On July 12, 2018, a panel of the U.S. Court of Appeals for the Ninth Circuit affirmed the dismissal by the U.S. District Court for the Northern District of California of a lawsuit bringing derivative claims against the board of directors of Yahoo! Inc. (Yahoo!) and certain corporate officers, as well as a direct claim against Yahoo!, under the Investment Company Act of 1940 (the 1940 Act). UFCW Local 1500 Pension Fund, on its own behalf and on behalf of others similarly situated (UFCW), alleged that when Yahoo! invested in Alibaba.com, a Chinese e-commerce company, Yahoo! violated the conditions of an exemptive order issued by the SEC granting the company relief from the registration requirements of the 1940 Act. The Ninth Circuit panel held that UFCW failed to state a claim because the 1940 Act does not establish a private right of action for challenging the continued validity of a 1940 Act exemption. 

Background—Investment Company Act Status 

Under Section 3(a)(1)(C) of the 1940 Act, an issuer is a prima facie investment company if it 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 in excess of 40% of the value of the issuer’s total assets (exclusive of government securities and cash items) on an unconsolidated basis. For this purpose, “investment securities” are defined to include all securities except government securities, securities issued by employees’ securities companies and securities issued by majority-owned operating subsidiaries of the owner. Consequently, an operating company more than 40% of whose total assets are investment securities may be deemed an “inadvertent” investment company. 

Background—Investment Company Act Status 

Under Section 3(a)(1)(C) of the 1940 Act, an issuer is a prima facie investment company if it 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 in excess of 40% of the value of the issuer’s total assets (exclusive of government securities and cash items) on an unconsolidated basis. For this purpose, “investment securities” are defined to include all securities except government securities, securities issued by employees’ securities companies and securities issued by majority-owned operating subsidiaries of the owner. Consequently, an operating company more than 40% of whose total assets are investment securities may be deemed an “inadvertent” investment company. 

For purposes of the 40% test described in the foregoing paragraph, investment securities are sometimes referred to as “bad assets,” in contrast to “good assets,” which would not count toward the 40% limit. In this regard, Rule 3a-1 allows an operating company to treat interests in subsidiaries that it controls primarily as “good assets” so long as the company engages in non-investment company business through subsidiaries. Specifically, Rule 3a-1 provides an exemption from the definition of investment company if no more than 45% of a company’s total assets consist of, and not more than 45% of its net income over the last four quarters is derived from, securities other than government securities and securities of majority-owned subsidiaries and companies it primarily controls.

Section 3(b)(2) of the 1940 Act provides that, notwithstanding Section 3(a)(1)(C), the SEC, upon application, 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, resulting in the issuer not falling within the 1940 Act’s definition of investment company. In determining whether a company is “primarily” engaged in a non-investment company business under Section 3(b)(2), the SEC considers (1) the applicant’s historical development; (2) its public representations of policy; (3) the activities of its officers and directors; (4) the nature of its current assets; and (5) the sources of its present income, with factors (4) and (5) deemed the most important factors. Section 3(b)(2) further provides that the SEC may revoke such an order when it, on its own motion or upon application “finds that the circumstances which gave rise to the issuance of an order granting an application [for a 1940 Act exemption] no longer exist.”

Yahoo!’s Exemptive Order

In 2000, Yahoo! requested and obtained from the SEC an exemptive order under Section 3(b)(2). At that time, Yahoo! stated that its interest in Yahoo! Japan represented over 90% of the value of its total assets (exclusive of government securities and cash items) on an unconsolidated basis. In its application for exemptive relief, Yahoo! stated that it was unable to rely on Rule 3a-1 because, although it owned over 25% of the outstanding voting securities of Yahoo! Japan, it was not the primary owner of Yahoo! Japan because another entity owned a larger percentage of its voting securities. Thus, if the interest in Yahoo! Japan was deemed to be an “investment security,” Yahoo! might have been deemed a prima facie investment company under Section 3(a)(1)(C). In connection with its application for exemptive relief, Yahoo! stated that it needed sufficient cash for bona fide business purposes, such as funding operations, funding research and development and improvements to its network and funding strategic non-controlling investments. The company also stated that it did not engage in speculative short-term trading with its cash and high-quality predominantly short-term debt instruments (together with cash items and government securities, Cash Management Investments). Thus, as a condition to its requested relief, Yahoo! agreed to continue to allocate and utilize its accumulated cash and Cash Management Investments for bona fide business purposes. In addition, Yahoo! agreed to refrain from investing or trading in securities for “short-term speculative purposes.”5 Yahoo!’s exemptive order has remained in place since 2000.

UFCW’s Lawsuit

UFCW filed a lawsuit in January 2016, alleging that, by investing in Alibaba, Yahoo! had violated the condition of its 1940 Act exemption requiring the company to use its cash and Cash Management Investments for bona fide business purposes and, consequently, that Yahoo! had “been operating as an unregistered investment company” in violation of the 1940 Act since at least 2013. At that time, Yahoo!’s investment in Alibaba and other holdings represented approximately 90% of the value of Yahoo!’s total assets. UFCW sought to (1) rescind the employment contracts of certain executives; (2) enjoin Yahoo! from further performing contracts executed in violation of the 1940 Act and from selling any material assets, and (3) recover damages for unjust enrichment. 

On October 19, 2016, the U.S. District Court for the Northern District of California granted the defendants’ motion to dismiss the complaint, principally on the grounds that a federal court is not empowered to find, at the behest of a private litigant, that a company has lost the protection of a 1940 Act registration exemption.

In an amended complaint, UFCW cited an internal memorandum from the SEC’s Office of Inspector General indicating that the staff of the SEC’s Division of Corporation Finance considers exemptive orders not applicable if the conditions have not been adhered to—i.e., they are “self-executing.” Nevertheless, on February 10, 2017, the District Court dismissed the amended complaint, stating in the opinion that although the memorandum introduces the “self-executing” language, it does not help UFCW’s case because there is no indication that a private litigant can compel the court to find that a company has lost the protection of a 1940 Act exemption. Because the SEC never revoked Yahoo!’s registration exemption, the District Court stated, Yahoo! never operated as an unregistered investment company, and UFCW’s claims’ fail as a matter of law. In a footnote, the District Court noted that the “self-executing” language refers to the Division of Corporation Finance, which provides exemptive relief under the securities registration and reporting sections of the Securities Exchange Act of 1934, not the Division of Investment Management, which provides exemptive relief under the 1940 Act and granted Yahoo!’s exemption in 2000.

On appeal, the Ninth Circuit panel affirmed the District Court’s dismissal of the lawsuit. In finding that the 1940 Act does not establish a private right of action to challenge the continued validity of an exemption, the Ninth Circuit noted that the 1940 Act provisions related to registration with the SEC and 1940 Act exemptions “do not have rightscreating language.” The Ninth Circuit also rejected UFCW’s argument for a private right of action under Section 47(b) of the 1940 Act, which provides that a “contract that is made, or whose performance involves, a violation of [the 1940 Act], or of any rule, regulation, or order thereunder, is unenforceable by either party” to the contract unless “a court” makes certain findings. The Ninth Circuit asserted that Section 47(b) “on its face merely establishes what it says: that contracts formed in violation of [the 1940 Act] are usually unenforceable.” Moreover, the Ninth Circuit stated that the 1940 Act empowers the SEC to enforce all provisions of the statute by granting the SEC broad authority to investigate suspected violations, and that Congress explicitly created private rights of actions to enforce particular sections, such as derivative suits against an investment company’s adviser for breach of certain fiduciary duties, clearly indicating that Congress never intended further private enforcement of the 1940 Act. 

The opinion was issued under the caption UFCW Local 1500 Pension Fund v. Mayer, Case No. 17-15435.