Investors often seek to hold fund interests in the name of a revocable or irrevocable trust. While such ownership may further an investor’s estate planning goals, fund managers often are surprised that the investor’s qualification as an accredited investor under Rule 501 of Regulation D of the Securities Act of 1933 (the “Securities Act”) or as a qualified purchaser under Section 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”) does not extend to the trust, which can create regulatory obstacles for the fund.
Further, many high net worth families hold their assets in family limited partnerships or LLCs to centralize investment management, protect assets and maximize intergenerational wealth transfer. These family investment vehicles, as well as private foundations controlled by or receiving contributions from family members, often seek investment in private funds. Some such entities will qualify as accredited investors and qualified purchasers under the criteria typically applied to corporate entities, but specific criteria apply to family investment entities and foundations that qualify otherwise ineligible investors as accredited investors or qualified purchasers.
ACCREDITED INVESTOR STATUS
Typically, fund offerings are made in reliance on Rule 506(b) of Regulation D of the Securities Act pursuant to which offers are made only to accredited investors to avoid substantial disclosure obligations. A trust may qualify as an accredited investor in two ways.
First, a trust is an accredited investor if (1) its assets exceed $5 million at the time the investment is made, (2) a “sophisticated person” (generally, a trustee) directs the trust’s investment and (3) the trust was not formed for the specific purpose of investing in the fund.
A trustee qualifies as a sophisticated person if he has the knowledge and experience necessary to evaluate the merits and risks of investing in the fund or if the fund manager reasonably believes him to have such knowledge and experience. A trust with a corporate trustee or an individual trustee who independently qualifies as an accredited investor should meet the “sophisticated person” test, but an individual who does not independently qualify as an accredited investor may also meet the test based on her professional activities, education or other qualifications.
A national bank, or any banking institution organized under the laws of a state or Washington, D.C. the business of which is “substantially confined to banking” and that is governed by the state banking commission, is an accredited investor. That accredited investor status is imputed to a trust of which such a bank serves as trustee as long as the bank has the power to – and, in fact, does – direct the trust with respect to its investment in the fund. A trust may have one or more trustees in addition to the bank as long as the trust follows the bank’s instructions with regard to the fund investment.
It is an unsettled question whether a trust company qualifies as a bank for purposes of determining accredited investor status. The statutory language suggests that “bank” only applies to depository institutions. In one instance, however, the SEC did not challenge (or affirm) a trust company’s assumption that it qualified as a “banking institution” under Rule 501(a)(1) of Reg D since a “substantial portion of its business consists of exercising fiduciary powers” and it was supervised by a state banking commission.
Second, a trust will qualify as an accredited investor if the trust’s grantor, individually, is an accredited investor and the grantor has the power to revoke the trust. A very few irrevocable trusts that are disregarded entities for federal income tax purposes and whose terms meet specific criteria will also be treated as accredited investors if their grantors qualify as such. To date, the SEC has identified only certain grantor retained annuity trusts (“GRATs”) and “rabbi trusts” (created by an employer as part of an employee’s compensation) as irrevocable trusts that may qualify due to their grantors’ qualification.
Family Investment Vehicles and Foundations
Accredited investor status for a family investment entity or a nonprofit is tested the same way it is for other corporate entities. First, such an investment vehicle is an accredited investor if (1) its assets exceed $5 million at the time the investment is made and (2) the entity was not formed for the specific purpose of investing in the fund.
Alternatively, a family investment entity that does not qualify under the asset test above, is an accredited investor if all of its equity owners are accredited investors. In the family limited partnership or LLC context, the relevant owners – partners or members – are likely to be individuals, trusts or other closely-held family entities. Each equity owner’s accredited investor status must be analyzed carefully, and a non-accredited investor’s ownership of even a nominal interest (for example, a partnership interest held by a junior generation family member) will disqualify the entity as an accredited investor under this test.
QUALIFIED PURCHASER STATUS
A private fund normally relies on registration exemptions under the Investment Company Act provided by 3(c)(1) (which limits the fund to 100 investors) or 3(c)(7) (which permits greater than 100 investors so long as all investors are qualified purchasers). A trust may be a qualified purchaser in three ways.
First, a trust is a qualified purchaser if, at the time of the investment, the value of its investments is at least $5 million and all of the trust’s beneficiaries are related as siblings or by direct lineal descent (each a “family member”), the spouse or former spouse of a family member, the estate of a family member or a foundation, charitable organization or trust established by or for the benefit of one or more family members.
Second, a trust that fails to qualify as a qualified purchaser because of one or more unrelated beneficiaries is a qualified purchaser if it has investments of at least $25 million.
Third, a trust is a qualified purchaser if both the grantor and the person(s) with investment authority over trust assets (generally, the trustee) are qualified purchasers. It is immaterial whether all beneficiaries – or even any beneficiary – are qualified purchasers. A trust may have multiple trustees, some of whom may not be qualified purchasers, but a trust will be a qualified purchaser if the trustee(s) with authority to make the investment decision are qualified purchasers.
A trust is not a qualified purchaser if it was formed for the specific purpose of acquiring the securities offered even it otherwise satisfies the above qualified purchaser criteria.
Family Investment Vehicles and Foundations
As with other corporate entities, a family investment entity or a nonprofit is a qualified purchaser if the value of its investments is at least $25 million. A family entity without sufficient investments is subject to a reduced asset test and is a qualified purchaser if the value of its investments is at least $5 million and all of the “beneficial owners” are related as siblings or by direct lineal descent (each a “family member”), the spouse or former spouse of a family member, the estate of a family member or a foundation, charitable organization or trust established by or for the benefit of one or more family members.
The “beneficial owners” of a partnership or an LLC are its equity owners: the partners or members. For purposes of determining whether a charitable organization is a qualified purchaser under the $5 million investment value test, each contributor is treated as a “beneficial owner.” A family foundation that has received contributions only from individuals or entities related as described above will therefore as a qualified purchaser. As with the accredited investor analysis, even one unrelated beneficial owner will disqualify an entity from qualification under the $5 million investment value test.
An entity cannot qualify under either asset test, however, if it was formed for the specific purpose of acquiring the offered securities.
A family partnership or LLC that does not meet one of the asset tests described above but whose beneficial owners all independently qualify as qualified purchasers will also be treated as a qualified purchaser (even if it was formed for the specific purpose of acquiring the fund interest). A foundation is also a qualified purchaser if (1) all of its contributors are qualified purchasers, (2) each person authorized to make investment decisions for the foundation is a qualified purchaser and (3) the foundation was not formed for the specific purpose of acquiring the fund interest.
Jessica Hardin advises clients at Robinson Bradshaw on a wide variety of matters related to wealth transfer, asset protection, tax planning and charitable giving.