Recently, the United States District Court for the Northern District of California (the “Court”) dismissed claims against Yahoo, Inc., holding that a 16-year old exemption granted to Yahoo by the Securities and Exchange Commission (“SEC”) barred the plaintiff’s claims alleging that Yahoo was operating as an unregistered investment company in violation of the Investment Company Act of 1940 (“ICA”). UFCW Local 1500 Pension Fund v. Mayer, et al., No. 16-cv-00478 (N.D. Cal. Oct. 19, 2016).

This litigation relates to a 2000 SEC order granting Yahoo an exemption from registering as an investment company. The SEC granted the exemption because it found that Yahoo was “primarily engaged in a business other than that of investing, reinvesting, owning, holding, or trading securities . . . .” The exemption was predicated on two conditions: “1. Yahoo! [would] continue to allocate and utilize its accumulated cash and Cash Management Investments for bona fide business purpose; and 2. Yahoo! [would] refrain from investing or trading in securities for short-term speculative purposes.”

According to the plaintiff’s complaint, Yahoo’s business has changed substantially since the exemption was issued. The complaint alleges that “in 2000 approximately 57 percent of Yahoo’s income came from its operating business, while approximately 44 percent came from investments.” According to the plaintiff, however, by 2014 operations were responsible for only 1.2 percent of Yahoo’s income, and in 2015, “all of its net income was attributable to its investments.” Additionally, the complaint asserts that “[i]n 2013, Yahoo began considering spinning-off its Alibaba holdings” and registering the spin-off company itself as an investment company.

Due to these “fundamental changes to Yahoo’s business” the plaintiff, UFCW Local 1500 Pension Fund (“UFCW”), filed derivative and direct claims against Yahoo and its directors and officers for the alleged failure to register Yahoo as an investment company in violation of the ICA. UFCW argued that Yahoo had lost the protection of its registration exemption such that Yahoo was required to register as an investment company under the ICA. It further argued that because Yahoo had never so registered, “it had been operating illegally as an unregistered investment company.”

Yahoo moved to dismiss the complaint for failure to make a pre-litigation demand on the board of directors, as well as failure to state a claim upon which relief could be granted. In response to the ICA allegations, Yahoo argued that its registration exemption has remained valid.

After holding that demand would have been futile, the Court granted Yahoo’s motion to dismiss because plaintiffs’ claims “all depend on the faulty theory [that] Yahoo operated illegally . . . as an unregistered investment company.” The Court questioned whether it was even “empowered to find, at the behest of a private litigant, that a company has lost the protection of a registration exemption.” Looking to the text of the ICA, the court found that “the ICA’s language strongly indicates there is no role for the courts to find . . . that a company should be stripped of its exemption . . . . Because the statute only contemplates revocation of an exemption by the SEC.” The Court also discussed the possibility that courts could retroactively find that a company failed to qualify with a past exemption, thereby operating illegally as an unregistered investment company. The Court reasoned, however, that “[t]he ICA is silent on this sort of retrospective examination, presumably because its remedy for undeserved or violated exemptions is contemporaneous revocation by the SEC.”

It thus concluded that “[i]f the SEC fails to revoke an exemption, the ICA makes no suggestion that the SEC’s decision should be second-guessed by a court.”

Notably, institutional investors governed by the ICA may be limited in their ability to invest in other investment companies. The so-called “antipyramiding provision” of the ICA, 15 U.S.C. § 80a-12(d)(1)(A), for example, puts limitations on the acquisition by investment companies of securities issued by other investment companies in certain situations. See meVC Draper Fisher Jurvetson Fund I, Inc. v. Millennium Partners, L.P., 260 F. Supp. 2d 616, 620 (S.D.N.Y. 2003). According to the SEC, Congress included Section 12(d)(1) in the ICA to prevent a registered investment company from controlling other investment companies and creating complicated pyramid structures. See S. Asia Portfolio, SEC No-Action Letter (Mar. 12, 1997). It is unclear if the unknowing acquisition of an unregistered investment company by another investment company would implicate Section 12(d)(1)(A). Luckily for investment companies holding Yahoo, the Court’s ruling takes this issue off the table.