PDF Gardner, Carton & Douglas Client Memorandum

Gardner, Carton & Douglas

Client Memorandum

June 2001

Investment

Investment Management

Management

A Service to Our Clients and Friends

SEC Opens Door to 401(k) Investments into Hedge Funds

The SEC staff recently issued a no-action letter that clarifies its position regarding whether certain ¡°self-directed¡±

retirement plans (such as most ¡°401(k)¡± plans) may offer participants the opportunity to invest in private investment funds that rely on the Section 3(c)(1) and 3(c)(7)

exceptions under the Investment Company Act of 1940

(the ¡°1940 Act¡±). This no-action letter resolves questions that had effectively kept many private funds from

considering 401(k) plans as potential investors.

Hedge Funds as Investment Vehicles

Private investment funds (commonly called ¡°hedge funds,¡±

even though many of them use no hedging strategies)

have recently become the investment vehicle of choice

for wealthy private investors and large institutions. These

private funds utilize many different strategies. Some seek

performance that meets or exceeds market indices, with

lower volatility. Others utilize strategies aimed at results

which have a low correlation with market indices. Still

others seek to exploit market inefficiencies. Therefore,

private funds may be attractive in themselves, or as components in the asset allocation of a portfolio.

401(k) plans may wish to offer the diversification of private funds, and these funds may view the plans as potential investors, but uncertainty about the consequences of

such plans investing in private funds has curtailed their

participation in this rapidly-growing investment sector.

Background

Under the 1940 Act, funds that would otherwise have to

register as investment companies are effectively exempt

from registration under two exceptions:

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Section 3(c)(1) of the 1940 Act allows privately offered funds, having no more than 100 investors, to

avoid registration as investment companies.

Section 3(c)(7) of the 1940 Act removes the 100investor ceiling as long as all of the investors are ¡°quali-

fied purchasers¡± (¡°QPs¡±) or ¡°knowledgeable employees¡± of the fund¡¯s manager.

When investors in the fund¡¯s securities are individual persons, determining the number of investors and each

investor¡¯s QP status is relatively straightforward. However, when individuals invest through another investment

entity (e.g., as a participant in a 401(k) plan investing

through the plan trust), determining the number of investors and whether each must be a QP becomes more complex. In certain situations, the ¡°investee¡± entity (the private fund) must look through the ¡°investor¡± entity to its

investors or participants. In those cases, the investee

entity claiming the 3(c)(1) exception must count all of the

investors in the investor entity toward the investee¡¯s 100investor ceiling. Similarly, in the case of an investee entity relying on the 3(c)(7) exception, if it is necessary to

look through the investor entity to its investors or participants, then each of those investors and participants must

be a QP.

PanAgora. In a no-action letter issued April 29, 1994

(PanAgora Group Trust), the SEC staff stated that a defined contribution plan cannot be counted as a single investor if it allowed its participants to decide if or how

much to allocate to a specified private investment fund

that relies on the Section 3(c)(1) exception (a ¡°3c1 Fund¡±).

Instead, the 3c1 Fund must count each plan participant

toward its 100-investor ceiling.

As a practical matter, the application of PanAgora effectively precluded 401(k) or other self-directed retirement

plans from investing in 3c1 Funds, as the number of participants in a plan of any consequence would likely cause

the 100-investor limit to be exceeded.

Standish Ayer. In contrast to PanAgora, in a no-action

letter issued December 28, 1995 (Standish, Ayer & Wood,

Inc.), the SEC staff took a different position, under facts

which made the participant-directed plan¡¯s investment

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more like that of a defined benefit plan. In Standish Ayer,

the plan participants did not directly decide if or to what

extent they would invest in any specific 3c1 Fund. Instead,

they selected among several generic investment strategies

(e.g., aggressive growth, income or stable value), some of

which included a 3c1 Fund. Only a plan fiduciary could

determine how to invest the assets within each generic strategy ¡ª i.e, only the fiduciary could decide which 3c1 Fund

or Funds would be accessed by the plan. Furthermore, the

plan would not represent to its participants that any specific

3c1 Fund would be included in a particular investment strategy, and no more than 50% of the assets allocated to the

investment strategy that included any 3c1 Funds would be

invested in any one 3c1 Fund.

Despite this logical progression and the staff¡¯s rationale for

distinguishing between the two situations, the SEC requested,

in its 1997 release implementing the rules under the newly

created 3(c)(7) exception, that the staff reconsider Standish

Ayer, in light of PanAgora and the adoption of Section 3(c)(7),

to determine if Standish Ayer was appropriate in the context of Section 3(c)(7). This created uncertainty as to the

continued availability of Standish Ayer1 to 3c1 Funds, as

well as its application to any fund relying on the Section

3(c)(7) exception (a ¡°3c7 Fund¡±).

H.E. Butt Grocery Co. The SEC staff responded to the

SEC¡¯s request in a no-action letter issued May 18, 2001

(H.E. Butt Grocery Co.), addressing the application of

Standish Ayer to a 3c7 Fund. The staff agreed that a ¡°selfdirected¡± retirement plan could, under circumstances which

conformed to those in Standish Ayer, invest in a 3c7 Fund

and be treated as a QP without the 3c7 Fund having to

¡°look through¡± to the plan¡¯s participants. The conditions

are:

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plan participants must be able to allocate their investment only among several generic investment strategies,

not directly to any one specific 3c7 Fund or specific

group of such funds;

the decision for the plan to use (both initially and for

subsequent investments) or discontinue use of a 3c7

Fund within an investment strategy must be made solely

by a plan fiduciary;

An SEC no-action letter is not considered binding legal

authority for any position that anyone other than the noaction letter¡¯s recipient may take. It is, however, considered

persuasive authority for persons in similar situations.

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immediately after a purchase of an interest in a particular 3c7 Fund on behalf of the plan, at least 50% of

the assets allocated to the investment strategy under

which the 3c7 Fund was purchased must consist of

assets other than that 3c7 Fund; and

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no representation may be made to the plan participants

that any portion of their accounts will be allocated to

any specific 3c7 Fund. Additionally, if the plan discloses an investment in a 3c7 Fund to the plan participants, it must also clearly indicate that no assurances

can be given that the 3c7 Fund will continue to be part

of an investment strategy¡¯s portfolio.

Based on this no-action letter, a 3c1 or 3c7 Fund that follows the guidelines above has a significant degree of comfort in accepting a self-directed plan as an investor, without

the 3c1 Fund having to count the plan¡¯s participants toward

its 100-investor ceiling, and without the 3c7 Fund having to

determine that all of the participants are QPs. The plan¡¯s

investment vehicle must itself qualify as an investor in a

3c7 Fund, principally by having $25 million in assets.

Applying the New SEC Guidance

There were several questions unresolved by H.E. Butt Grocery, and we contacted the SEC staff for further guidance

on these.

Q: Does H.E. Butt Grocery reaffirm Standish Ayer in light

of the commissioners¡¯ instructions to the staff?

A: According to the staff, H.E. Butt Grocery does reaffirm Standish Ayer as guidance for self-directed retirement plans wishing to invest in 3c1 Funds.

Q: Can a self-directed retirement plan, or more specifically an investment option available under a self-directed

retirement plan, invest in more than one 3c7 or 3c1

Fund, provided that no single Fund represents more than

50% of the investment option¡¯s assets?

A: Based on our reading of H.E. Butt Grocery and Standish

Ayer this seems permissible, so long as immediately

after an investment option¡¯s purchase of an interest in

either a 3c1 or 3c7 Fund, no more than 50% of the

investment option¡¯s assets are invested in any one 3c1

or 3c7 Fund. We received informal confirmation of

this interpretation from a securities law perspective,

although other concerns (such as plan liquidity needs,

from an ERISA perspective) might affect the extent to

which a plan investment option could invest solely in

private investment funds.

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Q: Assuming an investment option can invest in multiple

3c1 or 3c7 Funds, is there any prohibition on combining

3c1 and 3c7 Funds within a single investment option?

A: We have received informal confirmation that neither

H.E. Butt Grocery nor Standish Ayer intends such a

prohibition, assuming that the investment option was

otherwise qualified to invest in both 3c1 and 3c7 Funds.

ERISA Considerations

Care must be taken, in constructing and offering an investment option such as is permitted under H.E. Butt Grocery

and Standish Ayer, to address issues under the Employee

Retirement Income Security Act of 1974 (¡°ERISA¡±). Only

plan fiduciaries who have significant knowledge about private investment funds (or who use advisers with such

knowledge) should seek to structure an investment option

like this. Managers of 3c1 and 3c7 Funds may find an

attractive new source of investment, but may become ¡°fiduciaries¡± managing ¡°plan assets¡± under ERISA. Plan

sponsors or fiduciaries who consider offering such an investment option must understand the expense structure and

liquidity of private investment funds. (The typical private

investment fund allows contributions and withdrawals once

a month and would likely be unable to operate on a ¡°daily

valuation¡± basis.) Disclosure to participants of the risk/

reward characteristics and other information regarding these

investment funds is critical. Finally, the ability to meet all

the requirements of the regulations under ERISA Section

404(c), dealing with participant-directed plans, must be considered.

Conclusion

There are still issues to be considered and settled (including

those under ERISA). Nonetheless, H.E. Butt Grocery and

Standish Ayer offer, for the first time, an opportunity for a

self-directed retirement plan that follows the guidelines established in these letters to provide a way for participants

to invest in 3c1 and 3c7 Funds without impairing the fund¡¯s

ability to continue to rely on the Section 3(c)(1) and 3(c)(7)

exceptions from the 1940 Act.

This Memorandum was prepared by Jeff Blumberg, Charles

Manzoni and Fred White of the Firm¡¯s Investment Management Practice, and Gary Howell of its HR Law/Employee Benefits Practice. Please contact them or any of the other attorneys

listed below if you would like to explore possible applications

of these developments.

Marla B. Anderson

Michael C. Blaes

Jeffrey R. Blumberg

Gregory K. Brown

Natalie Cadavid

Kathryn M. Clancy

Lisa L. Collins

Barbara A. Cronin

Ralph E. DeJong

Paul H. Dykstra

Glenn E. Ferencz

Karin J. Flynn

Kimberly Frailey

Heidemarie Gregoriev

Carol M. Hines

Gary W. Howell

Jeffrey M. Johns

Ann M. Kim

Howard J. Levine

Charles R. Manzoni, Jr.

Doreen Meinck

Joyce L. Meyer

Maureen A. Miller

Valerie L. Miller

Kathleen O¡¯Connor

Paulita Pike-Bokhari

Sarah F. Rivera

Michael D. Rosenbaum

Jesse H. Ruiz

Mary K. Samsa

Timothy S. Scott

Jeffrey S. Shamberg

Lori L. Shannon

Timothy J. Stanton

Frederick L. White

Jennifer L. Wilson

David E. Winebrenner

David L. Wolfe

(312) 245-8879

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(312) 245-8421

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(312) 245-8727

(312) 245-8477

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(312) 245-8705

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(312) 245-8865

(312) 245-8423

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(312) 245-8881

(312) 245-8451

(312) 245-8524

(312) 245-8476

(312) 245-8427

(312) 245-8775

(312) 245-8438

Gardner, Carton & Douglas



321 North Clark Street

1301 K Street, N.W.

Suite 3400

Suite 900, East Tower

Chicago, Illinois 60610

Washington, D.C. 20005

(312) 644-3000

(202) 408-7100

This client memorandum is not intended as legal advice, which may

often turn on specific facts. Readers should seek specific legal advice

before acting with regard to the subjects mentioned here.

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