Section 3(c)(1)

Context:

Entities that meet the definition of being an “investment company” – which hedge funds that engage in securities do – are generally regulated by and required to register with the SEC under the Investment Company Act of 1940 (the “Act“).  Registration under the Act subjects investment companies to a wide variety of regulatory and reporting requirements that hedge funds typically seek to avoid.  The SEC provides for certain exemption frameworks from registration for qualifying entities, and as such, hedge funds generally seek to qualify under one of those exemption frameworks.  Section 3(c)(1) is generally the most common exemption, alongside its less common sibling, Section 3(c)(7).  An even rarer exemption framework, Section 3(c)(5), also exists, but only applies to certain types of real estate funds.

Exemption via Section 3(c)(1):

Exemption under Section 3(c)(1) is relatively straightforward to understand, although restrictive, with only one single requirement for the investment company:

1. No more than 100 investors*
   • An investor may be a natural person or an entity
   • Entity considerations: an investing entity, if it itself is an investment company, may trigger “look-through” that could cause the number of investors in the entity investing to be counted individually towards the threshold.  This article shall not delve into the nuances on that front, but notably, an company formed with the primary purposes of investing into another company will generally trigger look-through; in other words, there is no simple way to put a stack of investors into one company and then invest to effectively avoid the 100 investor limit.
   • Spinning up multiple funds: unless funds have materially different investment objectives and strategies, multiple funds will be considered by regulators to constitute a single fund for purposes of the Act and exemption frameworks.  Therefore, simply making a second fund once the 100 investor limit is reached is not an effective solution.  Regulation is not so easily sidestepped.

A common misconception is that there are other requirements associated with 3(c)(1) beyond the 100 investor limit.  There are not; such misconceptions typically are misattributing requirements from other acts, which may apply to most hedge funds, but which are technically distinct.  Understanding which act governs what and why is important for investment company owners and creators.

*Certain venture funds may have up to 250 investors while still qualifying for 3(c)(1) in certain circumstances, although the cap on such a venture fund is $10 million in assets under management.  Generally, this is not relevant to non-venture funds.

Final thoughts:

The 100 investor limit is a key threshold that most hedge funds must pay attention to.  3(c)(1)’s sibling, 3(c)(7), does allow for a higher investor count, but has an additional requirement that each and every investor be a Qualified Purchaser, which is a very challenging requirement for funds to meet and take advantage of.

Lastly, note that as a reminder, the Act only applies to funds that invest in securities.  Funds that do not invest at all in securities, such as commodities funds or non-security digital asset funds, fall outside of the regulatory purview of the Act and registration requirements with the SEC.  However, other similar acts from other regulators may apply, and naturally, the regulation landscape associated with digital assets and their categorization as securities, commodites, or neither securities nor commodites is ongoing.