether they are qualified purchasers. Thus, if family members invest in listed securities through a privately held partnership or limited liability company, each family member should be able to use his or her share of the value of those listed securities in the calculation of his or her investments.
b. Listed Company Exception . Proposed Rule 2a51-1 (b)(1)(ii) would permit a person to include in that person's investments the securities of a "listed company" that the person controls. The Release in the text accompanying note 37 requests comment on whether this concept should be applicable if any of the securities of the issuer have been offered to the public. We see no reason to limit this concept to listed companies. Its rationale, as stated in the Release in the text accompanying notethat persons who hold controlling interests in such companies are likely to have experience with securities-related disclosure and evaluating investment risk, would appear to apply equally to a controlling interest in a company any of the securities of which have been offered to the public, without regard to the stockholders' equity shown on its balance sheet. For the same reasons, this concept should include securities of a foreign issuer that are publicly held in such issuer's principal market.
c. Interests in Businesses that are not "Securities" . The Release in the text accompanying note 38 requests comment on whether other types of business holdings, whether or not characterized as securities, should be treated as investments. We believe that any type of ownership interest in a business should be treated as an investment, whether or not such interest can be characterized as a security.
2. Real Estate used in a Trade or Business . Proposed Rule 2a51-1(c) states that real estate will not be considered to be held for investment purposes if it is used by the owner or a related person as a place of business or in connection with the conduct of a trade or business of the owner or related person.
In general, we agree that the rule should include real estate as an investment. In our view, a decision to make a $5,000,000 investment in real estate demonstrates the investor's financial sophistication. We believe, however, that the reasoning underlying this exception for business property is misplaced. Making an investment in real property for business purposes requires a complex analysis of the costs, benefits and risks associated with such a financial investment. Having made such an investment would appear to demonstrate more, not less, financial investment expertise on the part of the investor than other types of real property investment. Again, we think this distinction errs toward micro-management. The ability of such extraordinarily wealthy persons to consult with professional advisers argues for simplicity in the rule. We believe that Proposed Rule 2a51-1(c) should provide that real property held in connection with a trade or business will be considered to be held for investment purposes.
3. Plans . An investor that holds substantial investments in self-directed employee benefit plans, such as Keogh plans, individual retirement accounts or other employee benefit plans within the meaning of Title I of the Employee Retirement Income Security Act (collectively, "Plans"), should be able to include those investments in the value of the investor's investments, if the investor has the ability to select investment options or individual investments for the Plan or the investor's account in the Plan. If so, the person would have the same type of experience and expertise that would be required for such an investment outside the Plan. Similarly, a Plan should be able to act as a qualified purchaser if such Plan is a self-directed plan, with investment decisions made by persons who are qualified purchasers. This is similar to the treatment of Plans by the SEC staff for purposes of whether such Plans are accredited investors under Regulation D ("Regulation D") under the Securities Act of 1933, as amended (the "1933 Act").
4. Cash . Proposed Rule 2a51-1(b)(5) includes "cash and cash equivalents held for investment purposes" as a type of investment. In the Release in the text accompanying note 50, the SEC requests comment on whether the proposed inclusion of "cash" as an investment needs to be clarified or qualified in any way. We believe that Proposed Rule 2a51-1(b)(5) is sufficient as it stands. Additional language, such as that suggested in the Release, would add unnecessary complication and probably would not achieve any benefit.
5. Valuation . Proposed Rule 2a51-1(d) states that the aggregate amount of investments owned and invested on a discretionary basis shall be their readily ascertainable market value or their cost. We agree that this is appropriate for most investments, including public securities. With respect to private securities, however, the cost of such securities usually bears little relationship to their value. We suggest that the alternatives of book value or a recent (within the last 12 months) third-party appraisal, be added to the list of possible methods of valuation. The rule should establish the priority of evaluation standards as readily ascertainable market value, appraised value, book value and, if none of the foregoing is available, cost.
The Release in the text accompanying note 55 asks whether a requirement that securities be valued at cost even if a market value is available would make it easier for a section 3(c)(7) fund to determine the continuing status of an investor as a qualified purchaser when an investor adds to its investment in the fund.
The Act's underlying policies do not suggest that a 3(c)(7) fund issuer should be required to make a new determination of each investor's qualified purchaser status each time an investor adds to that investor's investment in the fund. Many 3(c)(7) funds will have annual earnings reinvestment and optional additional investment options, as do 3(c)(1) funds today. We do not believe that Congress intended to impose on 3(c)(7) fund issuers and investors the enormous burden of continually checking each investor's qualified purchaser status. The rule should provide that the determination of each investor's status as a qualified purchaser need only be made at the time of the investor's initial investment in the 3(c)(7) fund. At that time the investor's sophistication is established and any further investment in that fund is not subject to a new determination.
6. Deductions . Proposed Rule 2a51-1 (e), (f) and (g) would provide that certain complex deductions be made from a person's investments in determining whether that person is a qualified purchaser. We believe these provisions are unwieldy and excessive, given their negligible benefit. We understand that Congress considered and rejected a net worth test for defining "qualified purchaser." We believe adding a concept of deductions contradicts the legislative intent to determine sophistication from the amount of investments a person holds. / 1 Whether an investor borrows to acquire investments is irrelevant to the investor's control of substantial investments and ability to evaluate the risks of investing in a 3(c)(7) fund. If the SEC insists on including this concept, however, we suggest the following alternatives with respect to deductions.
If subsections (f)(4) and (5) are retained, they should require the deduction of only the "outstanding indebtedness" under the types of loans described and not the "proceeds" of such loans. There is no reason to deduct the portions of such loans that have been repaid.
Even if other provisions of subsections(f) andare retained, subsections (f)(1),(2) and (3) (which would require the deduction of payments received during the preceding twelve months pursuant to an insurance policy, gift, bequest, legal separation, divorce or lawsuit) should be deleted. This relates to our general comment at the outset of this discussion, that the kinds of investors covered by Proposed Rule 2a51-1 are very likely to have access to professional investment advice. Subsections(2) andwould merely preclude such investors from engaging in one type of investment (a 3(c)(7) fund) for an arbitrary period.
If subsection (f)(2) is retained, we suggest that it provide that no deduction need be made for the value of any investments received in a legal separation or divorce if the investments were community property or otherwise jointly owned by the person and the person's former spouse during the marriage. This would be consistent with Proposed Rule 2a51-1(h), which would include such jointly-held investments in the value of a person's investments generally. Otherwise, a spouse who previously was a qualified purchaser and who then acquires sole ownership of the investments in a proceeding for legal separation or divorce might cease being a qualified purchaser for an arbitrary twelve-month period.
7. Jointly Held Investments . Proposed Rule 2a51-1(h) would provide that, in determining whether a natural person is a qualified purchaser, there may be included in the value of such person's investments any investments held jointly with such person's spouse. The Release in the text accompanying note 64 requests comment on whether spouses that hold not less than $5,000,000 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 3(c)(7) fund. We agree that this approach would be appropriate. A joint investment by spouses in a 3(c)(7) fund logically requires aggregation of the spouses' investments for purposes of the $5,000,000 requirement.
8. Good Faith Reliance by Issuers . Proposed Rule 2a51-1(j) states that, in determining whether a prospective purchaser is a qualified purchaser, an issuer or other relying person may rely on audited financial statements, brokerage account statements, and other appropriate information and certifications, "provided that such reliance is reasonable and the relying person, after reasonable inquiry, does not have any basis for believing that such information is incorrect in any material respect." Unlike similar provisions in RegulationRegulationand Ruleunder the 1933 Act, such a provision appears to impose on fund managers a due diligence standard of unknowable dimensions. The rule should provide instead that the standard of compliance for a 3(c)(7) issuer or other relying person is good faith reliance on information furnished by the prospective investor, in a signed statement or certificate.
For practical reasons, an issuer is unlikely to have access to an individual investor's audited financial statements (because they generally do not exist for individuals) or brokerage statements (due to privacy concerns). For section 3(c)(1) pools, issuers generally obtain the information needed for compliance with myriad regulatory requirements by way of subscription agreements and offering questionnaires that are completed and signed by the investors.
The rule should provide that an issuer or other relying person is entitled to rely in good faith on such a signed document, without further inquiry. The good faith requirement would preclude acceptance of information that the issuer has reason to believe is untrue or incomplete. Similar provisions can be found in Rule 144A(d), Rule 501(a), Rule 508(a)(3) and Rule 903(c)(3)(iii)B)(1) under the 1933 Act.
C. "Beneficial Ownership": Consent to Qualified Purchaser Status .
The intent of Congress in enacting the 3(c)(7) exception was to remove certain regulatory restrictions on private pools to expand capital formation opportunities for U.S. companies. Congress could not therefore have intended to erect practically insurmountable obstacles for a fund with investors that are funds of funds that have pre-April1996 beneficial owners to elect to participate in sectionpools as a qualified purchaser. We believe this would be the practical effect, however, of section 2(a)(51)(C) of the Act, as interpreted by the SEC in note 87 to the Release. Noteappears to require a fund with investors that are funds of funds to obtain consents from virtually every direct and indirect beneficial owner who invested in those funds of funds prior to April1996. We believe this is an unrealistic option for many funds. In all likelihood those funds will be required to forego investing in 3(c)(7) pools or to expel any investors with respect to which the consent procedures will be too difficult.
We understand that sectionof the Act will require in certain cases the consents of beneficial owners of such funds. Section 2(a)(51)(C) of the Act requires a fund sponsor to obtain the consent to qualified purchaser treatment from "all pre-amendment beneficial owners of the outstanding securities (other than short-term paper) of any excepted investment company that, directly or indirectly, owns any outstanding securities of such excepted investment company ..."(emphasis added). We urge the SEC to interpret the word "owns" similarly to the term "beneficial owner" as defined in Proposed Rule 2a51-2(c). In other words, the fund of funds in most cases should be able to give the required consent itself, unless a control relationship exists and a look-through was required on April 30, 1996, under section 3(c)(1)(A) of the Act as then in effect. This interpretation would be consistent with the intent of Congress and with the somewhat parallel provisions of section 3(c)(7)(B)(ii) of the Act and Proposed Rule 2a51-2(b), regarding who must be given notice and a redemption opportunity when a 3(c)(1) fund converts to a 3(c)(7) fund.
D. Beneficial Ownership by Knowledgeable Employees .
Proposed Rule 3c-5(a)(3) would define "knowledgeable employee" for purposes of excluding the securities owned by such an employee and certain related persons of such an employee from the calculation of the number of beneficial owners of a 3(c)(1) fund and whether the outstanding securities of a 3(c)(7) fund are owned exclusively by qualified purchasers. Proposed Rule 3c-5(a)(3)(ii) would exclude from the definition of "knowledgeable employee" any employee performing solely clerical, secretarial or administrative functions and any employee who does not, in connection with his or her regular functions or duties, participate in or obtain information regarding the investment activities of the relevant company (collectively, "Excluded Employees").
We believe the definition of "knowledgeable employee" in Proposed Rule 3c-5(a)(3) is too narrow, given the likely intent of Congress in providing relief from certain of the provisions of sections 3(c)(1) and 3(c)(7) of the Act for certain employees of private funds. We believe that Congress recognized that allowing employees to invest in private funds managed by their employer or an affiliate is an important employee benefit that can help sponsors of private funds attract and retain talented employees. We believe that Congress would therefore intend the SEC to allow this benefit to be offered to as broad a group of employees as possible, while at the same time providing protection to those employees as investors. Another benefit to allowing an expanded group of employees to invest in private funds is the elimination of the potential for conflicts of interest when an employee invests independently in the same types of securities as a fund managed by the employer or an affiliate.
We suggest that all employees, including Excluded Employees, be allowed to invest in such funds if they (a) are either "accredited investors" (as defined in Regulation D) or assisted by a "purchaser representative," as that term is used in Regulation D, and (b)the same information regarding the 3(c)(1) or 3(c)(7) fund as is generally provided to other prospective investors in the fund (such as a private placement memorandum). The employees will thus be required, either alone or with a purchaser representative, to meet a standard of experience or sophistication that the SEC has already recognized in other contexts to be sufficient to allow the evaluation of the risks of the investment. Such persons will thereby not be excluded from participation in an important benefit of their employment while they are protected as investors.
If the definition of "knowledgeable employee" is determined as described in the preceding paragraph, and is not tied to participation in or access to knowledge about the "Covered Company," as would be defined in Proposed Rule 3c-5(a)(1), there is no reason to exclude from the definition an officer or employee of an affiliate of the Covered Company that does not manage the investment activities of the Covered Company. Large financial services firms are often composed of a number of affiliated investment advisers and/or broker-dealers and those entities manage a number of investment products. Employees of one affiliate may want to invest in a product managed by another affiliate. This type of employee participation can be an important recruiting tool and can also mitigate or prevent conflicts of interest. In our view, there does not appear to be any regulatory reason to discourage such participation if the investor protections described in the preceding paragraph are present.
E. Certain Transfers .
Proposed Rule 3c-6 would deem beneficial ownership by certain transferees of interests in 3(c)(1) and 3(c)(7) funds to be beneficial ownership by, respectively, the 3(c)(1) transferor or a qualified purchaser under certain conditions, including that the transferee be a related person of the transferor. We see no reason for the transferee by gift, bequest, death or other involuntary action to be required to be a related person. There is no indication in section 3(c)(7) of the Act or in the legislative history of the 1996 Act ( see S. Rep. No.104th Cong., 2d Sess. in the text following note 77) that a transferee by gift or bequest from a qualified purchaser must be a member of the transferor's family.
We suggest that the requirement that the transferee be a related person of the transferor be deleted from Proposed Rule-6. If, however, the SEC retains this requirement, the definition of "related person" should be expanded to include aunts, uncles, nieces, nephews and cousins of the transferor, as such extended family members are likely to be beneficiaries by gift or bequest from unmarried transferors.
We also suggest that the rule clarify that any such transferee may invest profits or contribute additional capital. If this point is not resolved, it will be unclear whether a 3(c)(1) or 3(c)(7) fund that automatically reinvests profits (in the absence of an affirmative redemption notice) or periodically accepts or requires additional capital contributions, can realistically permit a transferee otherwise permitted under Proposed Rule 3c-6 to hold an interest. If the intent is to allow 3c-6 transferees to participate fully in the fund, that intent would be thwarted unless this point is clarified.
We appreciate the opportunity to comment on the Proposed Rules.
SHARTSIS, FRIESE & GINSBURG LLP
|1||/ We understand that our comment on this issue may appear to contradict our proposal that the SEC apply a two-pronged test to determine whether an investor is a qualified purchaser, with the second prong being a net worth test (see section We believe that our two-pronged proposal is not contrary to Congressional intent, however, because the second prong, the net worth test, is proposed as an addition to, and not in lieu of, the first test, which is the "investment" test. It is being proposed as an addition only to clarify the nature of the investments held by the investor, and its addition would make any deductions for indebtedness unnecessary.|