Oil & Gas Funds and Section 3(c)(9) – New Life for a Forgotten Exception

Private Funds and the Investment Company Act

A fund primarily engaged in investing or trading in securities must register under the Investment Company Act, unless it falls under an exception to the definition of investment company. The exceptions are listed in Section 3(c) of the Investment Company Act. For private equity, venture capital, hedge and similar funds, reliance on one of the exceptions is essential, as the regulatory quagmire of the Investment Company Act would prohibit several key features of private funds. Sponsors of these funds overwhelmingly rely on Section 3(c)(1), which limits a fund to 100 investors, or Section 3(c)(7), which limits a fund to qualified purchasers, in each case including knowledgeable employees. Managers and investors alike are well acquainted with the voluminous documentation in connection with the formation of funds intended to assure that the requirements of either exception are met.

The two exceptions form the cornerstones of the Investment Advisers Act’s definition of a “private fund,” which is a fund that would be an investment company but for Section 3(c)(1) or 3(c)(7), and thus the SEC’s recent regulatory initiatives target investment advisers to “private funds.” The most prominent examples are the Marketing Rule and the Private Fund Rules adopted by the SEC under the Investment Advisers Act in 2021 and 2023, respectively. The broad scope, some may say overreach, of the SEC’s regulation of investment advisers to “private funds” has renewed interest in other exceptions that, if available, would take a fund outside the definition of “private fund” and thus these rules. One such exception is Section 3(c)(9).

Section 3(c)(9)

Section 3(c)(9) excepts from the definition of investment company:

“[a]ny person substantially all of whose business consists of owning or holding oil, gas or other mineral royalties or leases or fractional interests therein, or certificates of interest or participation in or investment contracts relative to such royalties, leases or fractional interest.”

While reliance on Section 3(c)(1) or 3(c)(7) is based on the number or status of investors at closing, Section 3(c)(9) focuses on the activities of the fund, which can change over time. Even funds that primarily invest in oil & gas interests have historically relied on Section 3(c)(1) or 3(c)(7), simply because all that mattered was the certainty of not being an investment company. It is indicative that most no-action letters addressing interpretations of Section 3(c)(9) are over 40 years old.* The renewed interest in alternatives to Section 3(c)(1) and 3(c)(7) has made Section 3(c)(9) more relevant again. A sponsor of an oil & gas fund seeking to rely on Section 3(c)(9) should consider the following:

• Substantially all of the fund’s business must consist of owning or holding oil, gas or other mineral interests. Managers are well advised to read “substantially all” as “all and at all times.” A 3(c)(9) fund, even if it initially only invests in oil & gas interests, cannot sell an investment for securities. However, the SEC Staff has permitted 3(c)(9) funds to hold cash and temporary investments, as every fund has to manage the cash proceeds from capital calls, portfolio distributions, and sale proceeds.
• The fund must “own or hold” the eligible assets. According to the SEC Staff, the 3(c)(9) exception is not available to funds that trade or deal in such assets.
• The SEC Staff has interpreted the scope of the “oil, gas or other mineral royalties or leases, or fractional interests therein” prong to permit most investment structures common in the upstream industry. Fee simple ownership interests in oil & gas properties, which are generally not securities, have been deemed eligible as well. A 3(c)(9) fund may also engage in related business activities, including exploration, development and production.
• While Section 3(c)(9) does not refer to investments in securities of oil & gas companies, the prong “certificates of interest or participation in or investment contracts relative to” oil & gas assets has been interpreted to include equity interests in limited partnerships and joint ventures, and by extension should include equity interests in limited liability companies, that hold only eligible assets. On the other hand, loans to oil & gas companies are not covered by the exception.
• The sponsor should go on record in the fund’s disclosure documents and in any regulatory filings (g., Forms D, ADV and PF) that it is relying on Section 3(c)(9). We also recommend to include in the fund’s governing agreement a provision that limits permitted investments to those referred to in Section 3(c)(9) (in addition to oil & gas assets that may not be securities, such as real estate owned in fee simple) and temporary investments.
• Can a manager of an oil & gas fund that meets the Section 3(c)(9) requirements but previously relied on Section 3(c)(1) or 3(c)(7) change its position? The answer is not clear. At a minimum, disclosure documents and regulatory filings that reflect the prior position would have to be amended, but we are not aware of any precedent that such an amendment was sufficient to terminate the fund’s status as a “private fund” for all regulatory purposes.

Regulatory Implications

Investment Company Act

A 3(c)(9) fund, by definition, is not limited by Sections 3(c)(1) and 3(c)(7). It can accept more than 100 investors even if they are not qualified purchasers or knowledgeable employees. For sponsors of oil & gas funds that nonetheless expect to stay within these limits, we still recommend to obtain from investors the requisite information to establish that the fund could also rely on Section 3(c)(1) or 3(c)(7), in case it ever wanted to make investments that would take it outside Section 3(c)(9).

Investment Advisers Act

Fractional undivided interests in oil, gas or other mineral rights are securities. The manager of a 3(c)(9) fund is still an investment adviser and, depending on the amount of assets under management, subject to the Investment Advisers Act and its rules and regulations. However, reliance on Section 3(c)(9) for a fund avoids, solely with respect to the management of that particular fund, the application of several SEC rules:

• The Private Fund Rules, which impose a number of prohibitions, disclosure or consent requirements and affirmative obligations that fund managers by now are well familiar with, apply only to investment advisers to “private funds.” As the scope of the rules is fund-specific, so is the scope of the exception, and investment advisers to 3(c)(9) funds who also manage 3(c)(1) or 3(c)(7) funds must, of course, comply with the Private Fund Rules with respect to those funds.
• The Marketing Rule imposes various requirements, most significantly that any presentation of gross performance also present net performance, on an advertisement by an investment adviser directed at prospective clients (which, in the case of a fund, is the fund itself) or prospective “investors in a private fund advised by the investment adviser.” By implication, the requirements do not apply to advertisements directed at prospective investors in a 3(c)(9) fund.
• An investment adviser to a 3(c)(1) fund may not charge carried interest unless each investor in the fund that bears the carry is a “qualified client,” which currently means an investor with a net worth of $2.2 million or $1.1 million in assets under management with the adviser. The look-through to the fund investors does not apply to 3(c)(9) funds, for which it is sufficient that the fund itself meets these thresholds.

Securities Act

We must emphasize that, despite the greater regulatory flexibility under the Investment Company Act and the Investment Advisers Act, all relevant securities laws apply to the fundraising for 3(c)(9) funds as they do to “private funds.” Sponsors of a private placement of 3(c)(9) fund interests that rely on the safe harbor of Rule 506(b) under Regulation D should not engage in general solicitation and should only admit accredited investors.

* Indeed, most of these no-action letters are no longer publicly available. The following summary is primarily based on Robert H. Rosenblum, Investment Company Determination under the 1940 Act: Exemptions and Exceptions (Am. Bar Ass’n 2d ed. 2003).

This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.