Investment Company Act of 1940 Enters Its 81st Year

The Investment Company Act of 1940, sometimes referred to as the 1940 Act, regulates investment funds. The regulation sets forth the criteria for defining a company as an “investment company.” Companies that the Investment Company Act regulates face stringent restrictions. The Securities and Exchange Commission (SEC) is responsible for imposing restrictive measures upon companies that are investment companies. Thus, avoiding classification as an investment company has become an important part of corporate and finance transactions.

Mutual funds and other pooled investment vehicles are the most obvious examples of investment companies subject to the Investment Company Act’s rules and regulations. However, the Investment Company Act’s broad scope can cause operating companies to inadvertently fall within the definition of a an investment companies. Companies with diverse business models and across a range of industries can inadvertently become classified as investment companies.

Examining the consolidated balance sheet of a company is a necessary first step in determining whether an issue potentially exists. Specifically, analysis of financial assets must make sure they account for a relatively small percentage of the overall assets. This is a common trap that causes companies to inadvertently fall within the definition of an investment company. Operating companies may invest large percentage of their assets in money market funds and other instruments. These investments put them at risk of Investment Company Act regulation.

Investment Company Act
Investment Company Act

The next step is to review the unconsolidated balance sheets of the parent company and its subsidiaries. If certain entities within the corporate structure hold a substantial portion of financial assets, this could raise an issue. This is especially true if the company has financial investments in non-majority owned subsidiaries. Investing in such subsidiaries is an indication of holding securities in an investment vehicle.

The Investment Company Act defines an investment company with respect to two separate tests. The operations tests under Section 3(a)(1)(A) broadly defines the term as a company that “holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities.”

The second test, the balance sheet test, is narrower in scope and has a quantitative basis. Under Section 3(a)(1)©, the balance sheet test defines an investment company as “engaged in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40% of the value of such issuer’s total assets on an unconsolidated basis.”

Companies often perform a Investment Company Act analysis to avoid issues that could subject them to regulationas investment companies. This analysis provides insight into whether a company is actually an investment vehicle or an operating company.

Qualifying for certain exceptions and exemptions can exclude a company from the definition of an investment company. The most common exception is Section 3(b)(1) of the Investment Company Act. Section 3(b)(1) states that a company is not an investment company if it is “an issuer primarily engaged, directly or through a wholly-owned subsidiary, in a business other than that of investing, reinvesting, owning, holding, or trading in securities.”

The SEC has implemented a five-factor test to determine whether a company is in a business other than investing. The five criteria for the Section 3(b)(1) analysis are:

  1. Has the company historically operated in an investment business?
  2. Does the company publicly portray itself as investment business?
  3. Do the officers and directors of the company devote substantial time and effort to managing the company’s investments?
  4. Has the company invested 45% or less of its assets in investment securities?
  5. Does the company generate 45% or less of its income from investment securities?

The last two criteria of the five-factor test, the “nature of assets” and “sources of income” factors, are the most heavily emphasized in the analysis. If more than 45% of a company’s asset value or more than 45% of its income is derived from investment securities, the company is unlikely to be exempted from Investment Company Act obligations.

Another exception to avoid the onerous regulations of classification as an investment company is Rule 3a-5. Rule 3a-5 provides an exemption from the Investment Company Act for finance subsidiaries. Some companies set up finance subsidiaries that have the sole purpose of borrowing funds and lending them to their operating parent company. Although these finance subsidiaries are merely providing intercompany loans and do not have active operations, Rule 3a-5 allows them to be exempt from classification as investment companies.

Sections 3(c)(1) and 3(c)(7) provide an exemption for privately offered funds such as hedge funds, private equity funds, and real estate investment funds. These sections of the Investment Company Act exempt companies with securities owned by a small number of accredited investors. Without this exemption, hedge funds and other private investment companies would face the burdensome requirements of the Investment Company Act.

Ryan Carpenter serves as Attorney and Managing Director of Carpenter Wellington. Ryan advises clients across a broad set of corporate and commercial matters.