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  • Jonathan Page

Managing Other People's Money. Are You An Investment Company? (And You Don't Want to Be!)

You might be an investment company if you manage other people’s money or raise money from others and then reinvest it. This is critical legal analysis, that has substantial financial, operational and compliance implications on your business depending on the answer.[1] In general, an investment company is any business that invests in securities as its primary business activity. A security includes the purchase of equity, holding debt instruments or holding instruments that feature both debt and equity.



A company that meets the general definition of an “investment company” under the Investment Company Act of 1940 (“ICA”) and does not otherwise satisfy an exemption or exception, must register as an investment company with the U.S. Securities and Exchange Commission (“SEC”) and be subject to onerous organizational, governance, and financial reporting regulations and requirements. For obvious reasons, most companies would prefer to avoid these reporting regulations and requirements.


If a company meets the general definition of an “investment company” under the ICA, it can nevertheless avoid registration and regulation as an investment company by satisfying one of numerous exemptions and exceptions under the ICA. One common exception is Section 3(c)(1), which provides an issuer is exempt under the ICA if (a) its outstanding securities (other than short term paper) are beneficially owned by fewer than 100 persons . . . and (b) it is not making or currently proposing to make a public offering of its securities.[2] Under the Dodd-Frank Act,[3] however, an issuer that relies on Section 3(c)(1) is treated as a “private fund” under the Advisors Act, which may impose additional restrictions and regulations.


To determine what reporting regulations and requirements your business must comply with, if any, we recommend analyzing your current operations and business assets under the following four-step process:

  1. Determine if your company invests in securities.

  2. If your company invests in securities, then analyze whether your business meets the general definition of an “investment company” under the ICA.

  3. If it meets this definition, then analyze any exemptions or exceptions available to your business to avoid registration and regulation as an investment company.

  4. If it relies on Section 3(c)(1) (100 or fewer beneficial owners), then it must comply with the Advisors Act, which could include registration an investment advisor if an exemption or exception from registration is not otherwise satisfied.


Does your business invest in securities?


The definition of a “security” is broad. Specifically, the Securities Act of 1933 (the “Securities Act”) includes within the definition of a “security” the following:


any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement . . . investment contracts … [and so on].[4]


Based on the above definition, a “security” includes the purchase of equity, holding debt, and holding hybrid instruments. Debt is money that is borrowed. At a minimum, a debt instrument includes the amount borrowed, an interest rate and a maturity date. Equity is ownership in a company. A hybrid instrument combines aspects of both debt and equity. This includes a convertible note, that might start as debt, but then be converted into equity upon some subsequent financing round.


Partnership and LLC interests


The Securities Act does not explicitly refer to interests held in partnerships and LLCs as securities. As identified above, a “security” does include, however, “investment contracts.” A partnership and LLC interest can constitute an “investment contract” if they meet the “Howey Test.”[5] This test has the following four criteria:

  1. there is an investment of money

  2. in a common enterprise

  3. with an expectation of profits

  4. due to the efforts of others.

Essentially, if you are in the business of financing other businesses, then is your business’s income stream based solely on its investment of capital in the other businesses or based on its own efforts operating and servicing the businesses financed?


The ownership interests held by general partners or managing members are not securities under the Howey Test because these partners and members derive no profits from the efforts of others. Instead, the general partner or managing member puts forth the effort to create value in the enterprise. Furthermore, if a majority limited partner or investor member has meaningful control over an enterprise’s significant business decisions, then the interest held by these persons would not constitute securities. Securities do include minority interests held in an LLC or partnership. Additionally, passive membership interests and limited partnership interests carry a rebuttable presumption of being a security. Where a contract or interest can be a security, the SEC typically takes the position that the contract or interest is a security absent a compelling reason that it should not be treated as a security.


For purposes of the ICA, “investment securities” are defined as including all securities except (a) government securities; (b) securities issued by employees’ securities companies; and (c) securities issued by majority-owned subsidiaries of the owner that are not themselves investment companies relying on the exemption from the definition of investment company in Section 3(c)(1) and 3(c)(7) (discussed more below).[6] This definition of “investment securities” is virtually identical to the definition given under the Securities Act for evaluating private placement offerings.


Importantly, direct or indirect investments in real estate do not constitute investment securities.[7] As discussed above, general partnership interests that give the general partner the management rights typically exercised by a general partner are also not investment securities (whereas limited partnership interests are considered to be securities under the ICA).[8] Finally, “cash items” are not investment securities under the ICA.[9] For purposes of Section 3(a)(1)(C), a “cash item” has a high degree of liquidity and relative safety of principal.[10] This includes working capital.


If your business invests or otherwise holds securities, then it must determine if it is an investment company under the ICA. Otherwise, your business is not an investment company or an investment advisor.


Is your business an Investment Company?


If your business invests in securities, then you must consider whether your business is an investment company next.


Investment Company Definitions


Section 3(a)(1)(A) and (C) in the ICA contain definitions of an “investment company.”[11]


Operations Test [Section 3(a)(1)(A)]


Under Section 3(a)(1)(A), an “investment company” is any issuer which “is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.”[12] This is often referred to as the Operations Test. This definition is meant to identify companies that primarily manage other people’s money, such as hedge funds and private equity funds.


The SEC applies a “45% of assets or income” test to determine if a company is “engage[d] primarily” in the business of investing, reinvesting or trading in securities.[13] If more than 45% of the company’s assets consist of securities of any type or more than 45% of the company’s income is derived from investments of securities of any type, then the SEC will treat it as an investment company under Section 3(a)(1).


If your business primarily holds securities (i.e. LLC membership interests) in majority-owned subsidiaries (which are not themselves investment companies), then it is not deemed an investment company. Under the ICA, a “majority-owned” subsidiary is any entity whereby your business owns 50% or more of the outstanding voting securities.[14] And the ICA defines a “voting security” as simply any security entitling the owner to vote for the election of the subsidiaries’ directors or officers.[15]


If your business fails the Operations Test, then it’s an investment company under the ICA. If your business passes the Operations Test (meaning less then 45% of its assets or income is derived from securities), then you should analyze its business assets under the Balance Sheet Test.


Balance Sheet Test [Section 3(a)(1)(C)]


Under Section 3(a)(1)(C), an “investment company” is any issuer which “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%] of the value of such issuer’s total assets . . . on an unconsolidated basis.”[16] This is often referred to as the Balance Sheet Test.


Unlike the Operations Test, a company can inadvertently become an investment company under the Balance Sheet Test (often referred to as an “inadvertent investment company”) because the issuer does not need to be “engaged primarily” in an investment business to fall within the ICA’s coverage.[17]


If less than 40% of your total assets consist of investment securities, then your business venture does not meet the Balance Sheet Test under Section 3(a)(1)(C) of the ICA and is not required to register under the ICA.


Even if a company fails either or both the Operations Test or Balance Sheet test and therefore, meets the general definition of an “investment company” under Section 3(a)(1)(A) or (C), it may nevertheless avoid registration and not be deemed an investment company because of an available exclusion or exception from these definitions.


Is your business exempt under the ICA?


Section 3(b)(1) Exception


Section 3(b)(1) provides an exception for issuers primarily engaged in a business other than investing in securities.[18] In In re Tonopah Mining Co, the SEC applied a five-factor test to determine the Tonopah Mining Company of Nevada was not an investment company because it was primarily engaged in the business of metal mining, despite that over 40 percent of its assets were investment securities and Tonopah fell within the definition of “investment company” found in Section 3(a)(3) of the ICA.[19]


If a company conducts a substantial portion of its activities through subsidiaries, then this Section 3(b)(1) exemption is not available if the company does not wholly own those subsidiaries (as opposed to simply owning a majority of the subsidiaries or exercising control).


The ICA defines a “wholly owned subsidiary” as a subsidiary that the company owns 95% or more of the outstanding voting securities.[20]


Rule 3a-1


Rule 3a-1 applies the same “45% of assets or income” test under the Section 3(a)(1)(A) Operations Test, but it also allows a company to meet the test though the operations of subsidiaries primarily “controlled” by the company (as opposed to wholly owned or majority-owned subsidiaries).


Under the ICA, a company is presumed to “control” a subsidiary if it beneficially owns more than 25% of the voting securities.[21] This is a rebuttable presumption. Ultimately, the company must show it exercises a controlling influence over the management or policies of the subsidiary.


A “voting security” simply entitles the owner to vote for the election of the subsidiaries’ directors or officers.[22]


Private Company Exemptions to ICA


ICA provides exemptions to private investment companies under Section 3(c)(1) and 3(c)(2). These exemptions were meant for hedge funds and private equity funds that could not otherwise avoid becoming an inadvertent investment company through the other available exemptions discussed above.


Section 3(c)(1) [100-person limitation] and Section 3(c)(2) [Qualified Purchasers]


Under Section 3(c)(1), an issuer is exempt if it meets the following: (a) whose outstanding securities (other than short term paper) are beneficially owned by fewer than 100 persons . . . and (b) which is not making or currently proposing to make a public offering of its securities.[23] Keep in mind, under the Dodd-Frank Act,[24] an issuer that relies on Section 3(c)(1) is treated as a “private fund” under the Advisors Act, which may impose additional restrictions and regulations (discussed more later in this post).


Under Section 3(c)(7), an issuer is exempt if it meets the following: (a) whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers and (b) which is not making or currently proposing to make a public offering of its securities.[25] Under Section 2(a)(51) of the ICA, a “qualified purchaser” is a person holding $5 million or more in investments, a company holding $25 million or more in investments, an investment manager with $25 million or more under management, a trust holding $5 million or more in investments, and a company holding $5 million or more in investments owned by close family members.


Are you an Investment Advisor?


Section 202(a)(11) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) defines an “investment adviser” mean “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”[26] [27]


An Investment Advisor must register as an advisor at the state level or federal level, unless otherwise exempt from registration. Even if exempt, the anti-fraud provisions of Section 206 of the Advisors Act still apply to investment advisors. This includes an affirmative obligation to disclose in writing the capacity in which the advisor is acting. Courts have also interpreted Section 206 to impose fiduciary duties on investment advisors.[28] This means the advisor must act in the best interests of the client (rather than putting its own interests first).[29] This fiduciary duty cannot be waived, regardless of the client’s level of business sophistication.[30] An advisor’s reimbursement of expenses, for example, not clearly and explicitly provided in the fund document can constitute a breach of the advisor’s fiduciary duties.[31]


A U.S. investment adviser with less than $25 million in assets under management (“AUM”) is subject to the registration requirements of the state in which its principal office is located and is not subject to the federal registration requirements. Investment advisers with assets under management between $25 million and $100 million are subject to regulatory oversight from securities regulators of the state in which their principal offices are located (i.e., every state-registered investment adviser except those with a principal office located in New York) and are not required to register with the SEC. Instead, these advisors are required to register with the applicable state authorities. Investment advisers with assets under management between $25 million and $100 million that are exempt from registration within the state of their principal office or that have their principal office in New York are subject to regulatory oversight from, and unless exempt, required to register with, the SEC.


Florida, for example, excludes from the definition of an investment adviser “[a]ny person who does not hold herself or himself out to the general public as an investment adviser and has no more than 15 clients within 12 consecutive months in [Florida].” This maintains the 15-client exemption previously in effect under the Advisers Act.


Once your business’s AUM exceeds $25 million, if it continues to be exempt at the state level then it would become subject to federal investment adviser registration requirements. In that situation, you would want to qualify for the federal Private Fund Adviser exemption.


Under the Private Fund Adviser exemption, an investment adviser with its principal office and principal place of business in the U.S. is exempt from registration under the Advisers Act if (a) all assets managed by the investment adviser are solely attributable to private funds, the total AUM of which is less than $150 million and (b) the adviser acts solely as an investment adviser to one or more qualifying private funds.For a Private Fund to qualify as a private fund for purposes of the Private Fund Adviser Exemption, it must be exempt from registration as an investment company under either Section 3(c)(1) (100 or fewer beneficial owners) or Section 3(c)(7) (all investors are qualified purchasers) of the ICA (discussed above).


Reach out to us at support@contractsprint.com if you have any questions or need a specific analysis about your business activities. We partner with InPrime Legal to provide all attorney support.

[1]See, e.g., 15 U.S.C. ss 80a-16, -17, -18, -19, -29, -55, -56 (and corresponding regulations). [2] 15 U.S.C. s 80a-3(c)(1). [3] Dodd-Frank Wall Street Reform and Consumer Protection Act. [4]15 U.S.C § 77b(a)(1). [5]SEC v. W.J. Howey Co., 328 US 293 (1946) (US Supreme Court established four criteria to determine if an investment contract exists). [6] 15 U.S.C. ss 80a-3(a)(1)(A), 80a-3(a)(1)(C); 15 U.S.C. s 80a-3(a)(2). [7]See Xilinx, Inc., Securities Act File No. 000-18548 (October 27, 2014); Moody National REIT II, Securities Act File No. 333-198305 (February 18, 2015). [8]See Great American Management and Investment, Inc., SEC No-Action Letter, 1982 WL 29802 (Sept. 27, 1982)). [9] 15 U.S.C. s 80ª-3(a)(1)(C); 17 C.F.R. s 270 3a-1. [10]See Snowflake, Inc. ICA Release No. 34049, 2020 WL 5993059 (Oct. 9 2020) (cash positions in short-term investment securities considered cash items and exempt from ICA registration because such investments were undertaken to manage the company’s liquidity for legitimate business purposes). [11] 15 U.S.C. ss 80a-3(c)(1), 80a-3(c)(7). [12] 15 U.S.C. s 80a-3(a)(1)(A). [13]See Financial Funding Group, Inc., SEC No-Action Letter, 1982 WL 28965 (March 3, 1982). [14] 15 U.S.C. s 80a-2(a)(24). [15] 15 U.S.C. s 80a-2(a)(42); Standish Equity Investments, Inc., SEC No-Action Letter, 1993 WL 544113 (December 15, 1993) (introduces factors for LLCs in place of electing directors, such as removing and replacing the general partner). [16] 15 U.S.C. s 80a-3(a)(1)(C). [17]See SEC v. National Presto Industries, Inc., 486 F.3d 305, 307 (7th Cir. 2007) (the court found a seller of cookware, diapers and other household items failed the balance sheet test because its financial instruments comprised 92% of its total assets, but nevertheless concluded it was not an investment company under the ICA because it met an exception in Section 3(b)(1) based on its long history of engaging in traditional businesses of consumer products). [18]In re Tonopah Mining Co, 26 S.E.C. 426 (1947). [19]In re Tonopah Mining Co, 26 S.E.C. 426 (1947). [20] 15 U.S.C. s 80a-2(a)(43). [21] 15 U.S.C. s 80a-2(a)(43). [22] 15 U.S.C. s 80a-2(a)(42); Standish Equity Investments, Inc., SEC No-Action Letter, 1993 WL 544113 (December 15, 1993) (introduces factors for LLCs in place of electing directors, such as removing and replacing the general partner). [23] 15 U.S.C. s 80a-3(c)(1). [24] Dodd-Frank Wall Street Reform and Consumer Protection Act. [25] 15 U.S.C. s 80a-3(c)(7). [26] Georgia law defines an "investment adviser" to mean a person that, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or the advisability of investing in, purchasing, or selling securities or that, for compensation and as a part of a regular business, issues or promulgates analysis or reports concerning securities. See Ga. Code Ann. § 10-5-2(17). The term includes a financial planner or other person that, as an integral component of other financially related services, provides investment advice to others for compensation as part of a business or that holds itself out as providing investment advice to others for compensation. Georgia law does not specify what is meant by the business of advising others as to securities. [27] Florida law defines an “investment adviser” to include any person who receives compensation, directly or indirectly, and engages for all or part of her or his time, directly or indirectly, or through publications or writings, in the business of advising others as to the value of securities or as to the advisability of investments in, purchasing of, or selling of securities, except a dealer whose performance of these services is solely incidental to the conduct of her or his business as a dealer and who receives no special compensation for such services. FL Securities Act § 517.021. As with Georgia law, Florida law does not specify what is meant by the business of advising others as to securities, though as a general matter most states have looked to federal law guidance on this point. [28]See, e.g., Commission Interpretation Regarding Standard of Conduct for Investment Advisers, SEC Release No. IA-5248 (the “Conduct Release”). [29] Investment Advisers Act Release 3060, supra footnote 15 (adopting amendments to Form ADV and stating that “under the Advisers Act, an adviser is a fiduciary whose duty is to serve the best interests of its clients, which includes an obligation not to subrogate clients’ interests to its own,” citing Investment Advisers Act Release 2106). [30] Conduct Release. [31]e.g., In the Matter of State Street Bank and Trust Company, ICA Release No. 33534.

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