[Federal Register Volume 61, Number 249 (Thursday, December 26, 1996)]
[Proposed Rules]
[Pages 68100-68115]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-32652]



[[Page 68099]]

_______________________________________________________________________

Part II





Securities and Exchange Commission





_______________________________________________________________________



17 CFR Part 270



Private Investment Companies; Proposed Rule

  Federal Register / Vol. 61, No. 249 / Thursday, December 26, 1996 / 
Proposed Rules  

[[Page 68100]]



SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-22405, International Series Release No. 1037, File No. 
S7-30-96]
RIN 3235-AH09


Private Investment Companies

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rules.

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SUMMARY: The Commission is publishing for comment new rules under the 
Investment Company Act of 1940 to implement provisions of the National 
Securities Markets Improvement Act of 1996 that apply to private 
investment companies. The proposed rules would define certain terms for 
purposes of the new exception from regulation under the Investment 
Company Act for private investment companies whose investors are all 
highly sophisticated investors, termed ``qualified purchasers.'' The 
proposed rules also would address certain transition issues related to 
existing private investment companies that have no more than 100 
investors and certain other matters related to private investment 
companies.

DATES: Comments must be received on or before February 10, 1997.

ADDRESSES: Comments should be submitted in triplicate to Jonathan G. 
Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, 
N.W., Stop 6-9, Washington, D.C. 20549. Comments also may be submitted 
electronically at the following E-mail address: [email protected]. 
All comment letters should refer to File No. S7-30-96; this file number 
should be included on the subject line if E-mail is used. Comment 
letters will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 Fifth Street, N.W., Washington, 
D.C. 20549. Electronically submitted comment letters also will be 
posted on the Commission's Internet web site (http://www.sec.gov).

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, Stop 10-2, Securities and Exchange 
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549.

SUPPLEMENTARY INFORMATION: The Commission today is requesting public 
comment on proposed new rules 2a51-1, 2a51-2, 2a51-3, 3c-1, 3c-5, 3c-6 
and 3c-7 under the Investment Company Act of 1940 [15 USC 80a] (the 
``Investment Company Act'' or ``Act'').

Table of Contents

Executive Summary

I. Background
    A. Qualified Purchaser Funds
    B. Amendments to Section 3(c)(1)
    C. Other Directed Rulemaking
II. Rules Relating to Qualified Purchaser Funds
    A. Investments
    1. Definition of Investments
    a. Securities
    b. Real Estate
    c. Commodity Interests
    d. Cash and Cash Equivalents
    e. Request for Comment
    2. Determining the Amount of Investments
    a. Value of Investments
    b. Deductions from Amount of Investments
    i. Certain Indebtedness
    ii. Other Payments
    iii. Request for Comment
    3. Jointly-Held Investments
    4. Investments Held by Certain Corporate Affiliates
    5. Good Faith Reliance on Certain Documentation
    B. Definitions of Beneficial Ownership
    1. The Grandfather Provision
    2. The Consent Provision
    C. Conforming Rule
    D. Non-Exclusive Safe Harbor for Certain Section 3(c)(7) Funds
III. Other Rules for Private Investment Companies
    A. Transition Rule for Section 3(c)(1) Funds
    B. Investments by Fund Employees
    C. Certain Transfers
IV. General Request for Comment
V. Cost/Benefit Analysis
VI. Summary of Regulatory Flexibility Analysis
VII. Statutory Authority
Text of Proposed Rules

Executive Summary

    The Commission is proposing rules to implement certain provisions 
of the National Securities Markets Improvement Act of 1996 (the ``1996 
Act''), which was signed into law by President Clinton on October 11, 
1996. 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 private investment companies that consist solely of highly 
sophisticated ``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 
private 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 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 private investment companies require 
Commission rulemaking as well. The Commission is proposing for public 
comment new rules under the Investment Company Act that would:
     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;
     Address 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) or a 
section 3(c)(7) fund (referred to collectively in this Release as 
``private funds''), and knowledgeable employees of affiliates of these 
funds, to invest in the fund; and
     Address transfers of securities in a private fund when the 
transfer was caused by legal separation, divorce, death, and certain 
other involuntary events.

I. Background

    Section 3(c)(1) of the Investment Company Act excludes from 
regulation under the Act certain private 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
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    \1\ 15 U.S.C. 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.''
    \2\ See Division of Investment Management, SEC, Protecting 
Investors: A Half Century of Investment Company Regulation at 104 
(1992) (hereinafter Protecting Investors Report).

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[[Page 68101]]

A. Qualified Purchaser Funds

    In 1992, the Commission concluded that the 100-investor limit, 
while reasonably reflecting the point beyond which federal regulatory 
concerns incorporated in the Investment Company Act are raised, may 
place unnecessary constraints on investment pools that sell their 
securities exclusively to sophisticated purchasers.3 The 
Commission recommended that Congress amend the Investment Company Act 
to create an alternative exclusion for investment companies whose 
securities are owned exclusively by sophisticated investors.
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    \3\ 138 Cong. Rec. at S4822 (daily ed. Apr. 2, 1992) (Memorandum 
of the Securities and Exchange Commission in Support of the Small 
Business Incentive Act of 1992) (hereinafter Commission Memorandum). 
Some commenters also suggested that section 3(c)(1)'s 100-investor 
limit may have had the effect of providing an incentive for 
Americans to invest in unregulated off-shore markets. See S. Rep. 
No. 293, 104th Cong., 2d Sess. at 10 (1996) (hereinafter Senate 
Report); H.R. Rep. No. 622, 104th Cong., 2d Sess. at 18 (1996) 
(hereinafter House Report). These Reports relate to bills that were 
eventually enacted as the National Securities Markets Improvement 
Act of 1996, Pub. L. No. 104-290 (1996) (the ``1996 Act'') (to be 
codified in scattered sections of the United States Code 
(``U.S.C.''); U.S.C. references are to the sections in which the 
relevant provisions of the 1996 Act will be codified).
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    Congress implemented this recommendation in the 1996 Act. New 
section 3(c)(7) of the Investment Company Act creates an exclusion for 
investment companies whose investors consist solely of ``qualified 
purchasers.'' 4 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,5 (ii) a family-owned 
company (``Family Company'') that owns not less than $5 million in 
investments,6 (iii) certain trusts,7 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.8 The 
1996 Act directs the Commission to prescribe rules defining 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.9
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    \4\ 1996 Act section 209; 15 U.S.C. 80a-3(c)(7). As is the 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\ 15 U.S.C. 80a-2(a)(51)(A)(i).
    \6\ A Family Company is a company ``that is owned directly or 
indirectly by or for two 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 for the benefit of such persons . . . .'' 15 
U.S.C. 80a-2(a)(51)(A)(ii).
    \7\ 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. 15 U.S.C. 
80a-2(a)(51)(A)(iii).
    \8\ A qualified purchaser that meets the $25 million threshold 
may act for its own account or for the accounts of other qualified 
purchasers. 15 U.S.C. 80a-2(a)(51)(A)(iv).
    \9\ 1996 Act section 209(d)(2). Such rules are required to be 
prescribed by April 9, 1997 (180 days after the enactment of the 
1996 Act). The provisions of the 1996 Act enacting section 3(c)(7) 
take effect on the earlier of April 9, 1997 or the date on which the 
rulemaking defining the term investments is completed.
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    Section 3(c)(7) includes a ``grandfather'' provision that allows an 
existing section 3(c)(1) fund to convert into a section 3(c)(7) fund 
(``Grandfathered Fund''). The outstanding securities of a Grandfathered 
Fund may be beneficially owned by as many as 100 persons who are not 
qualified purchasers, provided that these persons acquired their 
investment in the Grandfathered Fund on or before September 1, 
1996.10 The grandfather provision is designed to allow an existing 
section 3(c)(1) fund wishing to avail itself of the new section 3(c)(7) 
exclusion to continue its existing relationships with investors who are 
not qualified purchasers.11
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    \10\ 15 U.S.C. 80a-3(c)(7)(B).
    \11\ See 142 Cong. Rec. at E1938 (Oct. 21, 1996) (Remarks of 
Hon. John D. Dingell); 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. (1995) (prepared statement of Marianne 
Smythe); 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, 779 (Dec. 5, 1995) (hereinafter Hedge Funds Task 
Force Report). The grandfather provision is not intended, however, 
to allow a sponsor of a section 3(c)(1) fund to nominally give the 
fund section 3(c)(7) status in order to be able to operate another 
section 3(c)(1) fund and thereby circumvent the 100-investor limit. 
Remarks of Hon. John D. Dingell, supra; see also section II.D of 
this Release.
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    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 such owner's interest in the fund.12 
This provision is designed to enable an investor in an existing section 
3(c)(1) fund to dispose of an investment, without penalty, if the 
investor does not choose to continue its investment in a private 
investment company that no longer will be limited to 100 
investors.13 The 1996 Act directs the Commission to define the 
term ``beneficial owner'' for this purpose.14 The 1996 Act also 
requires an existing section 3(c)(1) fund that wishes to become a 
qualified purchaser to obtain the consent of the beneficial owners of 
its securities and certain other persons (the ``consent 
provision'').15
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    \12\ 15 USC 80a-3(c)(7)(B)(ii).
    \13\ See 142 Cong. Rec. at E1929 (Oct. 4, 1996) (Remarks of Hon. 
Thomas J. Bliley, Jr.).
    \14\ 1996 Act section 209(d)(4). Such rules are required to be 
prescribed by April 9, 1997. See supra note 9.
    \15\ 15 USC 80a-2(a)(51)(C).
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    The Commission is proposing a rule under the Investment Company Act 
to define the term ``investments'' for purposes of the qualified 
purchaser definition. The Commission also is proposing rules to define 
the term ``beneficial owner'' for purposes of the grandfather and the 
consent provisions, and to address other transitional and 
interpretative issues related to section 3(c)(7).

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 the provision ``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 its 
securities.\16\ The look-through provision currently applies (i) if a 
company owns 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 are invested in section 3(c)(1) funds generally (``second 10% 
test'').\17\
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    \16\ 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 holder thereof to vote for election of directors [of 
the issuer] thereof.'' 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\ To illustrate the operation of the current look-through 
provision, assume Company A is seeking to rely on the provisions of 
section (3)(c)(1). If one of Company A's security holders, Company 
B, beneficially owns 10% or more of Company A's voting securities, 
then the security holders of Company B would be counted as security 
holders of Company A (under the first 10% test), unless no more than 
10% of Company B's assets consist of securities of section 3(c)(1) 
funds (the second 10% test).
    The operation of the 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 the consent 
provisions. See section II.B. of this Release.
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    The 1996 Act's amendments to section 3(c)(1) are designed, in part, 
to

[[Page 68102]]

simplify the way in which the number of investors in a fund is 
calculated for purposes of the 100-investor limit.\18\ When the 
relevant provisions of the 1996 Act become effective,\19\ the amended 
look-through provision will no longer apply to a security holder that 
is an operating company (i.e., a company that is not an investment 
company or a private fund).\20\ 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.\21\
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    \18\ These changes also had been recommended by the Commission 
in 1992. See Commission Memorandum, supra note 3; see also 
Protecting Investors Report, supra note 2, at 108-09.
    \19\ The amendments to section 3(c)(1)(A) will become effective 
on the earlier of April 9, 1997 or the date on which the rulemaking 
defining the term investments is completed. 1996 Act section 209(e).
    \20\ 15 USC 80a-3(c)(1)(A).
    \21\ See Testimony of Arthur Levitt, Chairman, SEC, Concerning 
S. 1815, the Securities Investment Promotion Act of 1996, Before the 
Senate Committee on Banking, Housing and Urban Affairs (June 5, 
1996).
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    The 1996 Act not only limits the scope of the look-through 
provision, but also seeks to simplify it by eliminating the second 10% 
test. The look-through provision will apply whenever an investment 
company, including a private fund, owns 10% or more of a section 
3(c)(1) fund, regardless of whether or not the investment company has 
more than 10% of its assets invested in section 3(c)(1) funds 
generally. 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.\22\
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    \22\ See, e.g., Protecting Investors Report, supra note 2, at 
106-09.
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    These amendments, while attempting to simplify the look-through 
provision and make it more consistent with its regulatory purpose, may 
create interpretative issues for existing section 3(c)(1) funds that 
have investors to which the first, but not the second, 10% test 
applies. The Commission is proposing a rule to address these issues.

C. Other Directed Rulemaking

    The 1996 Act directs the Commission to prescribe two sets of rules 
relating to private funds.\23\ The 1996 Act directs the Commission to 
prescribe rules permitting ``knowledgeable employees'' of a private 
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.\24\ The purpose of this provision 
appears to be to allow private funds to offer persons who participate 
in the funds' management the opportunity to invest in the fund as a 
benefit of employment.\25\
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    \23\ 1996 Act section 209(d).
    \24\ 1996 Act section 209(d)(3). These rules are required to be 
promulgated no later than October 11, 1997 (1 year after enactment 
of the 1996 Act).
    \25\ 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. 22-23 (1995) (testimony of Barry P. Barbash, Director, 
Division of Management, SEC).
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    The Commission is proposing a rule to allow directors, executive 
officers, general partners, and other knowledgeable employees of a 
section 3(c)(1) fund to invest in the fund without being counted for 
purposes of the fund's 100-investor limit. The proposed rule similarly 
would allow knowledgeable employees of a section 3(c)(7) fund to invest 
in the fund even though they may not meet the definition of qualified 
purchaser. The rule also would permit investments by knowledgeable 
employees of affiliates that manage the investment activities of these 
funds.
    In addition to directing the Commission to adopt rules relating to 
investments by knowledgeable employees, the 1996 Act directs the 
Commission to prescribe rules implementing section 3(c)(1)(B) of the 
Act.\26\ 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 made, pursuant to such rules and 
regulations as the Commission prescribes.\27\ The Commission is 
proposing a rule to permit securities acquired by a person as a result 
of certain transfers to be treated as being beneficially owned by the 
original beneficial owner. The proposed rule would address similar 
transfers of securities issued by section 3(c)(7) funds.\28\
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    \26\ 1996 Act section 209(d)(1).
    \27\ 15 USC 80a-3(c)(1)(B).
    \28\ See 15 USC 80a-3(c)(7)(A) (permitting certain transfers by 
qualified purchasers).
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II. Rules Relating to Qualified Purchaser Funds

A. Investments

    The 1996 Act provides that the term investments is to be defined by 
Commission rule. Section 2(a)(51)(B) of the Act also gives the 
Commission authority to prescribe such rules and regulations governing 
qualified purchasers as the Commission determines are necessary or 
appropriate in the public interest or for the protection of investors.
    In explaining why Congress deferred to the Commission's defining 
what constitutes an investment for purposes of the $5 million/$25 
million thresholds, 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 Investment Company Act.\29\ These investors 
are likely to be able to evaluate on their own behalf matters such as 
the level of a fund's management fees, governance provisions, 
transactions with affiliates, investment risk, leverage and redemption 
or withdrawal rights.\30\ Congress appears to have expected that the 
definition of investments be broader than securities, but not that 
every asset be treated as an investment. Rather, the legislative 
history suggests that the asset should be held for investment purposes 
and that the nature of the asset should indicate a significant degree 
of investment experience and sophistication such that the investor can 
be expected to have the knowledge to evaluate the risks of investing in 
unregulated investment pools.\31\
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    \29\ See Senate Report, supra note , at 10.
    \30\ Id.
    \31\ The Senate Report gave family-owned businesses and personal 
residences as examples of assets that should not be considered to be 
investments. See id. at 10.
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    Proposed rule 2a51-1 under the Investment Company Act seeks to 
define the term investments consistent with the principles set forth in 
the legislative history. The proposed rule would define investments 
broadly to include securities (other than controlling interests in all 
but certain issuers), and real estate, futures contracts, physical 
commodities, and cash and cash equivalents held for investment 
purposes. Proposed rule 2a51-1 also contains certain provisions 
designed to clarify how the amount of a person's investments would be 
determined (including investments held jointly with a spouse and 
investments held by certain affiliated entities). The proposed rule 
would permit a section 3(c)(7) fund to rely, in good faith, on certain 
documentation in determining a person's eligibility as a qualified 
purchaser.

[[Page 68103]]

1. Definition of Investments
a. Securities
    Proposed rule 2a51-1(b)(1) would include securities within the 
definition of investments. Defining investments in this way should 
result in a broad range of investments being treated as such for 
purposes of section 3(c)(7). Many investment opportunities are offered 
through entities that issue securities, such as limited partnerships 
and limited liability companies.\32\
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    \32\ For example, the term security includes any ``fractional 
undivided interest in oil, gas or other mineral rights.'' See 
section 2(1) of the Securities Act of 1933 (``Securities Act'') [15 
USC 70a(1)].
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    Under the proposed rule, securities of an issuer with which the 
prospective qualified purchaser has a control relationship generally 
would not come within the definition of investments for purposes of 
section 3(c)(7).\33\ Limiting the definition in this manner is designed 
to exclude, among other things, controlling ownership interests in 
family-owned and other closely held businesses, and controlled 
subsidiaries of operating companies. These holdings would appear not to 
demonstrate the degree of financial sophistication necessary to invest 
in unregulated investment vehicles or securities generally.
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    \33\ The proposed rule would exclude 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 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.'' 15 USC 80a-
2(a)(9). 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.
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    The proposed rule would not exclude from the definition of 
investments controlling ownership interests in investment companies and 
other issuers excepted from the definition of investment company by 
sections 3(c)(1) through 3(c)(9) of the Act.\34\ Ownership of a 
controlling interest in these types of companies generally suggests a 
significant degree of investment experience. The proposed rule also 
would not exclude a controlling ownership interest in a ``listed'' 
company (e.g., 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 
an offshore securities exchange) that is not a majority-owned 
subsidiary of the prospective qualified purchaser.\35\ A controlling 
ownership interest in a company listed on a national securities 
exchange or traded on NASDAQ is likely to evidence knowledge of and 
experience in dealing with investment risk, securities-related 
disclosure, corporate governance, transactions with affiliates, 
leverage, and other issues relevant to a person's ability to evaluate 
investment in a pooled investment vehicle. The proposed inclusion of 
securities traded on a ``designated offshore securities market'' is 
intended to include securities of foreign issuers that trade in an 
organized market that is not regulated by the Commission.
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    \34\ 15 USC 80a-3(c) (1) through (9). In addition to private 
investment companies, sections 3(c)(1) through (9) except from the 
definition of investment company certain types of issuers that 
engage in significant investment-related activities (i.e., brokers 
and other financial intermediaries, banks, insurance companies, and 
finance companies). A controlling interest in a foreign bank, 
foreign insurance company or structured finance vehicle also would 
be included as an investment, even if the issuer is not considered 
to be an investment company under rules 3a-6 or 3a-7 under the Act 
[17 CFR 270.3a-6 and 3a-7].
    \35\ A company would be considered to be a ``listed company'' if 
it has outstanding a class of equity securities that are (i) 
``reporting securities'' under rule 11Aa3-1 of the Securities 
Exchange Act of 1934 (``Exchange Act'') [17 CFR 240.11Aa3-1] (i.e., 
securities listed and registered, or admitted to unlisted trading 
privileges, on a national securities exchange or for which quotation 
information is disseminated in the NASDAQ and for which transaction 
reports are required to be made on a real-time basis pursuant to an 
effective transaction reporting plan) or (ii) listed on a 
``designated offshore securities market'' (as such term is defined 
in Regulation S under the Securities Act [17 CFR 230.901 et seq.]).
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    Comment is requested on the proposed exclusions from the definition 
of investments for certain securities. Should other controlling 
interests (such as controlling interests in large, but privately held, 
companies) be treated as investments for purposes of section 3(c)(7)? 
\36\ In the alternative, should the listed company exception be 
applicable if any securities of the issuer have been offered to the 
public, even if periodic reports with respect to the issuer's 
securities are no longer required to be filed under the Securities 
Exchange Act of 1934 (``Exchange Act'')? \37\ Should foreign securities 
be considered listed securities based on criteria other than, or in 
addition to, whether they trade on a designated offshore securities 
market (such as a public float requirement or a requirement that 
American Depositary Receipts with respect to these securities be traded 
in the U.S.)?
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    \36\ For example, a controlling interest in a company that has 
shareholders equity in excess of a specified amount (e.g., $50 
million or $100 million) could be treated as an investment on the 
theory that the size of the company suggests a certain level of 
financial sophistication on the part of the control person.
    \37\ See sections 12(b), 12(g) and 15(d) of the Exchange Act [15 
USC 78l(b), 78l(g) and 78o(d)].
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    Comment also is requested whether other types of business holdings 
(whether or not characterized as securities) should be treated as 
investments. For example, should any passive ownership interest in a 
trade or business be considered to be an investment? \38\ Finally, 
comment is requested whether other types of securities should be 
excluded from the definition of investments because they do not serve 
as an appropriate measure of investment experience.
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    \38\ A passive ownership interest could be defined for these 
purposes as an interest in a trade or business in which such person 
does not materially participate. See Internal Revenue Code (``IRC'') 
section 469(c)(1) [26 USC 469(c)(1)].
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b. Real Estate
    Proposed rule 2a51-1(b)(2) would include real estate held for 
investment purposes within the definition of investments. Consistent 
with the examples provided by the legislative history of the 1996 Act, 
real estate would not be 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).\39\ 
The term ``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.'' \40\ 
Thus, residential property could be treated as an investment if it is 
not treated as a residence for tax purposes. The Commission believes 
that reference to the Internal Revenue Code provisions is appropriate 
because it would allow prospective qualified purchasers to determine 
whether the residential real estate is an investment based on the same 
provisions they would apply in

[[Page 68104]]

determining whether certain expenses related to the property are 
deductible for purposes of completing their tax returns. Comment is 
requested on the proposed approach. Would alternative approaches (such 
as not treating the property as held for investment purposes if it is 
used at any time for personal purposes) be easier to apply?
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    \39\ Proposed rule 2a51-1(c). Proposed rule 2a51-1(a)(5) would 
define ``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 such descendant. See also section 
2(a)(51)(A)(ii) of the Act [15 USC 80a-2(a)(51)(A)(ii)] (specifying 
who is considered a family member for purposes of the Family Company 
definition).
    \40\ IRC section 280A(d) [26 USC 280A(d)]. The proposed rule 
would treat 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 
days during which the unit is rented at a fair market value.
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    Property owned by the 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'') would not be considered to be 
held for investment purposes.\41\ 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.
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    \41\ Proposed rule 2a51-1(c).
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    Comment is requested on including real estate as an investment for 
purposes of the proposed rule. Does real estate investing sufficiently 
reflect the kind of financial sophistication required to understand the 
risks of investing in an unregulated investment pool? Should real 
estate be included as an investment for purposes of the proposed rule 
only if the investment is in the form of a security?
c. Commodity Interests
    Proposed rule 2a51-1(b)(3) would include contracts for the purchase 
or sale of a commodity for future delivery (``commodity interests'') 
held for investment purposes within the definition of 
investments.42 Commodity interests are often used by investors to 
hedge their portfolios from declines in securities prices, changes in 
interest rates, or foreign currency fluctuations. Commodity interests 
also may provide a means to invest in the commodities markets.
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    \42\ Paragraph (a)(1) of proposed rule 2a51-1 would define 
commodity interests to mean commodity futures contracts, options on 
a 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 et seq.] 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.
    A futures contract generally is a bilateral agreement providing 
for the purchase or sale of a specified commodity at a stated time 
in the future for a fixed price. Robert E. Fink & Robert B. 
Feduniak, Futures Trading at 10 (1988). A commodity option gives its 
holder the right, for a specified period of time, to either buy (in 
the case of a call option) or sell (in the case of a put option) the 
subject of the option at a predetermined price. The writer (seller) 
of an option is obligated to sell or buy the specified commodity at 
the election of the option holder. 1 Philip M. Johnson & Thomas L. 
Hazen, Commodities Regulation at section 1.07 (2d ed. Supp. 1994) 
(hereinafter Johnson & Hazen).
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    Commodity interests would be included as investments to the extent 
of the initial margin and option premium deposited with a futures 
commission merchant.43 This approach is similar to that taken by 
rule 4.7 under the Commodity Exchange Act, which makes available a 
simplified regulatory framework for private commodity pools offered to 
certain sophisticated investors.44 Gains and losses on commodity 
interests generally would be reflected in changes in the prospective 
qualified purchaser's cash position (which also could be treated as an 
investment).45 Comment is requested on the proposed approach to 
treating commodity interests. Since the value of the commodity interest 
generally would be reflected in the investor's cash position (including 
initial margin), is it necessary for the rule to include commodity 
interests? Would the rule be easier to apply if it explicitly provided 
that ``variation margin'' posted to the commodity account of the 
prospective qualified purchaser to reflect gains could be treated as an 
investment for purposes of the rule? Would another formulation for 
determining how to value commodity interests be more appropriate?
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    \43\ Proposed rule 2a51-1(d)(1). To enter into a futures 
contract or write a commodity option, a customer typically deposits 
with a futures commission merchant (``FCM''), as security for 
performance of its obligations, a specified amount of assets or cash 
as ``initial margin.'' Initial margin is not considered part of the 
contract or option price, and is returned upon termination of the 
position, unless used to cover a loss. Johnson & Hazen, supra note 
42, at section 1.10.
    \44\ 17 CFR 4.7. In taking this approach, the Commodity Futures 
Trading Commission noted that ``account equity in excess of the 
minimum necessary for margin or option premiums is not includable 
because it has no necessary correlation with actual commodity 
interest transactions.'' See Exemption for Commodity Pool Operators 
With Respect to Offerings to Qualified Eligible Participants; 
Exemption for Commodity Trading Advisors With Respect to Qualified 
Eligible Clients, 57 FR 34853, 34855 n.17 (Aug. 7, 1992). Rule 4.7 
under the CEA establishes a different threshold for securities 
investments ($2,000,000 market value) and commodity interests 
($200,000 initial margin). Since the proposed rule would permit cash 
to be treated as an investment (see section II.A.2.d. of this 
Release), it would not be appropriate to incorporate this dual 
threshold into the proposed rule.
    \45\ See section II.A.1.d of this Release. An FCM must, on a 
daily basis, reconcile its customers' positions by crediting gains 
and debiting losses on a customer-by-customer basis. See CEA rule 
1.32 [17 CFR 1.32] (requiring daily computation of customer 
accounts); see also Custody of Investment Company Assets with 
Futures Commission Merchants and Commodity Clearing Organizations, 
Investment Company Act Rel. No. 22389 (Dec. 11, 1996) [61 FR 66207 
(Dec. 17, 1996)].
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    The proposed rule also would include in the definition of 
investments commodities that are held in physical form and for 
investment purposes.46 This provision would recognize that many 
investors hold gold, silver or other commodities as part of their 
investment portfolios. Commodities that are used as part of a trade or 
business (such as grain held by a food processor as part of its 
inventory or raw materials) would not be considered to be investments.
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    \46\ Proposed rule 2a51-1(b)(4). Physical commodities, for 
purposes of the proposed rule, would be defined as any commodity 
with respect to which a commodity interest is traded on a domestic 
or foreign commodities exchange. Proposed rule 2a51-1(a)(4). This 
approach is designed to provide certainty on the types of 
commodities that would be considered investments.
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    Comment is requested on the proposed inclusion of commodity 
interests and commodities within the definition of investments. Should 
any other types of financial instruments, to the extent they are not 
addressed by the proposed rule, be included within the definition of 
investments? 47
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    \47\ See, e.g., section 3(c)(2) of the Act, as amended by the 
1996 Act [15 USC 80a-3(c)(2)] (defining the term ``financial 
contract'').
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d. Cash and Cash Equivalents
    Proposed rule 2a51-1(b)(5) would include cash and cash equivalents 
held for investment purposes (``cash'') in the definition of 
investments.48 The Commission is proposing to include cash as an 
investment to reflect its views that many investors are likely at any 
given time to have a component of their investment portfolio in 
cash.49 The rule would specify that the cash would have to be held 
by the prospective qualified purchaser for investment purposes. Thus, 
cash used by the prospective qualified purchaser to meet its day-to-day 
expenses (or, in the case of a prospective qualified purchaser that is 
a business, its working capital) would

[[Page 68105]]

not be included for purposes of determining whether the prospective 
qualified purchaser has the requisite amount of investments.
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    \48\ Cash and cash equivalents would generally be considered to 
include cash, bank deposits, certificates of deposit, bankers 
acceptances and other bank instruments. See, e.g., Investment 
Company Act Rel. No. 10937 (Nov. 13, 1979) [44 FR 66608 (Nov. 20, 
1979)]; Statement of Cash Flows, Statement of Financial Accounting 
Standards No. 95, at section 95.08 (Fin. Accounting Standards Bd. 
1987); Treas. Reg. section 220.2 (as amended in 1996) [Fed. Sec. L. 
Rep. (CCH) para. 22,252]. The cash surrender value of an insurance 
policy (net of any loans) would also be considered to be a cash 
equivalent. Certain of the instruments that are considered to be 
cash equivalents (e.g., shares of money market mutual funds, certain 
Government securities) for purposes of these sources are securities 
and would be treated as investments for purposes of the proposed 
rule.
    \49\ 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 or cash equivalents may also be integral to certain 
sophisticated investment strategies (such as hedging).
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    Comment is requested on the proposed inclusion of cash as an 
investment. Should cash only be included if it is in excess of a 
certain amount (e.g., $25,000)? Should the rule provide examples of 
when cash would be considered to be held for investment purposes (i.e., 
if it represents proceeds from the sale of investments occurring during 
the preceding six months)? Should cash be included only if ``investment 
securities'' and other types of investments (e.g., real estate) 
constitute more than a specified average amount or percentage of the 
prospective qualified purchaser's investment portfolio (e.g., 25%, 50% 
or 75%) over the prior 12-month period? 50
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    \50\ Section 3(a)(3) of the Act [15 USC 80a-3(a)(3)] defines the 
term ``investment securities'' as all securities except (A) 
Government securities, (B) securities issued by employees' 
securities companies, and (C) securities issued by majority-owned 
subsidiaries of the owner which are not investment companies. Upon 
effectiveness of the 1996 Act's amendments related to section 
3(c)(7) funds, the term investment securities also will exclude 
majority-owned subsidiaries that are section 3(c)(1) or section 
3(c)(7) funds. See section 209(c)(6) of the 1996 Act.
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e. Request For Comment
    Comment is generally requested on the proposed definition of 
investments. Certain assets (such as jewelry, art work, antiques, and 
other collectibles) that may be held by some individuals as investments 
are not included because they do not necessarily suggest any experience 
in the financial markets or investing in unregulated investment 
pools.\51\ Should such assets be included if held for investment 
purposes? Should any property that produces income from interest, 
dividends, annuities or royalties not derived in the ordinary course of 
a trade or business be treated as an investment? \52\ Commenters should 
explain how these types of investments can serve as indicia of 
sophistication in investment matters. Finally, should any assets that 
are proposed to be included within the definition of investments not be 
included?
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    \51\ See Hedge Funds Task Force Report, supra note 11, at 788 
(suggesting that automobiles, jewelry and art be excluded from 
investments for purposes of measuring financial sophistication).
    \52\ See IRC section 163(d)(5) [26 USC 163(d)(5)] (definition of 
``property held for investment'' under tax code provisions allowing 
a limited deduction for investment interest).
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2. Determining the Amount of Investments
    Proposed rule 2a51-1 would allow the amount of a prospective 
qualified purchaser's investments to be based on either the market 
value of the investments or their cost. In either case, certain 
deductions from the amount of investments owned would have to be made 
as discussed below.
a. Value of Investments
    Proposed rule 2a51-1(d) would specify that the value of an 
investment would be determined based either on its market value on a 
recent date or its cost.\53\ A section 3(c)(7) fund could determine 
which methodology to use, or could allow prospective qualified 
purchasers to provide the amount of their investments based on either 
methodology. The Commission believes that this approach is appropriate 
because either the cost or market value of the prospective qualified 
purchaser's investments may provide an appropriate starting point for 
assessing the person's investment experience.
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    \53\ 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)]. In the case of other investments, 
other reasonable methods to ascertain market value (such as real 
estate appraisals by independent third parties) could be used. A 
prospective qualified purchaser could not use a ``fair value'' 
method of valuation such as that contemplated by rule 2a-4 under the 
Act [17 CFR 270.2a-4]. In the absence of a readily ascertainable 
market value, the value of an investment always would be based on 
its cost.
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    Comment is requested on the proposed approach to valuing 
investments. Should the proposed rule instead take an approach similar 
to that taken in rule 144A under the Securities Act, which generally 
requires that securities be valued at cost even if a market value is 
available? \54\ Would that approach make it easier for a section 
3(c)(7) fund to determine the continuing status of an investor as a 
qualified purchaser when the investor adds to its investment in the 
fund? \55\
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    \54\ See 17 CFR 230.144A(a)(3) (requiring securities to be 
valued at cost, unless a person reports its securities holdings in 
its financial statements on the basis of their fair market value, or 
no current information with respect to the cost of those securities 
has been published).
    \55\ See section 3(c)(7)(A) of the Investment Company Act 
(providing 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'').
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b. Deductions From Amount of Investments
(i) Certain Indebtedness
    The Commission believes 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 leverage or similar means. As a 
result, the proposed rule would require that the amount of any 
outstanding indebtedness incurred to acquire investments owned by a 
prospective qualified purchaser be deducted from that person's amount 
of investments. This requirement would apply to all types of 
prospective qualified purchasers.\56\
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    \56\ Proposed rule 2a51-1(e). The proposed rule would not 
require the deduction to be made with respect to investments that 
the person manages on a discretionary basis for others.
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    The Commission is concerned that section 3(c)(7) funds may have 
difficulty in determining whether certain indebtedness was incurred to 
acquire investments. To address this issue, the proposed rule would 
require that certain indebtedness, if incurred during the preceding 12 
months, be deducted from the amount of the person's investments, 
regardless of whether the proceeds of the indebtedness can be directly 
traced to the acquisition of investments. These provisions are 
generally applicable to natural persons and Family Companies.
    The amount of any loan to a natural person secured by a mortgage on 
the person's personal residence or other non-investment real estate 
would be deducted unless the proceeds of the loan were used solely to 
finance the acquisition or improvement of the property or to refinance 
an outstanding mortgage (``real estate loans'').\57\ The intent of this 
provision is 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 million threshold.\58\
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    \57\ Proposed rule 2a51-1(f) (4) and (5). The proceeds of a 
refinancing loan would be deducted to the extent that the amount of 
the new loan exceeds the lowest principal amount of the refinanced 
loan outstanding during the preceding 12 months.
    \58\ This deduction would generally apply to real estate that is 
not held for investment purposes. Outstanding indebtedness incurred 
to acquire investment real estate would already have been deducted 
as required by proposed rule 2a51-1(e).
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    Under the proposed rule, a Family Company would be required to 
deduct the amount of any outstanding indebtedness incurred by any of 
the Company's owners to acquire the investments held by the 
Company.\59\ In addition, a Family Company would have to deduct the 
amount of any real estate loans that any owner of the Family Company 
would have had to deduct if the owner were the

[[Page 68106]]

prospective qualified purchaser.\60\ Finally, the proposed rule would 
require a Family Company to deduct (i) 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 exceeds the fair 
market value of any assets of the Family Company other than investments 
and (ii) 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.\61\ These provisions would provide further assurance that 
indebtedness incurred by the Family Company or its owners to acquire 
investments was appropriately deducted.
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    \59\ Proposed rule 2a51-1(g)(1).
    \60\ Proposed rule 2a51-1(g)(2).
    \61\ Proposed rule 2a51-1(g)(3) and (4).
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    Comment is requested whether the rule should contain other 
provisions to clarify the extent to which indebtedness should be 
treated as incurred to acquire the investment. For example, should any 
indebtedness collateralized by the investment (whether directly or 
indirectly) be deemed to have been incurred to acquire the investment?
(ii) Other Payments
    Prospective qualified purchasers who are natural persons would be 
required to deduct from the amount of their investments certain other 
amounts received during the preceding 12 months that could inflate the 
amount of their investments (particularly cash) without reflecting any 
investment experience. These amounts include payments received pursuant 
to an insurance policy; the value of any investments received by the 
person as a gift or bequest or pursuant to an agreement related to a 
legal separation or divorce; and any amount received by the person in 
connection with a lawsuit.\62\
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    \62\ Proposed rule 2a51-1(f)(1) through (3). A Family Company 
would have to deduct any such payments received by the Company or by 
any owner of the Company. Proposed rule 2a51-1(g)(2).
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(iii) Request for Comment
    Comment is requested concerning the proposed approach for deducting 
indebtedness and other payments. Should the rule establish guidelines 
or presumptions concerning whether indebtedness was incurred to acquire 
an investment? Should other specified types of indebtedness or payments 
be deducted from the amount of investments?
    Comment also is requested whether the 12-month period is sufficient 
to establish, for example, that a person who has received a $5 million 
bequest is sufficiently sophisticated to be treated as a qualified 
purchaser based on investments that may have been made with that 
bequest? Would a longer (e.g., 24 months) or shorter (e.g., six months) 
period be more appropriate? In lieu of, or in addition to, the 12-month 
period, should the rule reduce the amount of the deductions to the 
extent that the prospective qualified purchaser can trace the use of 
the proceeds of the loans or other payments to non-investment 
activities?
3. Jointly Held Investments
    The proposed rule would clarify 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 (``joint investments'').\63\ 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. On the other hand, if each spouse owned, 
individually, $3 million of investments, but the spouses did not own 
any joint investments, neither spouse would be a qualified 
purchaser.\64\ Comment is requested on the proposed approach to joint 
investments. Should spouses that hold not less than $5 million in 
investments in the aggregate (regardless of whether the investments are 
held jointly) be treated as qualified purchasers if they make a joint 
investment in a section 3(c)(7) fund?
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    \63\ Proposed rule 2a51-1(h). Joint investments also would 
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 would have to deduct from the amount of any 
joint investments any amounts that the spouse would have had to 
deduct (e.g., indebtedness incurred to acquire the investments or 
bequests received by the spouse). Id.
    \64\ This rule would not affect whether a spouse that is not a 
qualified purchaser can hold a joint interest in a section 3(c)(7) 
fund with his or her qualified purchaser spouse. Section 
2(a)(51)(A)(i) of the Act provides that such a joint interest can be 
held.
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4. Investments Held by Certain Corporate Affiliates
    The proposed rule generally would permit a parent company in a 
corporate structure that is a prospective qualified purchaser to 
aggregate investments it owns with those owned by its wholly-owned and 
majority-owned subsidiaries. The investments of these affiliated 
entities would have to be managed under the direction of the parent 
company.65 This approach appears to be an appropriate way to 
address, 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.66 Comment is 
requested whether there are other structures for holding ownership 
interests in investments that should be addressed by the proposed rule. 
Should the rule also require the subsidiary to be consolidated with the 
parent company under Generally Accepted Accounting Principles? 67
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    \65\ Proposed rule 2a51-1(i).
    \66\ See, e.g., Resale of Restricted Securities; Changes To 
Method of Determining Holding Period of Restricted Securities Under 
Rules 144 and 145, Securities Act Rel. No. 6862 (Apr. 23, 1990) [55 
FR 17933 (Apr. 30, 1990)] (describing bank holding company 
structures).
    \67\ See rule 144A(a)(4) under the Securities Act [17 CFR 
230.144A(a)(4)].
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5. Good Faith Reliance on Certain Documentation
    The proposed rule would permit a section 3(c)(7) fund or a person 
acting on its behalf, when determining whether a prospective investor 
is a qualified purchaser, to rely upon audited financial statements, 
brokerage account statements and other appropriate information and 
certifications provided by the prospective purchaser or its 
representatives, as well as upon publicly available information as of a 
recent date.68 Reliance on this information must be reasonable and 
the section 3(c)(7) fund or its representatives, after reasonable 
inquiry, must have no basis for believing that the information is 
incorrect in any material respect. Comment is requested whether rule 
2a51-1 should include a list of documentation similar to that included 
in rule 144A under the Securities Act.69
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    \68\ Proposed rule 2a51-1(j). 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 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 3, at 53.
    \69\ 17 CFR 230.144A(d)(1). Rule 144A includes several non-
exclusive methods for purposes of determining whether a person is a 
``qualified institutional buyer.'' These methods include most recent 
publicly available financial statements, information filed with 
Federal and State regulatory authorities, and information appearing 
in recognized securities manuals, as well as certifications by a 
company's executive officers. Id.
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B. Definitions of Beneficial Ownership

    Proposed rule 2a51-2 would define the term ``beneficial owner'' for

[[Page 68107]]

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) funds that wish to become qualified 
purchasers. The proposed rule also would address what types of 
ownership constitute ``indirect'' beneficial ownership for purposes of 
the consent provision.
1. The Grandfather Provision
    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.70 
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.71
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    \70\ These non-qualified purchasers must have acquired all or a 
portion of their investment in the Grandfathered Fund prior to 
September 1, 1996. Any person acquiring an interest in the 
Grandfathered Fund after that date must, either on the date of the 
acquisition or on the date that the fund avails itself of the 
section 3(c)(7) exception, be a qualified purchaser. These persons 
are required to be given the notice and redemption opportunity 
described below.
    \71\ The opportunity must be provided ``notwithstanding any 
agreement to the contrary between the [Grandfathered Fund] and such 
beneficial owner.'' 15 USC 80a-3(c)(7)(B)(ii)(II). 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.
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    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 address any unnecessary burdens that might arise as a 
result of the application of section 3(c)(1)'s look-through 
provision.72 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 section 3(c)(1)(A).73 
Rather, the notice and redemption opportunity are generally intended to 
be provided only to the institutional investor, unless the 
institutional investor is controlled by or under common control with 
the Grandfathered Fund.74
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    \72\ See supra note 17 and accompanying text (describing section 
3(c)(1)(A) of the Investment Company Act).
    \73\ See Remarks of Hon. Thomas J. Bliley, supra note 13.
    \74\ Id.
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    Consistent with the purposes indicated in the legislative history 
of the 1996 Act, the Commission believes that the grandfather notice 
and redemption opportunity provisions were intended not only for the 
purposes described above, but for the benefit of certain persons who 
were deemed to be beneficial owners prior to the 1996 Act's amendments 
to the look-through provision.75 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.76 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.
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    \75\ See supra notes 18, 22 and accompanying text (discussing 
the elimination of the second 10% test). Consistent with this 
legislative intent, the Commission believes that the conditions in 
the grandfather provision must be complied with by any section 
3(c)(1) fund organized before the enactment of the 1996 Act that 
wishes to avail itself of section 3(c)(7). Thus, the notice and 
redemption opportunity must be provided to the beneficial owners of 
a Grandfathered Fund's securities, even if each beneficial owner 
meets the definition of qualified purchaser. If the notice and 
redemption opportunity provision had been intended only for the 
benefit of beneficial owners who are not qualified purchasers, 
Congress could have limited the provision accordingly. Compare House 
Report, supra note 3, 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 3, 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 70 .
    \76\ 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.
---------------------------------------------------------------------------

    Paragraph (a) of proposed rule 2a51-2 would provide generally that 
beneficial ownership is to be determined in accordance with section 
3(c)(1) of the Act. Paragraph (b) of the proposed rule would provide a 
special rule for determining beneficial ownership of securities held by 
a company. Paragraph (b) would provide 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,77 (ii) the owning company has a control relationship 
with the Grandfathered Fund,78 and (iii) the owning company is 
itself an investment company or a private fund.79 If these 
conditions do not apply, the grandfather notice and redemption 
opportunity would be provided to the owning company. If the conditions 
do apply, the grandfather notice and redemption opportunity would be 
provided to the owning company's security holders as the beneficial 
owners of the Grandfathered Fund's securities.
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    \77\ The applicability of the look-though provision would be 
determined as of October 11, 1996 to assure that the Grandfathered 
Fund does not engage in transactions subsequent to the enactment of 
the 1996 Act (which was signed by the President on that date) 
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%).
    \78\ See supra note (describing the Act's definition of 
control).
    \79\ Limiting the application of the look-through provision in 
this context to owning companies that are investment companies or 
private funds is consistent with amended section 3(c)(1)(A). If the 
owning company is not an investment company or a private 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 21 
and accompanying text.
---------------------------------------------------------------------------

    The intended application of the proposed 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

[[Page 68108]]

10% test),80 Company A must provide the grandfather notice and 
redemption opportunity to each of Company B's security holders.
---------------------------------------------------------------------------

    \80\ See section I.B. of this Release.
---------------------------------------------------------------------------

    Comment is requested on the proposed approach for determining 
beneficial ownership in the absence of a control relationship. Should 
Company B's security holders receive the grandfather notice and 
redemption opportunity if Company B owns more than 10% of Company A's 
voting securities? That is, should Company B's security holders receive 
the grandfather notice and redemption opportunity regardless of (i) 
Company B's status as an investment company or a private fund; (ii) the 
existence of a control relationship, or (iii) the applicability of the 
second 10% test?
    Comment also is requested whether any other rules may be necessary 
to clarify the operation of the grandfather provision. For example, a 
redeeming shareholder of a Grandfathered Fund is entitled to receive 
its proportionate share of the Fund's ``net assets.'' The term 
``current net assets'' is used in the Investment Company Act and 
defined by Commission rule.81 Should the same definition apply to 
Grandfathered Funds, or should net assets, for purposes of the 
grandfather provision, be determined based upon the methods that would 
have been used to determine the amount that the investor would have 
received in accordance with existing withdrawal provisions in the 
Grandfathered Fund's governing documents? Are these withdrawal 
provisions typically subject to conditions (e.g., a ``hold-back'') that 
would undercut the purpose of the redemption requirements of section 
3(c)(7) and, if so, how could the existence of such provisions be 
addressed? 82
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    \81\ 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).
    \82\ For example, if a section 3(c)(1) fund's withdrawal 
provision provides for a hold-back to assure that sufficient assets 
are available to satisfy contingent liabilities, the rule could 
provide that the Grandfathered Fund could not avail itself of 
section 3(c)(7) until the hold-backs are released or the liabilities 
extinguished.
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2. The Consent Provision
    The consent provision requires that a private 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 prior to April 30, 1996.83 The beneficial owners of the 
securities of any private fund that is a direct or indirect beneficial 
owner of the securities of the purchasing fund must also consent to the 
treatment of the purchasing fund as a qualified purchaser.84
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    \83\ 15 USC 2(a)(51)(C). Section 2(a)(51)(C) and the proposed 
rule use 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.
    \84\ Id.
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    The consent provision appears to be designed to give investors in 
an existing private fund with 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.85 The 
consent provision also may serve 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 through another 
private fund.86
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    \85\ The legislative history of the 1996 Act does not address 
the purpose of the consent provision.
    \86\ Such conduct may also raise issues under section 48(a) of 
the Investment Company Act [15 U.S.C. 80a-47(a)] (precluding 
indirect circumvention of the Act's provisions).
---------------------------------------------------------------------------

    Paragraph (c) of proposed rule 2a51-2 would clarify the meaning of 
the term ``beneficial owner'' for purposes of the consent provision. 
The proposed rule would provide that securities of a purchasing fund 
beneficially owned by a company (without giving effect to the look-
through provision) are deemed to be beneficially owned by one person 
unless the company has a 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''). If a 
control relationship exists, and the company is a private fund whose 
security holders were deemed to be beneficial owners of the purchasing 
fund on October 11, 1996, then these security holders would be deemed 
to be beneficial owners under the proposed rule.
    As in the case of the proposed definition of beneficial owner for 
purposes of the grandfather provision, the proposed 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 
institutional investor or the target fund, and the institutional 
investor is a private fund whose security holders were deemed 
beneficial owners of the purchasing fund prior to the enactment of the 
1996 Act, then the consent must be obtained from those security 
holders.
    The proposed rule also would clarify what constitutes ``indirect'' 
ownership with regard to the requirement that the consent be obtained 
from the security holders of a private fund that is an indirect 
beneficial owner of the purchasing fund. Paragraph (d) of the proposed 
rule would provide that the private fund would not be considered to own 
the securities of the purchasing fund indirectly unless the private 
fund has a control relationship with either the purchasing fund or the 
target fund.87
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    \87\ The following example illustrates the intended operation of 
the proposed rule. Assume Company A is a purchasing fund and that 
Companies B and C are beneficial owners of Company A's voting 
securities. Company B 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 
October 11, 1996. Company C is a private fund that was deemed to own 
beneficially Company A's voting securities on October 11, 1996 (in 
other words, the look-through provision did not apply). Each of 
Company C's investors (Companies D through F) are themselves private 
funds, but none has a control relationship with Company C or Company 
A.
    Company B would have to consent to Company A being a qualified 
purchaser. Because Company B is not a private fund, Company B'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 B's shareholders would not be required even if 
Company B had a control relationship with Company A.)
    Company C would have to consent to Company A being a qualified 
purchaser. Additionally, because Company C is a private fund, all 
beneficial owners of its outstanding securities also would have to 
consent to Company A being a qualified purchaser. Because there is 
no control relationship, however, security holders of Companies D 
through F would not be required to consent even if they are 
considered to be beneficial owners of Company C's securities under 
the look-through provision. Similarly, Companies D through F would 
not be deemed to indirectly own voting securities of Company A.
---------------------------------------------------------------------------

    Under the proposed rule, the purchasing fund could obtain a general 
consent with respect to most transactions in which it will be a 
qualified purchaser. Consent for specific transactions would be 
required only when there is a control relationship between the 
purchasing fund or certain of its beneficial owners and the target 
fund.
    Comment is requested on proposed rule 2a51-2. Comment specifically 
is requested on the proposed approach of

[[Page 68109]]

defining indirect beneficial ownership in the purchasing fund on the 
basis of whether the investor has a control relationship with the 
purchasing fund or the target fund.

C. Conforming Rule

    The Commission is proposing a rule to clarify an interpretative 
issue concerning companies that are qualified purchasers.88 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.'' 89 The proposed 
rule would make 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 or other interest in the company is a qualified purchaser. 
The proposed rule would limit 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).90
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    \88\ Proposed rule 2a51-3.
    \89\ 15 U.S.C. 80a-2(a)(51)(A)(iii).
    \90\ See supra note 86 and accompanying text.
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D. Non-Exclusive Safe Harbor for Certain Section 3(c)(7) Funds

    The legislative history of the 1996 Act indicates that the 
grandfather provision 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 in order to create another section 3(c)(1) fund and 
thereby avoid the 100-investor limit.91 While the 1996 Act 
includes a provision allowing a sponsor to operate both a section 
3(c)(1) and a section 3(c)(7) fund (the ``non-integration 
provision''),92 this provision was not designed to address whether 
a nominally converted section 3(c)(1) fund should be treated as a 
section 3(c)(7) fund for purposes of the integration and other 
applicable provisions.93
---------------------------------------------------------------------------

    \91\ See Remarks of Hon. John D. Dingell, supra note 11.
    \92\ Section 3(c)(7)(E) of the Investment Company Act [15 U.S.C. 
80a-3(c)(7)(E)]. 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) is 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.
    \93\ See Remarks of Hon. John D. Dingell, supra note 11. The 
bona fides of a conversion to a section 3(c)(7) fund also would 
affect the ability of the fund to use the new exemption from the 
prohibition in the Investment Advisers Act of 1940 (``Advisers 
Act'') on performance fees available to section 3(c)(7) funds. See 
new section 205(b)(4) of the Advisers Act [15 U.S.C. 80b-5(b)(4)].
---------------------------------------------------------------------------

    Since the passage of the 1996 Act, representatives of hedge funds 
and other investment pools have 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., sells its securities to 
new investors that are qualified purchasers) to then create a new 
section 3(c)(1) fund. These representatives have requested that the 
Commission clarify the application of the non-integration provision to 
sponsors of Grandfathered Funds who form new section 3(c)(1) funds. To 
respond to these concerns, the Commission is proposing rule 3c-7 under 
the Investment Company Act to provide that a Grandfathered Fund will be 
treated as an issuer excepted 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. The proposed rule is designed to provide a non-exclusive safe 
harbor for Grandfathered Funds. Comment is requested whether the 
percentage threshold should be higher (e.g., 50%). Comment also is 
requested whether existing investors that are qualified purchasers on 
the date that the Grandfathered Fund avails itself of section 3(c)(7) 
should also be counted for purposes of the proposed threshold.

III. Other Rules for Private Investment Companies

A. Transition Rule for Section 3(c)(1) Funds

    As noted above, the 1996 Act amended section 3(c)(1)(A) of the 
Investment Company Act, which governs the way 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 underlying security holders of any investment company and 
any private fund that owns 10% or more of the section 3(c)(1) fund 
(collectively, ``10%+ investors''). Until the amendment becomes 
effective, the look-through provision does not apply unless the 10%+ 
investor also has more than 10% of its assets invested in section 
3(c)(1) funds generally. The amendment, in effect, will limit the 
ability of certain types of investors to own more than 10% of a section 
3(c)(1) fund.94
---------------------------------------------------------------------------

    \94\ The limitation will exist only when an investment company 
or a private 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.
---------------------------------------------------------------------------

    The Commission is aware that some existing section 3(c)(1) funds 
may have 10%+ investors in reliance on the pre-amendment application of 
the look-through provision. The Commission believes that the amendment 
to the look-through provision was primarily designed to simplify the 
application of the provision and was not intended to disrupt existing 
investment relationships. The Commission, therefore, is proposing a 
rule under the Investment Company Act to provide that the amended look-
through provision will not apply in the case of an investor that held 
more than 10% of the outstanding voting securities of a section 3(c)(1) 
fund on October 11, 1996, provided that the investor continues to 
satisfy the second 10% test.95
---------------------------------------------------------------------------

    \95\ Proposed rule 3c-1. For the purpose of the proposed rule, 
investment in 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 exception created 
by the 1996 Act. The proposed rule also would address 10%+ ownership 
interests that result from voting securities acquired as a result of 
the conversion of convertible non-voting securities acquired prior 
to October 11, 1996.
---------------------------------------------------------------------------

    The Commission requests comment on the approach of the proposed 
rule. For example, the proposed rule would not limit additional 
investments by the 10%+ investors in the section 3(c)(1) fund as long 
as the second 10% test continues to be inapplicable. Should the rule 
prohibit additional investments? Should the rule only permit additional 
investments that do not increase the percentage of the section 3(c)(1) 
fund's voting securities that the 10%+ investor owns? Are there other 
circumstances when similar relief would be appropriate?
    Comment also is requested on rule 3c-2 under the Investment Company 
Act, which was adopted in 1958 to facilitate capital investments by 
operating companies in small business investment companies (``SBICs'') 
that were section 3(c)(1) funds.96 Rule 3c-2

[[Page 68110]]

provides that beneficial ownership of 10% or more of an SBIC's voting 
securities by a company is deemed to be ownership by one person if and 
so long as that company's total investment interest in all SBICs does 
not exceed 5% of the value of the company's assets. The amendments to 
the look-through provision made by the 1996 Act will make it 
unnecessary for an investor in an SBIC that is itself not an investment 
company or a private fund to rely on rule 3c-2.97 Comment is 
requested whether rule 3c-2 is still necessary.98 To what extent 
do SBICs rely on registered or private investment companies as a source 
of capital? To assure that the flow of capital to small businesses is 
not inhibited, should the rule be amended to incorporate the second 10% 
test? Should the rule be rescinded to reflect Congress' decision to 
eliminate the second 10% test?
---------------------------------------------------------------------------

    \96\ Rule 3c-2 [17 CFR 270.3c-2]. At that time, the look-through 
provision did not include the second 10% test and, therefore, 
inhibited SBICs' capital raising efforts because SBICs frequently 
depended upon corporate investors to make investments that resulted 
in their owning more than 10% of the SBICs voting securities.
    \97\ The need for SBICs to rely on rule 3c-2 may have diminished 
when the second 10% test was added to the look-through provision in 
1980.
    \98\ Rule 3c-2 also provides that the look-through provision 
does not apply to 10%+ investors that are ``state development 
corporations,'' subject to certain conditions.
---------------------------------------------------------------------------

B. Investments by Fund Employees

    The Commission is proposing rule 3c-5 under the Investment Company 
Act to permit directors, executive officers, general partners and 
certain knowledgeable employees of a section 3(c)(1) fund or of an 
affiliated person of the fund (collectively, ``fund personnel'') to 
acquire securities issued by the fund without being counted for 
purposes of section 3(c)(1)'s 100-investor limit. The rule also would 
permit fund personnel to invest in a section 3(c)(7) fund even though 
they did not meet the definition of qualified purchaser.
    The provision in the 1996 Act directing Commission rulemaking with 
regard to investments in private funds by knowledgeable employees 
appears to be intended to encompass all natural persons who actively 
participate in the management of a fund's investments. The proposed 
rule, therefore, would extend to directors, executive officers, and 
general partners of a fund or of an affiliate of the fund that oversees 
the fund's investments. The proposed rule also would extend to other 
employees who, in connection with their regular functions or duties, 
participated in, or obtained information regarding, the investment 
activities of the fund or other investment companies managed by the 
affiliate for a period of at least 12 months.99 Comment is 
requested whether the proposed rule should contain any other criteria 
for identifying knowledgeable employees (i.e., the employee's salary 
level or the amount of investments owned).
---------------------------------------------------------------------------

    \99\ The term ``employee'' as used in the proposed rule is 
intended also to encompass individuals who may be deemed independent 
contractors for tax purposes. See, e.g., Cornish & Carey Commercial, 
Inc. (pub. avail. June 21, 1996).
---------------------------------------------------------------------------

    The proposed rule would allow transfers of fund securities held by 
fund personnel to family members as a gift, bequest or pursuant to an 
agreement relating to legal separation or divorce, as well as to family 
trusts and similar family vehicles established by fund personnel for 
the exclusive benefit of family members and charitable organizations, 
provided fund securities had been acquired by fund personnel pursuant 
to, or are otherwise subject to, an arrangement prohibiting any other 
transfers of such shares.100 The Commission believes that this 
approach would afford adequate flexibility for employees' estate 
planning and other financial goals, while assuring that the securities 
of the issuer were not transferred in a manner inconsistent with the 
rationale underlying sections 3(c)(1) and 3(c)(7).
---------------------------------------------------------------------------

    \100\ The securities could be sold back to the issuing fund or, 
in the case of securities issued by a section 3(c)(7) fund, other 
qualified purchasers.
---------------------------------------------------------------------------

    The Commission recognizes that the proposed rule would not extend 
to employees performing certain other functions with respect to a fund, 
such as clerical, secretarial and other administrative personnel. 
Should the rule be extended to these employees (or employees of firms 
that provide such services) if, for example, the employees are assisted 
by an independent purchaser representative? 101 The Commission 
also requests comment whether the proposed rule should contain any 
other requirements, particularly with respect to investments that are 
made by fund personnel through plans that are subject to the Employee 
Retirement Income Security Act of 1974, as amended.
---------------------------------------------------------------------------

    \101\ A similar concept of ``purchaser representative'' is found 
in Regulation D under the Securities Act that governs securities 
transactions exempted from registration under section 5 of that Act. 
See rule 501(h) under the Securities Act [17 CFR 230.501(h)].
---------------------------------------------------------------------------

C. Certain 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 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.'' 102
---------------------------------------------------------------------------

    \102\ H.R. Rep. No. 1341, 96th Cong., 2d Sess. at 36 (1980).
---------------------------------------------------------------------------

    The 1996 Act directed the Commission to prescribe rules to 
implement section 3(c)(1)(B). The Commission is proposing 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 or other involuntary event will be deemed 
to be beneficial ownership by the person from whom the transfer was 
made (``transferor''). The proposed rule would limit transferees to 
family members of the transferor, trusts or similar vehicles 
established by the transferor for the exclusive benefit of family 
members, and charitable organizations. The proposed rule also would 
provide that the securities of the section 3(c)(1) fund must have been 
acquired by the transferor pursuant to, or are otherwise subject to, an 
arrangement prohibiting any other transfers, except transfers back to 
the fund. The Commission believes that the proposed rule would afford 
sufficient flexibility to section 3(c)(1) funds and their investors 
consistent with the intent behind section 3(c)(1)(B).
    Proposed rule 3c-6 also would address 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. Proposed rule 3c-6 would permit transfers of securities of a 
section 3(c)(7) fund under essentially the same conditions as those 
proposed for transfers under section 3(c)(1)(B).
    Comment is requested on the proposed rule governing transfers of 
private funds' securities. Should transfers of a section 3(c)(7) fund's 
securities be governed by different conditions than transfers of a 
section 3(c)(1) fund's securities, or be permitted in other types of 
situations as well?

[[Page 68111]]

Should the rule provide other examples of ``involuntary events''?

IV. General Request for Comment

    Any interested persons wishing to submit written comments on the 
rules that are the subject of this Release, to suggest additional rules 
to address interpretative and other issues relating to private funds 
resulting from the 1996 Act, or to submit comments on other matters 
that might have an effect on the proposals contained in this Release, 
are requested to do so. In accordance with section 2(c) of the 
Investment Company Act, comment is requested regarding the effects of 
the proposed rules on efficiency, competition and capital formation.

V. Cost/Benefit Analysis

    Consistent with legislative intent and the protection of investors, 
the proposed rules would benefit private funds and their investors in a 
number of ways. The proposed rules would: 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; enable knowledgeable 
employees of a private fund to invest in the fund without causing the 
fund to relinquish its exclusion from regulation under the Act; permit 
certain transfers of private fund securities; and address certain 
interpretative issues for private funds.
    The Commission believes that the proposed rules would not impose 
any additional costs on private funds. Rather, the proposed rules would 
clarify the statutory requirements for private funds in order to reduce 
any unnecessary burdens without jeopardizing investor protection. 
Comment is requested on this cost/benefit analysis. Commenters are 
requested to provide views and empirical data relating to any costs and 
benefits associated with the proposed rules.
    For purposes of making determinations required by the Small 
Business Regulatory Enforcement Fairness Act of 1996, the Commission is 
requesting information regarding the potential impact of the proposed 
rules on the economy on an annual basis. Commenters should provide 
empirical data to support their views.

VI. Summary of Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA'') in accordance with 5 USC 603 regarding proposed 
rules 2a51-1, 2a51-2, 2a51-3, 3c-1, 3c-5, 3c-6 and 3c-7 under the 
Investment Company Act. The IRFA indicates that the proposed rules 
would comply with the provisions of the 1996 Act directing the 
Commission to prescribe certain rules concerning private funds, and 
would address certain interpretive issues raised by the 1996 Act's 
amendments relating to private funds. The IRFA states that the proposed 
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 IRFA further states that the proposed rules would give private 
funds greater flexibility as well as minimize certain compliance 
burdens imposed by the applicable provisions of the Investment Company 
Act.
    The IRFA sets forth the statutory authority for the proposed rules. 
The IRFA also discusses the effect of the proposed rules on small 
entities that are section 3(c)(7) or section 3(c)(1) funds. For 
purposes of the proposed rules, small entities are those with assets of 
$50 million or less at the end of their most recent fiscal year. The 
IRFA states that the proposed rules would make possible the creation of 
small entities that are section 3(c)(7) funds, and would 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 IRFA states that the proposed rules would 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 proposed rules.
    The IRFA discusses the various alternatives considered by the 
Commission in connection with the proposed 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 thereof, for small entities. The 
Commission believes that it would be inconsistent with the purposes of 
the Act to exempt small entities from the proposed rules or to use 
performance standards to specify different requirements for small 
entities. Different compliance or reporting requirements for small 
entities are not necessary because the proposed 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 proposed rules for small entities.
    The IRFA includes information concerning the solicitation of 
comments with respect to the IRFA generally, and in particular, the 
number of small entities that would be affected by the proposed rules. 
Cost-benefit information reflected in the ``Cost/Benefit Analysis'' 
section of this Release also is reflected in the IRFA. A copy of the 
IRFA 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.

VII. Statutory Authority

    The Commission is proposing rules 2a51-1, 2a51-2, 2a51-3 and 3c-7 
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. The Commission 
is proposing 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 proposing 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. The 
Commission is proposing rule 3c-6 pursuant to the authority set forth 
in sections 3(c)(1), 3(c)(7), 6(c) and 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.

Text of Proposed 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

[[Page 68112]]

Code of Federal Regulations is proposed to be amended as follows:

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

    1. The authority citation for Part 270 is amended by adding the 
following citations to read as follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-37, 80a-39 unless 
otherwise noted;
* * * * *
    Section 270.2a51-1 is also issued under 15 U.S.C. 80a-
2(a)(51)(B) and 80a-6(c), and secs. 209(d) (2) and (4), National 
Securities Markets Improvement Act of 1996;
    Section 270.2a51-2 is also issued under 15 U.S.C. 80a-
2(a)(51)(B) and 80a-6(c), and secs. 209(d) (2) and (4), National 
Securities Markets Improvement Act of 1996;
    Section 270.2a51-3 is also issued under 15 U.S.C. 80a-
2(a)(51)(B) and 80a-6(c), and secs. 209(d) (2) and (4), National 
Securities Markets Improvement Act of 1996;
    Section 270.3c-1 is also issued under 15 U.S.C. 80a-6(c);
    Section 270.3c-5 is also issued under 15 U.S.C. 80a-6(c), and 
sec. 209(d)(3), National Securities Markets Improvement Act of 1996;
    Section 270.3c-6 is also issued under 15 U.S.C. 80a-3(c)(1), 
80a-3(c)(7), 80a-6(c) and 80a-37(a) and sec. 209(d)(1), National 
Securities Markets Improvement Act of 1996;
    Section 270.3c-7 is also issued under 15 U.S.C. 80a-2(a)(51)(B) 
and 80a-6(c);
* * * * *
    2. Section 270.2a51-1 is added to read as follows:


Sec. 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 shall mean 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
    (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];
    (2) The term Family Company shall mean 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 Listed Company shall mean a company that has 
outstanding a class of equity securities that are:
    (i) Reported securities as such term is defined by Sec. 240.11Aa3-1 
of this Chapter; or
    (ii) Listed on a ``designated offshore securities market'' as such 
term is defined by Regulation S under the Securities Act of 1933 [17 
CFR 230.901 through 230.904];
    (4) The term Physical Commodities shall mean any physical commodity 
with respect to which a Commodity Interest is traded on a market 
specified in paragraphs (a)(1) of this section; and
    (5) The term Related Person shall mean a person who is related to 
another person as a sibling, spouse or former spouse, or is a direct 
lineal descendant or ancestor by birth or adoption of such person, or 
is a spouse of such descendant, 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.
    (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 shall mean:
    (1) Securities (as defined by section 2(1) of the Securities Act of 
1933 [15 U.S.C. 70a(1)]), other than securities of an issuer that 
controls, is controlled by, or is under common control with, the person 
that owns such securities, unless the issuer is:
    (i) An investment company or 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 Secs. 270.3a-6 or 270.3a-7; or
    (ii) A Listed Company that is not a majority-owned subsidiary of 
such person or a person that controls, is controlled by, or is under 
common control with such person;
    (2) Real estate held for investment purposes;
    (3) Commodity Interests held for investment purposes;
    (4) Physical Commodities held for investment purposes; and
    (5) Cash and cash equivalents held for investment purposes.
    (c) Real Estate Not Held for Investment Purposes. For purposes of 
this section, real estate shall not be considered to be held for 
investment purposes by its owner if it is used by the owner or a 
Related Person of the owner for personal purposes or as a place of 
business, or in connection with the conduct of the trade or business of 
such owner or a Related Person of the owner. 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 USC 280A].
    (d) Valuation. For purposes of determining whether a person is a 
qualified purchaser, the aggregate amount of investments owned and 
invested on a discretionary basis by such person shall be their readily 
ascertainable 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 such person the amounts specified in paragraphs 
(e), (f) and (g) of this section, as applicable.
    (e) Deductions: General. In determining whether any person is a 
qualified purchaser there shall be deducted from the value of such 
person's investments the amount of any outstanding indebtedness 
incurred to acquire the investments owned by such person.
    (f) Deductions: Natural Persons. In determining whether any natural 
person is a qualified purchaser, in addition to the amounts specified 
in paragraph (e) of this section there shall also be deducted from the 
value of such person's investments the following amounts:
    (1) Any payments received by such person pursuant to an insurance 
policy during the preceding 12 months;
    (2) The value of any investments received by such person during the 
preceding 12 months as a gift or bequest or pursuant to an agreement 
related to a legal separation or divorce;
    (3) Any amount received by such person during the preceding 12 
months in connection with a lawsuit (whether pursuant to a judgment or 
settlement agreement);
    (4) The proceeds of any loan incurred during the preceding 12 
months secured by a mortgage or deed of trust on such person's personal 
residence or other property that is not held for investment (``mortgage 
loan'') unless the proceeds of such loan were used solely to finance 
the acquisition or improvement of such residence or property; and
    (5) The proceeds of any loan (``refinancing loan'') incurred during 
the preceding 12 months secured by a mortgage or deed of trust on such 
person's personal residence or other property that is not held for 
investment used to refinance a mortgage loan (``refinanced loan'') to 
the extent that the proceeds of the refinancing loan exceed the lowest 
principal amount of the refinanced loan outstanding during the prior 12 
months.
    (g) Deductions: Family Companies. In determining whether a Family 
Company is a qualified purchaser, in addition to

[[Page 68113]]

the amounts specified in paragraph (e) of this section, there shall 
also be deducted from the value of such Family Company's investments 
the following amounts for purposes of this section:
    (1) Any outstanding indebtedness incurred by an owner of the Family 
Company to acquire such investments;
    (2) The amounts described in paragraph (f) of this section received 
by the Family Company or any owner of the Family Company;
    (3) The amount of any indebtedness incurred by the Family Company 
to the extent that the principal amount of such indebtedness exceeds 
the fair market value of any assets of the Family Company other than 
investments; and
    (4) The amount of any indebtedness incurred 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.
    (h) Joint Investments. 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, or investments in which such person shares with such person's 
spouse a community property or similar shared ownership interest. There 
shall be deducted from the amount of any such investments any amounts 
specified by paragraphs (e) and (f) of this section incurred or 
received by such spouse.
    (i) Corporate Investments. For purposes of determining the amount 
of investments owned by a corporation (``Corporation'') 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 
Corporation (``Subsidiaries''), provided that the investments of the 
Subsidiary are managed under the direction of the Corporation.
    (j) Good Faith Reliance. In determining whether a prospective 
purchaser is a qualified purchaser, an issuer or a person acting on the 
issuer's behalf (collectively, ``relying person'') shall be entitled to 
rely upon audited financial statements, brokerage account statements 
and other appropriate information and certifications provided by the 
prospective purchaser or its representatives and dated as of a recent 
date, or publicly available information as of a recent date, 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.
    3. Section 270.2a51-2 is added to read as follows:


Sec. 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) Except as set forth below, 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) 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; 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) 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 owners of the excepted investment company's 
outstanding voting securities.
    (d) 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.

    Note to Sec. 270.2a51-2. On October 11, 1996, the National 
Securities Markets Improvement Act of 1996 [P.L. 104-290] was signed 
into law. Prior to that date, section 3(c)(1)(A) of the Act 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).

    4. Section 270.2a51-3 is added to read as follows:


Sec. 270.2a51-3  Certain companies not qualified purchasers.

    For purposes of section 2(a)(51)(A) (ii) and (iv) of the Act [15 
U.S.C. 80a-2(a)(51)(A)] 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 or 
other interest in the company is a qualified purchaser.
    5. Section 270.3c-1 is added to read as follows:


Sec. 270.3c-1  Definition of beneficial ownership for certain private 
investment companies.

    (a) As used in this section:
    (1) The term Covered Company shall mean 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 shall mean a company that 
would be an

[[Page 68114]]

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 shall mean 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 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 October 11, 1996, 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:


Sec. 270.3c-5  Beneficial ownership by knowledgeable employees and 
certain other persons.

    (a) As used in this section:
    (1) The term Covered Company shall mean a company that is an 
investment company, a Section 3(c)(1) Company or a Section 3(c)(7) 
Company.
    (2) The term Executive Officer shall mean 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.
    (3) The term Knowledgeable Employee with respect to any Covered 
Company shall mean any natural person who is:
    (i) An Executive Officer, director, or general partner of the 
Covered Company or of an affiliated person of such Covered Company that 
manages the investment activities of such Covered Company; or
    (ii) An employee of the Covered Company or of an affiliated person 
of such Covered Company that manages the investment activities of such 
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, or obtains information regarding, the 
investment activities of such Covered Company or other investment 
companies the investment activities of which are managed by such 
affiliated person, provided that such employee has been performing such 
functions and duties for or on behalf of the Covered Company or the 
affiliated person of the Covered Company for at least 12 months.
    (4) The term Related Person shall mean a person who:
    (i) Is related to another person as a sibling, spouse or former 
spouse; or
    (ii) Is a direct lineal descendant or ancestor by birth or adoption 
of such person, or is a spouse of such descendant.
    (5) The term Section 3(c)(7) Company shall mean 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)].
    (6) The term Section 3(c)(1) Company shall mean 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)].
    (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 a 
Knowledgeable Employee of such Company; an estate of such Knowledgeable 
Employee; a Related Person of such Knowledgeable Employee who acquired 
such securities as a gift, bequest or pursuant to an agreement relating 
to a legal separation or divorce; or a company established by the 
Knowledgeable Employee exclusively for the benefit of (or owned 
exclusively by) the Knowledgeable Employee, his or her estate, and his 
or her Related Persons or charitable organizations, provided, however, 
that in each case such securities shall have been acquired by the 
Knowledgeable Employee pursuant to, or shall otherwise be subject to, 
an arrangement that prohibits the transfer, pledge or hypothecation of 
such securities, or any interest in such securities, to any person 
other than the Covered Company, such estate, such Related Persons, such 
companies or, if the Covered Company is a Section 3(c)(7) Company, 
qualified purchasers.
    7. Section 270.3c-6 is added to read as follows:


Sec. 270.3c-6  Certain transfers of interests in section 3(c)(1) and 
section 3(c)(7) funds.

    (a) As used in this section:
    (1) The term Related Person shall mean a person who is:
    (i) Related to another person as a sibling, spouse or former 
spouse; or
    (ii) A direct lineal descendant or ancestor by birth or adoption of 
such person, or is a spouse of such descendant.
    (2) The term Section 3(c)(7) Company shall mean 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)].
    (3) The term Section 3(c)(1) Company shall mean 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)].
    (4) The term Transferee shall mean 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 shall mean 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 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 securities from a qualified purchaser 
(``Qualified Purchaser Transferor'') shall be deemed to be owned by a 
qualified purchaser (``Qualified Purchaser Transferee''), provided 
that:
    (1) The transfer was made as a gift or bequest, or pursuant to an 
agreement relating to a legal separation or divorce or as a result of 
another involuntary event;
    (2) The Transferee is:
    (i) The estate of the Transferor;
    (ii) A Related Person of the Transferor; or
    (iii) A company established by the Transferor exclusively for the 
benefit of (or owned exclusively by) his or her estate, Related Persons 
or charitable organizations; and
    (3) The securities shall have been acquired by the Transferor 
pursuant to, or shall otherwise be subject to, an arrangement that 
prohibits the transfer, pledge or hypothecation of such securities, or 
any interest in such

[[Page 68115]]

securities, to any person other than the Company that issued the 
securities, the Transferor's estate, such Related Persons or such 
companies or, in the case of a Qualified Purchaser Transferor, 
qualified purchasers.
    8. Section 270.3c-7 is added to read as follows:


Sec. 270.3c-7  Non-exclusive safe harbor for certain section 3(c)(7) 
funds.

    An issuer relying on section 3(c)(7)(B) of the Act [15 U.S.C. 80a-
3(c)(7)(B)] shall be deemed to be excluded under section 3(c)(7) of the 
Act [15 U.S.C. 80a-3(c)(7)] if 25% or more of the value of the issuer's 
securities is held by qualified purchasers that acquired these 
securities after October 11, 1996.

    Dated: December 18, 1996.

    By the Commission.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 96-32652 Filed 12-24-96; 8:45 am]
BILLING CODE 8010-01-P