Latham investment company act

Many deal lawyers view the Investment Company Act of 1940 a bit like a great white shark: you know it’s swimming around out there; you have no desire to encounter it and find out if it’s hungry; and yet, at some point, you have to emerge from the shark cage. This usually occurs at opinion time, when you may need to conclude that the company is not an investment company as part of a securities offering.

While we don’t think “Investment Company Act Week” will ever threaten to displace “Shark Week“ in the ratings, we still can help you prevent your deals from getting bitten by the Investment Company Act. Why do we have to deal with the Investment Company Act?

The Investment Company Act and related SEC rules establish a comprehensive regulatory scheme for “investment companies.” The definition of investment company is broad and can even cover companies that would view themselves as operating companies rather than investment companies. These are often called “inadvertent investment companies,” and it’s a status you would just as soon avoid.

The Investment Company Act broadly prohibits unregistered investment companies from issuing securities and makes their contracts voidable. Worse still, registration is not realistically possible for most inadvertent investment companies, so investment company status can drop the issuer, and your deal, straight into Davy Jones’ Locker.

As a result, a company that intends to offer securities for sale must:

• fall outside of the definition of investment company;
  fit the offering to within an exemption from the Investment Company Act; or
• obtain special exemptive relief from the SEC–but that’s typically a time-consuming process.

A key metric for concluding that an operating company is not an investment company is the composition of the assets on its balance sheet and, in particular, whether it owns “investment securities” exceeding 40% of the value of its total assets on an unconsolidated basis, excluding “Government securities” and certain “cash items” (both of which we flesh out below).

Let’s take the elements of the 40% test in turn.

What is an “investment security”?

The definition of “investment securities” is broad, and includes the following items:

• any note, stock, treasury stock, security future, bond or debenture;
  any evidence of indebtedness;
• any certificate of interest or participation in any profit-sharing agreement;
• any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting‑trust certificate or certificate of deposit for a security;
• any 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 of index securities (including any interest therein or based on the value thereof);
• any put, call, straddle, option, or privilege entered into on a US national securities exchange relating to non-US currency;
  any interest or instrument commonly known as a “security;” and
• 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.
  

See Section 2(a)(36) (defining security) and Section 3(a)(2) (defining investment securities as all “securities” with certain exceptions).

However, the following are not investment securities:

• Government securities;
  securities issued by “employees’ securities companies” (more about these below); and
• securities issued by a majority‑owned subsidiary that is itself not an investment company (and is not relying on the exceptions under Section 3(c)(1) or 3(c)(7), typically used by private pooled investment vehicles).

What is a “Government security”?

Section 2(a)(16) defines “Government security” to include “any security issued or guaranteed as to principal or interest by the United States” or one of its instrumentalities “pursuant to authority granted by Congress” or a certificate of deposit for any of the foregoing. So, a US Treasury security would be a Government security, but a muni bond (issued by a state or local government) generally would not. What is an “employees’ securities company”?

An employees’ securities company is an investment company or similar issuer all of the outstanding securities of which (other than short-term paper) are beneficially owned (a) by the employees or persons on retainer of a single employer or of two or more employers each of which is an affiliated company of the other, (b) by former employees of such employer or employers, (c) by members of the immediate family of such employees, persons on retainer, or former employees, (d) by any two or more of the foregoing classes of persons or (e) by such employer or employers together with anyone or more of the foregoing classes of persons. See Section 2(a)(13).

What are cash items?

The Investment Company Act does not define “cash items,” but the SEC Staff has stated that the term would include:

• cash;
• coins;
• paper currency;
• demand deposits with banks;
• cashier checks;
• certified checks;
• bank drafts;
• money orders; and
• letters of credit.
  

The SEC Staff also takes the position that cash items would generally include shares held for cash management purposes by an operating company in a registered US money market fund with a stable net asset value of $1.00 per share. See Willkie Farr & Gallagher (avail. Oct. 23, 2000).

However, other liquid instruments that companies typically use for treasury management can be problematic. Certificates of deposit, for example, may be viewed as investment securities, depending on why an issuer holds them, how long and other factors. Similarly, the SEC Staff may take the position that time deposits in a bank are not cash items.

In our next installment, we will move on from great whites to hammerheads, and discuss the 45% tests of Rule 3a-1 before moving on to inadvertent investment companies in part three. Don’t touch that dial!