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An Overview of the Investment Company Act of 1940

The Investment Company Act of 1940 (ICA) has many practical implications in the realm of corporate law. The ICA was enacted by Congress and subsequently interpreted by the Securities and Exchange Commission (SEC) over the years. It was designed to regulate entities whose primary business is investing, reinvesting, owning, holding or trading securities.

Companies that meet the definition of an “investment company” under the ICA are subject to many restrictions on their activities. Entities that may be particularly prone to classification as an “investment company” under the ICA include:

  • Financial service firms that hold investment securities
  • Companies with minority ownership stakes in portfolio investments
  • Companies that have recently downsized or sold assets, resulting in increased ownership percentages in investment securities
  • Companies that operate through joint ventures or non-wholly owned subsidiaries

The analysis of whether an entity falls under the regulations of the ICA involves two principal tests—a subjective test and an objective test. An entity that meets the criteria of being an investment company under either test must register under the ICA unless it satisfies one of the exclusions from ICA registration. As a practical matter, businesses generally try to avoid being subject to the onerous requirements of the ICA.

The subjective test is set forth in Section 3(a)(1)(A) of the ICA. It involves a five-factor test, known as the Tonopah test, for assessing whether an entity is “engaged primarily in the business” of investing, reinvesting or trading in securities. While the determination is facts and circumstances based, the SEC typically places greater weight on the first two criteria of the Tonopah test.

  • Assets: Percentage of the entity’s assets composed of investment securities
  • Income: Percentage of the entity’s income derived from investment securities
  • Activities: Activities of entity’s officers and directors
  • Public Statements: Entity’s public representation of policy in SEC filings, press releases, and other public disclosures
  • History: Entity’s historical development and activities

The objective test is set forth in Section 3(a)(1)(C) of the ICA. Also known as the balance sheet test, it involves meeting a 40% asset threshold. An entity will be deemed an inadvertent investment company if it is engaged in the business of investing, reinvesting or trading securities and owns securities having a value exceeding 40% of the value of the entity’s total assets.

There is also an alternative objective test, which provides an exception for companies unable to comply with the 40% asset test. The goal is to avoid burdensome restrictions on companies that are clearly not intended to be classified as investment companies. Rule 3a-1 provides a safe harbor from investment company status if: (i) no more than 45% of the value of an entity’s total assets consists of certain securities and (ii) no more than 45% of the entity’s net income after taxes for the last 4 fiscal quarters is derived from certain securities.

There are a number of exemptions from registration under the ICA that entities may rely on. These exceptions include:

  • Section 3(b)(1) – Exception for entities primarily engaged in a business other than investing, reinvesting, owning, holding or trading securities
  • Section 3(b)(2) – Exemption if an entity gets an affirmative ruling from the SEC that it is not deemed an investment company
  • Section 3(c)(1) – Exempts an entity whose outstanding securities are beneficially held by fewer than 100 security holders
  • Section 3(c)(7) – Exempts an entity whose outstanding securities are held exclusively by persons who meet the definition of “qualified purchasers”
  • Section 3(c)(9) – Exemption if substantially all of the entity’s business consists of holding oil and gas interests
  • Rule 3a-2 – Exception for transient investment companies
  • Rule 3a-5 – Exception for finance subsidiaries
  • Rule 3a-8 – Exception for research & development companies

An entity that meets the definition of an “investment company” and therefore regulated by the ICA is subject to restrictions regarding the issuance of dividends, affiliate transactions, corporate governance, and capital structure. It is important for a company’s legal counsel to have a thorough understanding of the various tests for determining investment company status as well as the exemptions from registration under the ICA.

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