Oil, Gas Private Equity Funds May Escape New SEC Transparency Rules

A “forgotten exemption” tucked away in an 83-year-old law may spare oil and gas funds from new Security and Exchange Commission (SEC) reporting requirements widely disliked in private equity circles.

Private equity and hedge funds have been bracing for the implementation of new rules approved by the SEC in August. The exemption could let oil and gas funds off the hook from new SEC transparency and reporting requirements that much of private equity see as intrusions that could throw a wrench into investor relations and add costs, administrative burdens and tight deadlines. A coalition of investment and fund industry groups are suing the SEC for what they see as an overreach of the commission’s statutory authority.

But word is spreading among fund managers and their lawyers. Funds investing exclusively in oil and gas appear to have a way out thanks to an obscure section—3(c)(9)—of the 1940 Investment Company Act.

“I like it,” said Haynes Boone partner Vicki Odette, who said she is discussing the exemption with clients. “If all you do [in a fund] is energy, you really should look at 3(c)(9) to see if you can get out” of the new requirements.

Robert Seber, a partner at Vinson & Elkins, referred to 3(c)(9) as the “forgotten exemption” due to the statute sitting mostly unneeded and almost entirely unnoticed for more than 80 years.

“It’s hard to find anything written about this exemption in the last 30 years. … But, now with the new private fund rules, there’s certainly a reason to look at this more closely,” he said. “If you are relying on the forgotten exemption and managing an oil and gas fund, then the new rules don’t apply to you with regard to that fund. … Now, there’s reason to pay more attention to this.”

Seber said the rules are disliked by private equity firms partially for the new administrative burdens they will bring.

“When we talk to the CFOs of funds, it scares the hell out of them. They’re like, ‘I’m going to have to spend all next year to figure out how to calculate returns,’” he said, adding that some of the financial reporting has narrow timeframes and there will be a cost for the new financial reporting. Further complication comes from new rules on what are commonly called side letters, he said. The letters specify terms for individual investors, and larger investors can often negotiate better terms for themselves.

Scott Moehrke, a partner with Kirkland & Ellis, said the new rules are less onerous than what the SEC originally proposed, “but there are still things that might cause headaches, like rules on how you’re supposed to allocate expenses relating to deals that don’t necessarily have a lot of definition.”

“There are requirements in certain instances to get investor approval of certain transactions, which might slow you down if you want to engage in a certain practice and need to get an investor consent to do it.”

This is where the Investment Company Act’s exemption for oil and gas funds can help.

“One of the benefits is you’re outside of these new rules. The other benefit is you’re generally not limited in the type or number of investors that you can take,” he said.

Moehrke said that a private fund using Investment Company Act Section 3(c)(1) can have up to 100 beneficial owners. A private fund using Section 3(c)(7) must limit owners to “qualified purchasers”—generally individuals with at least $5 million, or investments and institutions with at least $25 million of investments. The exemption for oil and gas funds would bypass those restrictions. Moehrke said that while the real estate sector has shown interest in the exemption the Investment Company Act offers them, he has not yet not heard much from those who can benefit from the oil and gas exemption. He expects that to change.

“The rules were just adopted about a month ago, and a lot of them don’t really come into play until next year. It takes a while for the industry to figure out what they are going to do with this issue,” he said. “I’m certain some energy funds, when they’re raising their next fund, may think about this, and some may decide it’s advantageous to use the oil and gas exemption.’”

Odette said private equity firms—and especially hedge funds—see the new rules as “very intrusive” and are “not happy” about the side letter rule because it makes preferential liquidity “virtually impossible,” especially for hedge funds.

Seber said parts of the regulations are less concerning, such as audits, because most firms already conduct them.

The Investment Company Act, signed by President Franklin D. Roosevelt, was originally intended to protect regular investors. In the 1930s and 1940s, oil and gas investing was seen as a domain of extremely rich Americans. A 2003 American Bar Association publication described the original basis of 3(c)(9) as exempting “wealthy, sophisticated investors” from protections they did not need.