Traps for the Unwary: What Every Operating Company Should Know to Avoid Regulation Under the Investment Company Act

For some companies, avoiding regulation under the Investment Company Act of 1940 (Investment Company Act, 1940 Act, or Act) can be the bane of their existence. The Investment Company Act was enacted to provide for the registration and regulation of investment vehicles. However, operating companies, depending on their business model, composition of assets, or organizational structure, can find themselves within the scope of the Act’s extensive regulatory regime, the potential of which could have significant consequences to their operations. Such companies often include those that are not perceived to be of the type that the Investment Company Act was intended to regulate.

Companies at risk of falling within the scope of the Investment Company Act may need to frequently assess their status under that Act. At times these companies may require a legal opinion that the company is not an investment company, such as when offering securities or engaging in other financing arrangements. In addition, Securities and Exchange Commission (Commission) staff will often request that a company provide its Investment Company Act status analysis while conducting selective reviews of disclosures filed with the Commission in accordance with the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act), or during examinations of any affiliated investment advisers, registered investment companies, or broker-dealers, if the staff decides such information would be relevant. In the event that the staff is unsatisfied with the analysis provided, the staff could, depending on the facts and circumstances, require the company to address in its disclosures the company’s risk that it might be an investment company, request the Commission’s Division of Examinations to conduct examinations of the company’s affiliated entities (if such entities are subject to the Commission’s examination authority), or refer the matter to the Commission’s Division of Enforcement.

The purpose of this article is to provide a roadmap for operating companies and their counsel when analyzing the company’s status under the Investment Company Act. The article will also provide insight and present potential options a company may wish to consider in order to avoid triggering potential Investment Company Act regulation.

I. Background: What Is the Investment Company Act and Why Should Companies Care?

The Investment Company Act was among the federal securities laws enacted following the market crash of 1929. The Act, which was drafted in collaboration with the Commission and members of the investment company industry, prescribes an extensive regulatory scheme for companies that fall within the scope of the Act. Such companies are also subject to a disclosure and reporting regime that differs from non-investment companies. The Investment Company Act reflects the view that the disclosure and reporting requirements set forth in the previously enacted Securities Act and Exchange Act did not go far enough in addressing the abuses found in the investment company industry during that time period.

The regulatory regime prescribed by the Investment Company Act is incompatible with the activities of most operating companies. To comply with the Act, an operating company would likely need to significantly restructure its business and be subject to limitations to its operations. Thus, whether to register under the Act is not a decision to be taken lightly. Rather, companies that choose to be subject to the requirements of the Investment Company Act generally do so because they want to be an investment company.

Companies that fall within the scope of the Investment Company Act but continue to operate without complying with the Act’s requirements could suffer adverse consequences. Such companies may find their contracts voidable under Section 47(b) of that Act. They could also be subject to Commission enforcement action or private litigation that alleges that they are unregistered investment companies.

II. Threshold Question: Does the Company Meet the Definition of Investment Company?

The threshold question facing operating companies is whether they, or any of their subsidiaries, fall (or is at risk of falling) within one of the definitions of investment company set forth in Section 3(a) of the Investment Company Act. Of the three definitions, two—Section 3(a)(1)(A) and Section 3(a)(1)(C)—are relevant to operating companies.

A. Section 3(a)(1)(A)

Section 3(a)(1)(A) defines an investment company as any issuer that “is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.” This definition captures a so-called “orthodox investment company,” which is “a company that knows that it is an investment company and does not claim to be anything else.” Thus, mutual funds, closed-end funds, exchange-traded funds, and other investment vehicles that are generally considered to be investment companies typically fall within this definition. At times, however, operating companies may fall within the scope of the definition as well.

A company does not need to “hold itself out” to be engaged primarily in the business of “investing, reinvesting or trading in securities” to fall within Section 3(a)(1)(A). Rather, the company need only be engaged primarily in or proposing to be engaged primarily in that business regardless of its intent. In addition, Commission staff has taken the position that, depending on the facts and circumstances, a company that passively holds a fixed pool of securities could meet the definition in Section 3(a)(1)(A).

To fall within Section 3(a)(1)(A), the company generally must be (1) investing, reinvesting, or trading in securities for purposes of the Investment Company Act, and (2) engaged primarily, or proposing to be engaged primarily, in the business of such securities.

1. What Is a “Security” Under the Investment Company Act?

Section 2(a)(36) of the Investment Company Act defines a security as:

[A]ny note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof ), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

The definition of security in the Investment Company Act is identical to the definition of security in the Investment Advisers Act of 1940 (Advisers Act) and is very similar to the definition of security in the Securities Act and in the Exchange Act.

Whether a particular asset may be considered to be a security may depend on the facts and circumstances. Accordingly, the staff at times has chosen not to address whether a particular transaction involves securities. Nevertheless, the following discussion may prove useful in determining whether a company’s business involves securities.

As a general matter, assets that are securities for purposes of the Securities Act and the Exchange Act have been similarly treated as securities for purposes of the Investment Company Act. Furthermore, the tests set forth in SEC v. Howey and its progeny have been used to determine whether an investment contract exists—and thus is a security—for purposes of the Investment Company Act even though the tests were articulated in the context of the Securities Act and Exchange Act. Thus, consistent with this analysis, depending on the facts and circumstances, companies whose primary business is to acquire general or limited partnership interests could meet the definition of investment company if such assets are investment contracts. Similarly, companies that engage in their businesses through joint ventures might also be investment companies if, depending on the facts and circumstances, such joint venture interests are investment contracts. Companies that hold digital assets should also consider whether those assets are investment contracts under the Investment Company Act using the same framework.

While a security for purposes of the Investment Company Act generally includes assets that are considered securities under the Securities Act and the Exchange Act, certain assets that may not be securities under the Securities Act or the Exchange Act may nevertheless be securities for purposes of the Investment Company Act. Such a distinction can be found in the statutory language of the Investment Company Act. For example, in 1982, Congress amended the definition of security in Section 2(a)(36) of the Investment Company Act to indicate that certificates of deposit are included in the definition, but it did not make a corresponding change in the Securities Act and the Exchange Act. In addition, although Section 2(a)(36) does not specifically include “loans,” other sections of the Investment Company Act make clear that loans (including mortgages) are securities for purposes of that Act.

Furthermore, the Commission has taken the position that, despite the similarities in the definition of security among the federal securities laws, under certain circumstances whether a particular asset is a security may differ given the “potential differences in the scope of the securities statutes.” Accordingly, the Commission at times has taken the position that an asset may be a security under the Investment Company Act even though the asset may not be a security under the Securities Act or the Exchange Act because “the regulatory context under the Investment Company Act differs fundamentally from that under the Securities Act and the . . . Exchange Act.” Thus, the Commission views certain bank instruments, including certificates of deposit issued by a bank, as securities under the Investment Company Act. The Commission has also pointed to the staff ’s position that loan participations are securities under the Investment Company Act.

Finally, the staff has viewed the definition of securities under the Investment Company Act broadly. For example, the staff has taken the position that a determination that a note evidencing a commercial transaction is not a security under the Securities Act and Exchange Act is not relevant when determining whether an issuer engaged in the business of investing in these notes is in fact investing in securities for purposes of determining the issuer’s Investment Company Act status. The staff explained:

The 1940 Act explicitly recognizes that although an instrument is of a commercial character, it is still a security. In other words, for purposes of the 1940 Act (i.e., the regulation of a pool of portfolio securities), it makes no difference that the securities are commercial instruments except as otherwise specifically provided in the 1940 Act.

Thus, the staff has taken the position that promissory notes evidencing loans held by a financial institution, notes acquired in connection with the sale of certain businesses, and loan participations, among others, are securities under the Investment Company Act.

2. Being “Engaged Primarily” in the Business of Securities

To fall within Section 3(a)(1)(A), a company must be “engaged primarily” in the business of investing, reinvesting, or trading in securities. To determine a company’s primary engagement for purposes of the Act, the Commission applies a five-factor test initially set forth in Tonopah Mining Co. of Nevada. These factors, which are commonly called the Tonopah factors, are: (a) the company’s historical development, (b) its public representations of policy, (c) the activities of its officers and directors, (d) the nature of its present assets, and (e) the sources of its present income. The Commission has generally taken the position that the most significant of these factors are the nature of the company’s assets and the source of the company’s income (i.e., the quantitative factors). Even in such situations, however, the Commission has indicated that the other Tonopah factors would need to be considered when analyzing a company’s primary engagement.

A comprehensive discussion about the application of the Tonopah factors would be remiss without including the Seventh Circuit’s holding in SEC v. National Presto Industries Inc., a case in which the court applied the Tonopah factors in a manner contrary to the Commission’s position. That decision ended a long and contentious dispute between the Commission and National Presto Industries (Presto) regarding the company’s status under the Investment Company Act. The Commission took the position that the company was operating as an unregistered investment company given the significant amount of securities that the company had held over a lengthy time period. The court applied the Tonopah factors and found that only the fourth factor, Presto’s asset composition, favored the Commission’s position. The court also disagreed with the Commission’s view that the nature of a company’s assets is the “most important” of the Tonopah factors. The court concluded that the Commission was misapplying its own test, stating that:

[T]he Commission thought in Tonopah that what principally matters is the beliefs the company is likely to induce in investors. Will its portfolio and activities lead investors to treat a firm as an investment vehicle or as an operating enterprise? The Commission has never issued an opinion or rule taking a different view, and its lawyers cannot adopt a new approach by filing briefs. Only the Commission’s members may change established norms, and they must do so by rulemaking or administrative adjudication.

Reasonable investors would treat Presto as an operating company rather than a competitor with a closed-end mutual fund. The SEC has not tried to demonstrate anything different about investors’ perceptions or behavior. It follows that Presto is not an investment company.

The National Presto holding was subsequently addressed in Daxor Corp. The decision specifically noted that:

National Presto holds that, under the Tonopah analysis, what matters most is—not asset composition alone, but rather—the belief the issuer is likely to induce in investors; will investors treat the issuer as “an investment vehicle or operating enterprise?” 486 F.3d at 314–15. However, Tonopah considered investors’ perception as being created by the issuer’s assets and income. 26 S.E.C. at 430 (“More important … [is whether] the nature of the assets and income of the company, disclosed in the annual reports filed with the Commission and in reports sent to stockholders, was such as to lead investors to believe that the principal activity of the company was trading and investing in securities.” (emphasis added)). Therefore, even from an investor perspective, assets and income are most important.

In testimony before Congress that occurred two months after National Presto was issued, the Director of the Commission’s Division of Investment Management (Investment Management Division or the Division) at that time explained the use of the Tonopah factors to determine a company’s primary engagement and that “the Commission traditionally considers the nature of the assets and income to be the most important factors in this analysis.”

3. “Proposes” to Engage Primarily

A company could meet the definition of investment company under Section 3(a)(1)(A) merely by proposing to engage primarily in the business of investing, reinvesting, or trading in securities. Thus, such a company could fall within the scope of the Investment Company Act even prior to actually being primarily engaged in the business of securities.

Whether a company meets the “proposes” to engage primarily requirement of the definition is a question of facts and circumstances. The Commission has taken the position that “once a company has taken affirmative action which evidences its determination to engage primarily in the business of investing, reinvesting, or trading in securities, the requirements of Section 3(a)(1)[(A)] are satisfied.” Thus, a company could trigger the definition if its activities indicate that a decision has been made for the company to become an investment company (such as, for example, the company’s board of directors hiring a chief executive officer with the appropriate experience needed to operate an investment company). The Commission made clear that formal corporate action does not need to occur for a company to meet the definition of investment company.

B. Section 3(a)(1)(C)

Section 3(a)(1)(C) defines an investment company as any issuer that

is engaged or proposes to engage 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 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Companies that meet this definition often are called “inadvertent investment companies” because typically they did not intend to fall within the scope of the Act. Many operating companies have found themselves in danger of falling within the scope of this definition.

Section 3(a)(1)(C) has two parts, both of which must be met for an issuer to be an investment company under that provision. Each part is discussed below.

1. Part 1: Engaged or Proposes to Be Engaged in the Business

The first part requires the issuer to be engaged or proposing to be engaged in the business of investing, reinvesting, owning, holding, or trading in securities. While this requirement is similar to that found in Section 3(a)(1)(A), Section 3(a)(1)(C) does not require the issuer to be primarily engaged in the business, only that it is engaged in that business. In addition, unlike Section 3(a)(1)(A), Section 3(a)(1)(C) specifically includes issuers that “own” or “hold” securities. The Commission has noted that “section 3(a)(1)[(A)] does not apply to companies which merely ‘own or hold’ securities, while section [3(a)(1)(C)] applies to such companies.”

2. Part 2: The 40% Test

For an operating company to fall within the definition of investment company, its investment securities must exceed 40 percent of its total assets (exclusive of government securities and cash items) (often referred to as “failing” the 40% test). This complicated quantitative test can ensnare many operating companies that, without counsel well-versed in the Investment Company Act, could, to their surprise, find themselves to be operating as unregistered investment companies. Understanding the application of the 40% test is imperative when assessing a company’s risk of becoming an investment company. Such an understanding may also allow companies to organize and operate their businesses in a manner that would ensure that they do not fall within the definition of investment company.

Below are some of the issues operating companies and their counsel should consider when applying the 40% test.

a. What Constitutes “Total Assets”?

When calculating the 40% test, a company’s total assets are generally considered to be those assets that appear on the company’s balance sheet as prepared according to Generally Accepted Accounting Principles (GAAP). Thus, for example, internally generated intellectual property is not considered to be a GAAP asset and is thus excluded from a company’s total assets for purposes of calculating the 40% test. This interpretation can be problematic for certain technology companies and service providers that have significant internally generated intellectual property but few tangible assets other than investment securities.

b. Exclusive of Government Securities and Cash Items

Section 3(a)(1)(C) requires that government securities and cash items be deducted from the issuer’s total assets when calculating the 40% test. Thus, depending on the other assets on a company’s balance sheet, a company that holds large amounts of government securities and cash items can find themselves in danger of failing the 40% test.

Section 2(a)(16) of the Act generally defines “government security” to include “any security issued or guaranteed as to principal or interest by the United States, or by a person controlled or supervised by and acting as an instrumentality of the Government of the United States.” The staff has issued a number of letters addressing what securities may be considered to be government securities for purposes of the Investment Company Act.

The Investment Company Act does not define the term “cash items.” The staff, however, has taken the position that for purposes of Section 3(a)(1)(C) and in other contexts under the Act, cash items generally are considered to be “cash, coins, paper currency, demand deposits with banks, timely checks of others (which are orders on banks to immediately supply funds), cashier checks, certified checks, bank drafts, money orders, traveler’s checks, and letters of credit.” Similarly, the staff has taken the position that shares of money market funds that are registered under the Act may also be deducted from total assets when calculating the 40% test.

The Commission has stated that certificates of deposits and other time deposits are securities for purposes of the Investment Company Act. Unlike shares of money market funds, the staff has not specifically addressed whether such items should be treated differently when calculating the 40% test.

c. Calculating on an Unconsolidated Basis

Section 3(a)(1)(A) requires the 40% test to be applied on an unconsolidated basis. Given this requirement, a company may need to consider whether it, as well as each of its subsidiaries (both direct and indirect), meets the 40% test based on each entity’s own balance sheet. The fact that, for accounting purposes, GAAP may require consolidation is irrelevant when calculating the 40% test. Rather, each entity’s balance sheet generally must stand on its own.

The requirement that the 40% test is calculated on an unconsolidated basis may produce unexpected outcomes. For example, a company that holds more than 40 percent of its total assets in “investment securities” (as that term is discussed below) on a consolidated basis may not necessarily fail the 40% test when the test is calculated on an unconsolidated basis. Furthermore, a company with majority-owned subsidiaries may itself fail the 40% test because of the assets on its unconsolidated balance sheet (i.e., its direct holdings), even if each of its subsidiaries does not fail that test. Conversely, a company with a majority-owned subsidiary that fails the 40% test (generally causing the subsidiary to be an investment company absent the availability of an exclusion) may not itself fail the 40% test if the securities issued by the subsidiary that are held by the company (which for purposes of the company’s 40% test calculation would be considered to be investment securities), combined with the company’s other investment securities, do not have a value exceeding 40% of the value of the company’s total assets.

d. The Definition of “Investment Security”

Whether a company meets the definition of investment company under Section 3(a)(1)(C) depends, in part, on the amount of investment securities that it holds. The definition of investment security is complicated and its application may be particularly challenging for operating companies that operate through subsidiaries.

Section 3(a)(2) of the Act defines investment securities to include

all securities except (A) Government securities, (B) securities issued by employees’ securities companies, and (C) securities issued by majority-owned subsidiaries of the owner which (i) are not investment companies, and (ii) are not relying on the exclusion from the definition of investment company . . . [in Section 3(c)(1) or Section 3(c)(7) of the Act].

Thus, a company (and each of its subsidiaries, separately, given the requirement that the test is conducted on an unconsolidated basis) must deduct from its direct securities holdings all securities set forth in (A), (B), and (C) above (the deducted securities—and anything else not considered to be investment securities—are often referred to as “good assets”). The staff has also taken the position that shares of money market funds that are registered investment companies need not be treated as investment securities for purposes of the 40% test and thus may be deducted from a company’s direct securities holdings. The percentage of remaining securities (i.e., the investment securities) compared to total assets will determine whether the company (or any of its subsidiaries independently) fails the 40% test.

For some companies, whether they fail the 40% test is dependent on the Investment Company Act status of their subsidiaries. Since securities issued by certain majority-owned subsidiaries that are held by their parent may not be investment securities, the first question to be addressed is whether each subsidiary meets the definition of “majority-owned” as defined by the Investment Company Act. Section 2(a)(24) of the Act generally defines a majority-owned subsidiary of a person as a company of which 50 percent or more of the outstanding voting securities are owned by such person or by a company that is a majority-owned subsidiary of such person. Securities of entities that do not meet the definition of majority-owned subsidiary are investment securities for purposes of calculating the 40% test.

The analysis does not stop even if a subsidiary meets the definition of majority-owned subsidiary. Rather, only securities issued by those majority-owned subsidiaries that are not investment companies and are not relying on Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act (which excludes private investment companies from the definition of investment company under certain conditions) may be considered to be good assets for purposes of the 40% test.

Furthermore, any company that operates through direct and indirect majority-owned subsidiaries needs to be cognizant that its Investment Company Act status may be directly tied to the status of its subsidiaries, including their indirect subsidiaries. It is possible that a company may fail the 40% test solely because one or more of their indirect subsidiaries are investment companies (or rely on Section 3(c)(1) or Section 3(c)(7)). Accordingly, a company with direct or indirect subsidiaries needs to focus first on the status of its most bottom-tiered subsidiaries and then effectively work its way up its organizational chart to determine whether the company itself fails the 40% test. Below are two examples:

• To calculate the 40% test for a company that operates through a wholly owned subsidiary (i.e., its direct subsidiary) that in turn has a wholly owned subsidiary (i.e., its indirect subsidiary), the company needs to first focus on the status of the indirect subsidiary. If the indirect subsidiary is not an investment company and does not rely on Section 3(c)(1) or Section 3(c)(7), then the direct subsidiary’s holdings in the indirect subsidiary are not investment securities for purposes of determining the direct subsidiary’s status. If, as a result, the direct subsidiary does not fail the 40% test, then the company’s holdings in the direct subsidiary would also not be considered to be investment securities for purposes of the company determining its own status.
• Using the same organizational structure as the example above, if the indirect subsidiary is an investment company under Section 3(a) (and does not meet an exclusion other than Section 3(c)(1) or Section 3(c)(7)), its interests held by the direct subsidiary would be considered investment securities for purposes of determining the direct subsidiary’s status. If, because of its investment in the indirect subsidiary, the direct subsidiary fails the 40% test (and cannot rely on any exclusion other than Section 3(c)(1) or Section 3(c)(7)), then the company’s holdings in the direct subsidiary would also be considered to be investment securities, which could adversely affect the company’s calculations regarding its own status.

Finally, the fact that a company (or its subsidiary) holds investment securities does not necessarily mean that the company has an Investment Company Act status issue. A company can hold up to 40 percent of its total assets (exclusive of government securities and cash items) in these assets without falling within the definition of investment company. Nevertheless, the 40% test could be particularly problematic for companies whose business model includes acquiring minority stakes in other companies as part of their strategic partnerships.

e. How Often to Value Assets and Calculate the 40% Test

The Commission generally takes the position that an issuer must at all times have no more than 40 percent of its total assets in investment securities to avoid meeting Section 3(a)(1)(C). However, a company does not need to value its assets on a continuous basis to determine whether it meets the test. Rather, under Section 2(a)(41)(A) (which defines the term “value”), currently owned securities for which market quotations are readably available and that were owned at the end of the last preceding fiscal quarter are to be valued at the market value as of the end of that preceding quarter. Other currently owned securities and assets that were owned at the end of the last preceding fiscal quarter must be valued at “fair value” as determined in good faith by their board of directors, also as of the end of the last preceding quarter. Securities and other assets acquired after the end of the last fiscal quarter are to be valued at cost.

Nevertheless, a company with significant amounts of investment securities needs to be vigilant of the valuation of its assets to ensure that the company does not inadvertently cross the 40 percent threshold. Any changes with respect to the valuation of its assets—such as, for example, the valuation of its investment securities increasing, or the valuation of its good assets decreasing—could have implications regarding its investment company status. Similarly, the company should be mindful when purchasing or selling assets whether such transactions might cause the company to fail the 40% test.

C. Special Situation Investment Companies

Although not defined in the Investment Company Act, so-called special situation investment companies may also be considered to be investment companies for purposes of the Investment Company Act. The Commission has stated that “[s]pecial situation investment companies are companies which secure control of other companies primarily for the purpose of making a profit in the sale of the controlled company’s securities.” A company therefore may be a special situation investment company if its primary business is to acquire interests in other companies (regardless of whether such companies are wholly owned subsidiaries, majority-owned subsidiaries, or controlled companies) for the intention of increasing their value, and then, within a short period of time, sell such interests for a profit. Special situation investment companies are different from holding companies in that a holding company generally acquires controlling interests in other companies “primarily for the purpose of engaging in the other companies’ line of business.”

Whether a company is a special situation investment company is a factual determination. Based on Commission and staff guidance, the following is a list of factors that a company may wish to consider when determining whether it might be a special situation investment company:

• How the company describes the nature of its business;
• The company’s history with respect to acquiring and selling controlled interests of other companies, including how long the company typically retains such interests before selling them;
• How the proceeds are used from the sale of the interests; and
• Whether the acquired companies are diversified with respect to the nature of their businesses.

Whether the company actively participates in the management of the business of the companies whose interests they acquire is not indicative of whether the company is a special situation investment company. Rather, the Commission has taken the position that “[c]ontrol and operation of businesses is not . . . necessarily inconsistent with the activities of that type of investment company.”

Finally, any company deemed to be a special situation investment company has fewer options in avoiding registration under the Investment Company Act than other companies that may meet the definition of investment company in Section 3(a)(1). In this regard, special situation investment companies cannot rely on the exclusions in Section 3(b)(1) or Section 3(b)(2) of the Investment Company Act or Rule 3a-1 or Rule 3a-8 under that Act.

III. Potential Options to Pursue to Avoid Investment Company Act Regulation

Depending on the facts and circumstances, an operating company that is concerned that it or one of its subsidiaries may potentially fall within the definition of investment company in Section 3(a)(1)(A) or Section 3(a)(1)(C) may have options it could pursue to avoid having to register and be regulated under the Investment Company Act.

A. Managing Organization and Operations Cognizant of Investment Company Act Implications

An operating company may be able to manage its business in a manner that does not raise Investment Company Act implications. For example, the company may be able to monitor its balance sheet to ensure that it does not fail the 40% test. This could entail careful planning and ongoing monitoring regarding the impact of any acquisition or sale of assets as such actions may affect the company’s Investment Company Act status. Similarly, the company may need to be cognizant of the valuation of its assets.

To address such concerns, a company could sell investment securities and deploy the proceeds in assets that are not securities under the Investment Company Act or in operations that further the company’s business. A company could also purchase government securities or shares of money market funds since such assets are deducted from total assets and are not considered to be investment securities. Similarly, a company might consider acquiring cash items since such assets are deducted from total assets when calculating the 40% test. The company could also avoid certain acquisitions that might otherwise result in it inadvertently becoming an investment company.

Of course, depending on the facts and circumstances, continual monitoring and, where necessary, adjusting a company’s balance sheet could be time consuming, adversely impede the company’s business operations, and potentially affect future growth. A company might need to sell investment securities that it otherwise had no wish to sell or avoid investing in certain assets that might be beneficial to the company’s business. Similarly, investing in government securities and money market funds, or acquiring cash items, might bring lower rates of return than other investments. Too much of such purchases could also raise other Investment Company Act issues.

A company that operates through subsidiaries may have additional considerations when managing the operations of its business. A company’s organizational chart, each subsidiary’s asset composition, and the Investment Company Act status of each subsidiary (including whether the subsidiary could rely on certain exclusions, if necessary) could all potentially impact the company’s status under the Act. For example, depending on the facts and circumstances, a company’s acquisition of investment securities (including strategic interests) could cause the company to fail the 40% test if the company held the securities directly. However, it may not have any negative impact on the company if the securities were held by a majority-owned subsidiary, provided that the majority-owned subsidiary is not an investment company, such investments do not cause the subsidiary itself to become an investment company, or the subsidiary can rely on an exclusion other than Section 3(c)(1) or Section 3(c)(7). However, the Commission in another context warned against an issuer transferring assets to an affiliate “primarily for the purpose of avoiding the Act,” while acknowledging that such action might be permissible if the transfer is “to a majority-owned subsidiary primarily for bona fide business reasons.”

B. Relying on an Exclusion from the Definition of Investment Company

Sections 3(b) and 3(c) of the Investment Company Act set forth a litany of provisions that specifically exclude certain issuers from the definition of investment company. Most of these exclusions cover entities that, at the time the Act was enacted, were generally not considered to be engaged in the activities of an investment company. The Commission has also enacted several rules that exclude certain issuers based on their activities. Most of these statutory provisions and rules exclude issuers that meet the definition of investment company under all provisions of Section 3(a)(1). A few exclusions (i.e., Section 3(b) and Rule 3a-1) specifically exclude issuers only from Section 3(a)(1)(C) and not from Section 3(a)(1)(A). Note that, with the exception of Section 3(b)(2), these exclusions are self-operating.

Accordingly, a company that meets the language of an exclusion, or that can rely on Commission or staff-issued guidance with respect to an exclusion, is typically not subject to regulation under the Investment Company Act. In addition, with respect to a company that operates through subsidiaries, securities of majority-owned subsidiaries that can rely on any exclusion (other than the exclusions set forth in Section 3(c)(1) or Section 3(c)(7)) are generally treated as good assets for purposes of the company’s calculation of the 40% test.

1. Exclusions from the Definition of Investment Company Under Section 3(a)(1)

a. Exclusions for Specific Types of Companies

Section 3(c) of the Investment Company Act generally excludes specific types of companies that were not envisioned to be in the investment company business. These include, among others, domestic banks and domestic insurance companies, underwriters, common trust funds maintained by a bank, pension plans, and charitable organizations. The provisions also exclude certain issuers who engage (or, depending on the provision, primarily engage or substantially engage) in certain businesses, such as businesses related to the origination or acquisition of specified types of loans (including small loans, mortgage loans, and obligations related to specified merchandise, insurance, and services), businesses that acquire “liens on and interests in real estate,” and businesses that own or hold oil, gas, or other mineral royalties or leases. The Commission has similarly adopted rules that generally provide that, notwithstanding Section 3(a), certain issuers are not investment companies for purposes of the Act provided they meet the rule’s conditions. These include, among others, certain financing subsidiaries, foreign banks and foreign insurance companies, research and development companies, asset-backed securities issuers, crowdfunding vehicles, and investment advisory programs as defined by each respective rule.

For some exclusions, reliance is dependent on the issuer complying with certain conditions that could impact a company’s activities. The issuer therefore would need to continuously monitor its activities to ensure that it does not fall out of compliance.

b. Exclusions Not Limited to Specified Businesses

An operating company whose activities do not fall within one of the specified businesses excluded by the Investment Company Act or by Commission rules may be able to rely on Section 3(c)(1), Section 3(c)(7), or Rule 3a-2. In addition, a company that meets Section 3(a)(1)(C) but not Section 3(a)(1)(A) may also be able to rely on Rule 3a-1 or Section 3(b)(1), or receive an order under Section 3(b)(2).

1. Section 3(c)(1) and Section 3(c)(7)—Private Investment Companies

Section 3(c)(1) generally excludes from the definition of investment company any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons and that is not making and does not presently propose to make a public offering of its securities. Section 3(c)(7) generally excludes from the definition of investment company any issuer whose outstanding securities are owned exclusively by persons who, at the time of acquisition, are “qualified purchasers,” and that is not making and does not at that time propose to make a public offering of such securities. Either of these exclusions might be useful to an operating company that has no intention of conducting a public offering and that is willing to keep tabs on the number or type of investors that own its shares. In addition, an operating company with majority-owned subsidiaries might find it advantageous for one or more of its subsidiaries to rely on either Section 3(c)(1) or Section 3(c)(7), particularly if the subsidiary has few investors other than its parent.

Reliance on either of these exclusions could be challenging for some companies. Such a company would need to be mindful that any misstep regarding the sale of its securities to persons not permitted under the relevant exclusion could potentially cause the company to fall outside the exclusion’s requirements. In addition, any company that intends to publicly offer its shares would need to find another means to avoid Investment Company Act regulation, which potentially could require a restructuring of its organization or a change in its business operations. Given that both Section 3(c)(1) and Section 3(c)(7) may prohibit reliance by issuers that are proposing to make a public offering, a company that intends to conduct a public offering may wish to take the actions necessary to rely on another exclusion (other than Section 3(c)(1) or Section 3(c)(7)) before taking affirmative steps toward engaging in the offering process. Finally, as discussed above, a company’s holdings of any securities issued by a majority-owned subsidiary that is relying on either of these two sections are considered to be investment securities. Thus, the company would need to ensure that the value of these securities do not adversely affect its own Investment Company Act status.

Private companies can rely on any exclusion from the Investment Company Act, and the rules thereunder, provided that they meet the relevant exclusion’s requirements. There is no requirement that such companies must rely only on Section 3(c)(1) or Section 3(c)(7). In addition, a company’s holdings of securities issued by a majority-owned subsidiary that can rely on an exclusion other than Section 3(c)(1) or Section 3(c)(7) may still be treated as a good asset for purposes of determining the company’s status regardless of whether the subsidiary also meets Section 3(c)(1) or Section 3(c)(7)’s requirements.

2. Rule 3a-2—Transient Investment Companies

Rule 3a-2 generally provides a one-year safe harbor from the definition of investment company to any issuer that has a bona fide intent to be engaged primarily, as soon as is reasonably possible, in a business other than that of investing, reinvesting, owning, holding, or trading in securities. Such intent must be evidenced by the issuer’s business activities and a resolution of the issuer’s board of directors (or other appropriate person(s) for any issuer not having a board of directors) in a manner specified in the rule.

Rule 3a-2 is intended to provide a safe harbor to issuers that, upon the occurrence of an unusual business event, fall within the definition of investment company. These events, include, among others, a start-up that invests proceeds raised in an offering in securities until the proceeds are distributed, a company that sells a significant operating asset (such as a wholly owned subsidiary) and invests the proceeds in securities until the company acquires another significant operating asset, and a company that acquires minority interests in a target company as a result of a failed tender offer. The rule thus provides these so-called “transient investment companies” with a period not to exceed one-year to transition to a non-investment company business.

The rule is intended to give companies a temporary reprieve. It is not a long-term solution. In addition, given the intent of the rule, the rule states that no issuer may rely on the exclusion more frequently than once during any three-year period.

2. Exclusions from the Definition of Investment Company Under Section 3(a)(1)(C)

a. Rule 3a-1—Certain Prima Facie Investment Companies

Rule 3a-1 generally deems an issuer not to be an investment company for purposes of Section 3(a)(1)(C) if no more than 45 percent of the value of its total assets (exclusive of government securities and cash items) consists of, and no more than 45 percent of its net income after taxes (for the last four fiscal quarters combined) is derived from, what the staff has referred to as “adjusted investment securities.” Thus, like Section 3(a)(1)(C), the rule sets forth a complicated statistical formula based on the nature of the issuer’s assets. However, unlike Section 3(a)(1)(C), the rule also looks at the sources of the issuer’s income.

To determine whether a company may rely on Rule 3a-1, the issuer must first identify its adjusted investment securities. Like investment securities, adjusted investment securities are securities exclusive of government securities, securities issued by ESCs, and securities issued by certain majority-owned subsidiaries that are not investment companies. In addition, the staff has taken the position that an issuer need not include shares of money market funds that are registered investment companies when calculating its adjusted investment securities.

Unlike Section 3(a)(1)(C), Rule 3a-1 also excludes from an issuer’s securities holdings those securities of companies that are controlled primarily by the issuer “through which such issuer engages in a business other than that of investing, reinvesting, owning, holding or trading in securities” and that are not themselves investment companies. Thus, when determining the issuer’s adjusted investment securities, securities may be deducted from the issuer’s securities holdings if (1) the issuer has “control” of the company as defined in Section 2(a)(9) and (2) the issuer primarily controls that company, which the staff has interpreted to mean that the issuer is the company’s largest shareholder.

To rely on Rule 3a-1, the issuer must satisfy both the asset test and the income test. The calculations are determined on an unconsolidated basis, except that the issuer must consolidate its financial statements with the financial statements of any wholly owned subsidiaries.

Rule 3a-1 may be advantageous for certain issuers that would otherwise fall within Section 3(a)(1)(C) but not Section 3(a)(1)(A). The rule expands the amount of securities the issuer might hold before tripping the threshold, both by increasing the threshold to 45 percent and by excluding from securities holdings those securities issued by primarily controlled companies when calculating the issuer’s adjusted investment securities. Thus, Rule 3a-1 may be particularly useful for issuers whose business operations include primarily controlling another company with the intention of becoming actively involved in the management of that company’s business. The rule also has the added benefit of being a quantitative test; thus, the issuer does not need to make any subjective determinations to rely on it.

One potential issue for some issuers might be compliance with Rule 3a-1’s income test. For example, any issuer that derived significant net income from the sale of adjusted investment securities may not meet Rule 3a-1’s income test. In addition, the rule specifically excludes special situation investment companies from relying on it.

b. Section 3(b)(1)

Another option for an operating company that triggers Section 3(a)(1)(C) may be to rely on Section 3(b)(1), which excludes an “issuer primarily engaged, directly or through a wholly owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities” (referred to herein as “non-investment company business”).

Section 3(b)(1) specifically states that to rely on the provision, a company must have met the definition of investment company under Section 3(a)(1)(C) but not Section 3(a)(1)(A). The Commission takes the position that a determination under Section 3(b)(1) (or Section 3(b)(2)) that an issuer is primarily engaged in a non-investment company business also means that the issuer does not meet the definition of investment company under Section 3(a)(1)(A).

To rely on the provision, a company must be primarily engaged directly or through wholly owned subsidiaries in a non-investment company business. To be operating through the wholly owned subsidiary, the company must be actively engaged in the non-investment company business of that subsidiary. The Commission has also taken the position that Section 3(b)(1) (and Section 3(b)(2)) may only be utilized by “industrial companies” or “industrial holding companies.” Thus, certain financial entities, including those that are otherwise addressed in Section 3(c), may not rely on this exclusion. Special situation investment companies also may not rely on Section 3(b)(1) (or Section 3(b)(2)).

Any company that wishes to rely on Section 3(b)(1) must first determine whether it is directly, or through wholly owned subsidiaries, engaged in a noninvestment company business. Upon concluding that it is in fact engaged in that business, the company must determine whether it is primarily engaged in that business. To determine an issuer’s primary engagement, the company should utilize the five-factor Tonopah test.

Whether a company can rely on Section 3(b)(1) is a question of facts and circumstances, and there is little Commission or staff guidance on the application of the provision. Given the subjective nature of the provision, for some operating companies, relying on Section 3(b)(1) may not be helpful even though they may believe that they meet the section’s requirements. The lack of legal certainty could be problematic as the Commission, a court, or another party might disagree with the company’s position. Similarly, depending on the facts and circumstances, it may be difficult for counsel to issue an unqualified opinion that an issuer claiming to rely on Section 3(b)(1) is not an investment company.

c. Section 3(b)(2)

Section 3(b)(2) provides that the Commission may issue an order declaring an issuer “to be primarily engaged in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities either directly or (A) through majority-owned subsidiaries or (B) through controlled companies conducting similar types of businesses.” Section 3(b)(2) is one of several provisions found in the Act that provides the Commission with authority to issue orders granting regulatory relief.

To be eligible for a Section 3(b)(2) order, the company must meet the definition of investment company under Section 3(a)(1)(C) but not Section 3(a)(1)(A). Additionally, while Section 3(b)(1) applies only to companies operating either directly or through wholly owned subsidiaries, Section 3(b)(2) is more expansive by also applying to companies operating a non-investment company business though majority-owned subsidiaries or through controlled companies that are engaged in similar types of businesses.

To receive a Section 3(b)(2) order the company (often referred to in this context as the “applicant”) must file with the Commission a public application that establishes that it is engaged in a non-investment company business. The applicant must also demonstrate that it is primarily engaged in that business based on the Tonopah factors. Applicants must also provide information regarding the activities of its employees in addition to those of its officers and directors. Applicants have at times deviated from certain of these factors so as to better convey the company’s business. For example, although the Tonopah factors include a review of the company’s income, some applicants have also included in their application a description of their revenues with an explanation that their revenues provide a more accurate portrayal of its business. In addition, although applicants generally describe the company’s assets and income on an unconsolidated basis, some applicants have also provided financial data on a consolidated basis with their wholly owned subsidiaries.

Where relevant, applicants may agree that relief will be contingent on their compliance with certain conditions specified in the application. Applicants will also often describe other orders that the Commission has previously issued which have similarities to the applicant’s request and have precedential value.

Division staff will review the submitted application. Frequently, the staff will provide comments, necessitating the applicant to file one or more amended applications. Once the staff is satisfied that the application meets the applicable standards, a notice of the application will be published in the Federal Register and on the Commission’s public website, stating that the Commission intends to grant the requested relief unless the Commission orders a hearing on the application. The notice gives interested persons information on how to request a hearing. Typically, if a hearing request is not received during the notice period (which is approximately twenty-five days), the order will be issued declaring that, based on the information provided in the application, the applicant is not an investment company within the meaning of the Act.

Applicants that have received orders under Section 3(b)(2) include among others:

• Companies in capital-intensive businesses whose investment securities consist solely, or substantially, in capital preservation instruments. Many of these companies have few tangible assets. They have also included research and development companies that can no longer rely on Rule 3a-8, the exclusion specifically designed for such companies. Recent orders were contingent on applicants agreeing generally to comply with the following three conditions: (1) to use its accumulated cash and securities to support its described business; (2) to refrain from investing or trading in securities for speculative purposes; and (3) that no more than 10 percent of its total assets would consist of investment securities other than capital preservation instruments.
• Companies that enter into joint ventures to further their non-investment company businesses.
• Companies that operate their non-investment company businesses through controlled companies. Applicants provided extensive descriptions of how they are actively involved in the management of those controlled companies.
• Companies (often called internet incubators) that create and operate a network of internet companies, some but not all of which are majority-owned subsidiaries or controlled companies.

The advantage of obtaining a Section 3(b)(2) order is that it provides the applicant—and others doing business with the applicant—legal certainty as to the applicant’s status under the Investment Company Act. The order allows the applicant to operate its business without concerns that it could fall within the scope of the Act, provided that the company continues to operate in the manner described in its application. Another advantage for some applicants (other than those registered as investment companies) may be that upon filing a Section 3(b)(2) application, the applicant is granted a sixty-day exemption from all provisions of the Investment Company Act, provided that the application is filed in good faith. An applicant, depending on this sixty-day reprieve, however, should be mindful that the period includes the time period between the notice and the order.

Seeking an order from the Commission, however, is often a time-consuming process that can expend significant resources. In addition, there is no guarantee that the Commission will in fact grant the order—or grant the order within the desired time period. Applications that are noticed may also be subject to a hearing request from interested persons.

Companies contemplating whether to file a Section 3(b)(2) application may wish to consider whether their situations mirror those of past applicants that were successful in obtaining Section 3(b)(2) orders. Those with fact patterns similar to past applicants that successfully obtained orders should draft their applications using these past precedents as a guide.

Companies with novel fact patterns or that seek relief that raises unprecedented questions of law or policy may need to consider whether requesting a Section 3(b)(2) order is the appropriate option to pursue. A review of past applications that were granted—both under Section 3(b)(2) and (as will be discussed) Section 6(c)—may be useful in determining whether to pursue such relief. When reviewing these applications, companies might wish to focus on such factors as the nature of each applicant’s business activities, why relief was needed, and the type of information that was included in each application. A review of appropriate Commission and staff guidance can also be helpful in reaching a determination.

Companies contemplating filing an application—even those that are based on precedent—may wish to reach out to the Commission staff prior to filing the application (and as early as possible) to gauge the staff ’s willingness to entertain the application as well as to make sure all timing needs can be met. The amount of time necessary for the staff to complete its review depends in part on the nature of the application and whether the applicant provides the necessary information in the application. Applications with novel fact patterns and/or that ask for unprecedented relief may be particularly time-consuming. In such cases, the staff will often work with the applicant to amend its application so that it meets the appropriate standard for relief.

C. Section 6(c)

As a last resort, an operating company that is unable to take advantage of any exclusion under the Act or take any other action to avoid Investment Company Act regulation could consider filing an application under Section 6(c). Section 6(c) gives the Commission the authority to exempt any person, security, or transaction from any provision or provisions of the Investment Company Act or any rule thereunder “if and to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of [the Act].”

Most applications filed under Section 6(c) request relief from specific sections of the Act and pertain to the operations of registered investment companies or business development companies. It is relatively rare for operating companies to file applications under Section 6(c) requesting relief from all provisions of the Act. Nonetheless the Commission has provided such relief under certain circumstances.

While the process for seeking relief under Section 6(c) is generally the same as that for applications filed under Section 3(b)(2), the relief sought is different. An applicant that files an application under Section 3(b)(2) requests that the Commission declare that the applicant is primarily engaged in a non-investment company business (i.e., in a business other than that of investing, reinvesting, owning, holding, or trading in securities). Thus, the applicant must describe in its application its non-investment company business and demonstrate that it is primarily engaged in that business using the Tonopah factors. In contrast, to obtain relief under Section 6(c), an operating company will typically request an order exempting it from all provisions of the Act. The Commission has stated that any applicant requesting relief under Section 6(c) must provide in its application “an adequate basis for the relief requested, including detailed justification for removal of any statutory protections, and identify any benefits expected for investors and any conditions imposed to protect investors.” Like Section 3(b)(2) orders, however, Section 6(c) orders provide applicants with certainty with respect to their status under the Investment Company Act and generally allows the applicant to operate its business without complying with the Act’s regulatory regime. Applicants that have received these types of orders include among others:

• An operator of an internet-based platform that facilitates issuance of small consumer general purpose loans.
• Foreign banking or finance institutions that cannot rely on Rule 3a-6 under the Act (the exclusion for foreign banks).
• Companies and their controlled entities that directly or indirectly acquire minority ownership interests in foreign ventures through which they are engaged in an operating business.
• Companies that needed time-limited relief pending restructuring of business beyond that afforded by Rule 3a-2.

An applicant may find it challenging to determine whether it should request relief under Section 3(b)(2) or Section 6(c). The Commission has granted orders to applicants who have requested relief under Section 3(b)(2) but have also requested relief under Section 6(c) as an alternative. Applicants requesting such relief should explain in their application how they meet the standards of both provisions.

Given its fact-specific nature, obtaining a Section 6(c) order can be extremely time-consuming and resource intensive. As with Section 3(b)(2) orders, applicants wishing to obtain Section 6(c) relief might wish to consider their time frame and the need for any interactions with the Division staff prior to filing their application.

Conclusion

At first blush it may appear inconceivable that an operating company could be subject to the same regulatory requirements as mutual funds, closed-end funds, and other pooled investment vehicles. Nevertheless, the broad definition of investment company under the Investment Company Act could encompass many types of operating companies, potentially subjecting them to a regulatory regime that would make their operations extremely difficult, if not impossible. Thus, depending on the facts and circumstances, operating companies may need to frequently assess their potential risk for falling within the scope of the Investment Company Act and, if necessary, take appropriate steps to avoid triggering potential regulation under that Act.