Buying What You Are Selling

June 29, 2020  |  By

An Investment Company is a company that issues securities and is primarily engaged in the business of investing in securities. Unless there is an exemption, an Investment Company needs to file with the SEC and make certain disclosures to investors. Most “private” funds like the common hedge fund or venture capital fund are organized with the specific intent to fit under an exemption so as to avoid the often profitability prohibitive filing and resulting disclosures. The SEC defines three types of investment companies: closed-end funds, mutual funds, and unit investment trusts. You might notice that these are usually very large, complex, and public fund structures, not your standard private fund offering. 

One of the SEC’s underlying themes is that offerings of certain sizes must be registered and subject to the various SEC requirements. Hence, they’ve offered exemptions for smaller, private funds. The most popular exemptions are what we commonly refer to as the 501(3)(c)(1) (on the street the “3-c-1 funds”) and the 501(3)(c)(7) (coined the “3-c-7 funds”) exemptions.  

Both exemptions require that the fund does not make a public offering of its securities offering. Most funds meet this requirement by filing under Rule 506 of Regulation D ( a “reg D filing”). One of the requirements of a Reg D filing is that all investors must be an accredited investor (total assets generally over $1M). If not accredited, the investors are limited to 35 and the fund is required to make additional disclosures.

Next to fall under the 3(c)(1) exemption, the fund’s investors must be limited to 100.

A venture capital fund that qualifies for the 3(c)(1) exemption may have up to 250 investors if the fund is less than $10M and it meets certain requirements qualifying it as “venture.”

And to fall under the 3(c)(7) exemption, the fund may have up to 1,999 investors but each investor must be a qualified purchaser (total assets generally over $5M).

Some investors, like a knowledgeable employee may not count towards the investor count. An investor set up as an entity probably only counts as “one,” unless it is set up for the sole purpose of investing in this fund.

Above we mention that the SEC traditionally requires funds of certain sizes to register and provide additional disclosures with the offering. While individual funds may qualify for the exemption individually, the SEC may feel differently. The integration doctrine attempts to identify when seemingly separate offers should be combined and treated as one offer. Thus, if an advisor manages two funds that are technically different (names, offering periods, etc.) but in practice the same (similar terms, investment model and holdings), the SEC may conclude that these are indeed one fund and should be integrated together. The combination of both investor counts may push the funds outside of the exemption. The integration doctrine is meant to prohibit private funds from simply “copy/pasting” their fund structure in order to maintain their exemption status. However, it may unknowingly complicate matters for those funds who run series or various “vintages” over time.

Lastly, it is imperative that you speak with an attorney regarding your specific situation anytime you are giving financial advice, analysis, opinions, or commentary to a third party. As you will see throughout this series, there are many pieces of law that weave together to make this a sticky legal genre.

About the Author(s)

Lacey Shrum

Lacey is an attorney at Vela Wood where she serves businesses that use blockchain technology and digital assets. She serves as a subject matter expert and expert witness to attorneys and advisors as they encounter digital assets in their traditional legal practice.

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