Section 3(c)(7) of the Investment Company Act

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)(7) is one of two commonly used exemption frameworks, alongside its more common sibling, Section 3(c)(1).  An even rarer exemption framework, Section 3(c)(5), also exists, but only applies to certain types of real estate funds.

How to be exempt via Section 3(c)(7):

Exemption under Section 3(c)(7) is relatively straightforward to understand, although potentially challenging to actually satisfy, with two key prongs that must be satisfied by the investment company in question:

1. All beneficial owners (investors) must be Qualified Purchasers.
   • Most people are familiar with the notion of an “accredited investor”, which for a natural person means someone who either meets (a) a net worth test: investable assets of $1 million or greater, not including the value of their primary residence, if any, either individually or counted jointly with a spouse; or (b) an income test: an income of at least $200,000 per year for the last two years, with an expectation that such income will continue in the current year and forthgoing; if that person has a spouse, then joint income of at least $300,000 qualified similarly is acceptable as well.  For an entity to be an accredited investor, it must both be considered a qualifying entity – certain types of entities, which will not be discussed herein – as well as have investable assets of at least $5 million.
   • Qualified Purchaser (“QP“) status can only be met via a net worth test of a standard much higher than that of an accredited investor.  QPs must have investable assets of $5 million or greater, not including the value of their primary residence, if any, either individually or counted jointly with a spouse. For an entity to be a QP, it must botb be considered a qualifying entity – certain types of entities, which will not be discussed herein – as well as have investable assets of at least $25 million.
2. No more than 2,000 investors in the fund. 
   • Assuming everyone meets the standard to qualify as a QP, then you can have as many as 2,000 investors in the fund, which is a much higher threshold than the 100 investor cap in a 3(c)(1) fund.

Final thoughts:

While the idea of having up to 2,000 investors is quite attractive, because the standard required to be a QP is high, it is often uncommon for emerging or first time managers – and even sometimes institutional funds – to structure their funds as 3(c)(7) exempt. Consequently, 3(c)(1) ends up being a more common exemption utilized by hedge funds.

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.