Summary

The US Investment Company Act of 1940, as amended (the Investment Company Act), which governs the activities of mutual funds and other collective investment vehicles that invest in securities, imposes registration and numerous other requirements on companies that fall within the act’s definition of “investment company.” However, because of the broad scope of the act’s definition of the term “investment company”, some non-US issuers conducting a Rule 144A offering are surprised to find that they fall within the technical definition of “investment company” and may need to take additional steps to establish exemptions from the requirements of the act. This briefing addresses a number of questions that commonly arise in the context of these offerings and outlines approaches to addressing these issues.  

Overview

The US Investment Company Act of 1940 governs the activities of companies, such as mutual funds and other collective investment vehicles, that invest in securities in the United States. In general, under that law, if such entities sell their securities to the US public they are required to register with the US Securities and Exchange Commission (SEC) and are subject to substantial regulation. To the extent that such a company has an external adviser, the adviser’s activities are separately regulated under the US Investment Advisers Act of 1940, as amended (the Investment Advisers Act).  

Although generally non-US issuers are not required to register as investment companies under the Investment Company Act, for the reasons that are discussed in more detail below, the Investment Company Act raises issues for some non-US issuers even when they do not hold themselves out to be investment companies as the term is commonly understood. The definition of “investment company” in the Investment Company Act is very broad and covers companies whose assets consist largely of “investment securities”, which itself is a broadly defined term in the Investment Company Act. Therefore, on occasion, non-US issuers seeking to offer securities in the United States pursuant to Rule 144A of the US Securities Act of 1933, as amended (the Securities Act), surprisingly find that they meet the technical definition of an investment company. These issuers are commonly referred to as “inadvertent investment companies”. However, it is not a practical option for a non-US issuer to be regulated as a US investment company. Moreover, Rule 144A is not available for offerings by investment companies that are required to be registered under the Investment Company Act. Consequently, it is important that any such issuer that is seeking to offer securities in the United States pursuant to Rule 144A find an applicable exemption for itself from the provisions of the Investment Company Act.

This briefing addresses frequently asked questions regarding the application of the Investment Company Act and the principal exemptions available to inadvertent investment companies.  

What is an “investment company”?

The Investment Company Act definition of “investment company” captures not only issuers that would commonly be considered to be investment companies – that is, issuers that hold themselves out as being engaged primarily in the business of investing, reinvesting or trading in securities (for example, a mutual fund) – but also includes any issuer that:

  • is engaged in, 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 per cent of the value of such issuer’s total assets (exclusive of US government securities and cash items)1 on an unconsolidated basis.

The term “investment securities” includes all securities, except (i) US government securities, (ii) securities issued by employees’ securities companies2 and (iii) securities that are issued by subsidiaries that are majority owned and are not themselves investment companies.  

How does an issuer become an “inadvertent” investment company?

Because the definition of an investment company is so broad, a company that holds substantial minority interests in other companies that it does not control, or an operating company that temporarily holds investment securities constituting a large percentage of its assets (for example, as the result of a capital raising exercise), may find itself to be an “inadvertent investment company”. In many cases, this determination is complicated by the difficulty of ascertaining the business in which the company is “primarily” engaged, or of valuing the company’s “investment securities” and other assets for the purpose of determining whether it meets the 40 per cent value test.

What are the implications of being deemed an investment company?

The Investment Company Act was enacted by the US Congress to protect members of the US public when they entrust their assets to others for investment on a collective or pooled basis. The liquid nature of investment company assets was perceived to create an increased risk of management abuse not found in operating companies. Accordingly, the Investment Company Act imposes a registration requirement on non-exempt investment companies and requires that a number of structural safeguards, such as an independent board of directors and a separate investment adviser whose contract must be approved by a majority of the company’s shareholders, be put in place within such companies. The Investment Company Act also imposes significant disclosure and reporting requirements beyond those found in the Securities Act and the US Securities Exchange Act of 1934, as amended (the Exchange Act). Likewise, the Investment Company Act contains its own anti-fraud provisions and private remedies. Moreover, the Investment Company Act strictly limits investments made by one investment company in another, addressing concerns with the so-called pyramiding of investment companies, which it was feared would lead to an undue concentration of control over investment assets and investment companies acting in the interest of other investment companies rather than in the interest of securities holders. Because of these and other provisions, it is an impractical option for a non-US company to seek to be regulated as an investment company under the Investment Company Act. As a consequence, any non-US company that falls within the definition of an investment company, and which seeks to offer its securities in the United States, will effectively be required to rely on an exemption from registration under the Investment Company Act.

Is it possible for a non-US issuer to register as an investment company under the Investment Company Act?

While it is theoretically possible for a non-US issuer to register as an investment company under the Investment Company Act, as a practical matter it is a cumbersome and expensive process with significant ongoing structural, reporting and other obligations as briefly summarised in the answer to the immediately preceding question. Furthermore, Rule 144A is not available for offerings by most registered investment companies. Therefore, a non-US issuer that falls within the technical definition of an investment company under the Investment Company Act, and that is seeking to offer securities in the United States pursuant to Rule 144A, can, as a practical matter, only do so by finding an applicable exemption from registration under the Investment Company Act rather than by registering as an investment company.

What are the exemptions from regulation under the Investment Company Act most relevant to non-US issuers seeking to offer their securities in the United States?

While there are a number of possible exemptions from regulation under the Investment Company Act available to non-US issuers (including exemptions for non-US banks, non-US insurance companies and finance subsidiaries of non-US issuers), there are four principal exemptions from regulation typically relevant for inadvertent investment companies:

  • the Rule 3a-1 exemption for certain “prima facie investment companies”;
  • the Rule 3a-2 “transient investment company” exemption, which provides temporary relief only;
  • the Section 3(c)(7) “unlimited qualified purchasers” exemption; and
  • the Section 3(c)(1) “100-person limitation” exemption.

When is the exemption for certain “prima facie investment companies” available to non-US issuers?

Rule 3a-1 under the Investment Company Act provides an exemption from the definition of “investment company” for certain issuers that have more than 40 per cent of their assets invested in investment securities. Such issuers are deemed prima facie investment companies as discussed under “What is an investment company?” above. These prima facie investment companies are often either holding companies or industrial companies that have a substantial portion of their assets invested in minority interests in other companies.  

To qualify for the Rule 3a-1 exemption, an issuer must not hold itself out as being engaged in the business of investing, reinvesting or trading in securities and must also satisfy the following numerical tests:

  • the value of investment securities owned by the issuer must not exceed 45 per cent of the value of the issuer’s total assets (consolidated with its wholly-owned subsidiaries), exclusive of US government securities and cash items; and
  • the issuer’s net income derived from investment securities must not exceed 45 per cent of the after-tax net income of the issuer (consolidated with its wholly-owned subsidiaries) for the preceding four fiscal quarters combined.

The Rule 3a-1 numerical tests are somewhat more flexible than the 40 per cent numerical test set out in the definition of “investment company” in the Investment Company Act itself because the Rule 3a-1 tests, as interpreted by the SEC’s staff, do not treat as investment securities the securities of controlled companies through which the issuer conducts its business if (i) the issuer owns more than 25 per cent of the controlled company’s voting securities, (ii) the issuer primarily controls the controlled company (that is, the issuer is the largest shareholder of the controlled company) and (iii) the controlled company is not itself an investment company.

When is the transient investment company exemption available to non-US issuers?

Rule 3a-2 under the Investment Company Act provides temporary relief from the registration requirements of the Investment Company Act to an issuer that, on a transient basis, is deemed to be an investment company because of an unusual business occurrence. A typical example is a start-up company that temporarily invests the proceeds of an offering or other capital raising exercise in securities during the period of time in which it is negotiating and finalising the purchase of assets. The transient investment company exemption may be relied upon for a period of up to one year by an issuer that can demonstrate a bona fide intent to be, as soon as is reasonably possible, engaged primarily in a business other than that of investing, reinvesting, owning, holding or trading in securities. An issuer may avail itself of this exemption only once in any three-year period.  

How is the transient investment company exemption one-year period calculated?

The one-year period begins on the earlier of:

  • the date an issuer owns or proposes to acquire investment securities having a value exceeding 40 per cent of the value of the issuer’s total assets (excluding US government securities and cash items) on an unconsolidated basis; or
  • the date on which the issuer owns securities and/or cash having a value exceeding 50 per cent of the value of the issuer’s total assets on either a consolidated or unconsolidated basis.

In certain cases, the SEC’s staff has granted exemptive relief in the form of “no-action letters” to issuers that fail to transfer sufficient assets from investment securities to non-investment security assets within the one-year period. In determining whether to grant such exemptive relief, the SEC’s staff typically examines three factors: (i) whether the failure of the issuer to transfer such assets within the one-year period was due to factors beyond its control, (ii) whether the issuer attempted, in good faith, during the course of the one-year period, to invest in assets other than investment securities and (iii) whether the issuer invested in securities solely to preserve the value of its assets. Notwithstanding the possibility of being granted this relief, an issuer seeking to rely on the transient investment company exemption is well-advised to ensure that by the end of the one-year period, it no longer falls within the definition of an investment company under the Investment Company Act. For example, the issuer should use funds raised in an offering to purchase operating assets so that within one year of being deemed to be an investment company no more than 40 per cent of its total assets, (excluding US government securities and cash items) on an unconsolidated basis, are in the form of investment securities and no more than 50 per cent of its total assets, on either a consolidated or unconsolidated basis, are in the form of securities and/or cash. Cash items are not considered when calculating an issuer’s total assets and, therefore, an issuer cannot rely on the transient investment company exemption by simply rolling up a portion of its investments and holding the cash.

How does an issuer demonstrate its bona fide intent?

The determination as to whether an issuer has the requisite non-investment intent to fit within the transient investment company exemption will be based on all the relevant facts and circumstances. Certainly an issuer should refrain from actively investing and reinvesting in securities and holding itself out as being in the business of investing, reinvesting and trading in securities for the period during which it is relying upon the transient investment company exemption. In addition, the issuer’s board of directors must pass a resolution (see the example set forth in Appendix A to this briefing) expressing such non-investment intent. This resolution should be contemporaneously recorded in the issuer’s minute books or comparable documents.  

When is the “unlimited qualified purchasers” exemption available to non-US issuers?

Section 3(c)(7) of the Investment Company Act provides an exemption from the definition of investment company for any issuer (i) all of the outstanding securities of which are exclusively owned by persons who, at the time of the acquisition of such securities, are qualified purchasers and (ii) which is not making, and does not at that time propose to make, a public offering of such securities. Pursuant to this provision and SEC staff interpretations of Section 7(d) of the Investment Company Act, a non-US issuer that would otherwise be deemed to be an investment company within the meaning of the Investment Company Act may privately offer and sell its securities to an unlimited number of US investors that are “qualified purchasers” (as defined below), as well as offer and sell its securities to an unlimited number of non-US investors, so long as all of its outstanding securities placed in the United States are originally placed with qualified purchasers and are never resold to US persons that are not qualified purchasers.

Accordingly, if an issuer intends to conduct a Rule 144A offering of securities in the United States in reliance on the unlimited qualified purchasers exemption, it should establish procedures to ensure that, at any given time, all of the US purchasers of its securities originally sold pursuant to Rule 144A are qualified purchasers. The procedures should provide the issuer with a means of limiting original US purchasers, and their transferees, to qualified purchasers (or outside the US in reliance on Regulation S) and a mechanism by which the issuer can void any transfer that causes a violation of the requirements of the unlimited qualified purchasers exemption. More specifically, offerings of securities by such issuers are frequently structured so that they include, among other provisions:

  • initial sales in the United States are limited to persons that are qualified purchasers, each of whom has executed a letter representing its status as a qualified purchaser and its agreement to comply with the transfer restrictions described below;
  • US purchasers are permitted to resell their securities only outside the United States in reliance on Regulation S under the Securities Act or within the United States to other qualified purchasers who have executed a letter to the same effect as that of the initial US purchaser;
  • legends are placed on the securities (to the extent permitted by applicable laws, rules and regulations) describing the restrictions on transfer of the securities;
  • provisions are added to the issuer’s articles of association that permit the issuer or its agents to void any transfer of securities made in violation of the Investment Company Act and or to force the sale of such securities; and
  • where feasible, procedures are adopted to enable depositaries and/or transfer agents to stop or void any transfer of securities if such transfer would result in a violation of the Investment Company Act.

Alternatively, it may also be possible for certain issuers relying on Section 3(c)(7) of the Investment Company Act, under certain circumstances, to arrange for the deposit of their securities into The Depository Trust Company (DTC) clearance system in the United States. In 2003, market participants working with DTC established detailed procedures intended to enable the issuer to satisfy the unlimited qualified purchaser exemption on an ongoing basis without the need for investment letters from purchasers. The authors of these procedures emphasized that they were intended primarily for certain US and non-US issuers who were not classic investment companies (i.e., for non-fund issuers) that were issuing debt securities placed in book-entry facilities. These procedures were most recently revisited in July 2008 and the authors introduced alternative procedures targeted at non-US fund issuers of debt and equity securities, as well as at non-US non-fund issuers of equity securities. It should be noted, however, that the SEC has declined to pass on the effectiveness of any of these particular procedures and has indicated that it will refuse to pass on any particular set of procedures in the future.

What is a “qualified purchaser”?

In general terms, a “qualified purchaser” is defined as:

  • any natural person that owns at least US$5 million in investments (as defined below);
  • any family-owned entity that owns at least US$5 million in investments (however, if the entity is formed specifically for the purpose of acquiring the securities offered, then each beneficial owner of the entity’s securities must be a qualified purchaser);
  • any trust established and funded, and for which investment decisions are made by qualified purchasers, so long as the trust was not established specifically for the purpose of acquiring the securities offered;
  • any business entity, acting for its own account or for the accounts of other qualified purchasers, that in aggregate owns and invests on a discretionary basis at least US$25 million in investments; and
  • any business entity if each owner of the entity’s securities is a qualified purchaser.

The SEC has defined “investments”, for the purposes of the “qualified purchaser” definition, as including a wide range of securities (except securities issued by a non-public company with shareholders’ equity of less than US$50 million or by a company controlling, controlled by or under common control with the prospective qualified purchaser), investment real estate and cash or cash equivalents held for investment purposes. In each case, all outstanding debt incurred to acquire the investments must be deducted from the amount of the investments.

When is the “100-person limitation” exemption available to non-US issuers?

Section 3(c)(1) of the Investment Company Act provides an exemption from the definition of investment company for any issuer (i) all of the outstanding securities of which are beneficially owned by not more than 100 persons and (ii) which is not making and does not presently propose to make any public offering of its securities. Pursuant to Section 3(c)(1) and SEC staff interpretations of Section 7(d) of the Investment Company Act, a non-US issuer that would otherwise be deemed to be an investment company within the meaning of the Investment Company Act may privately offer and sell its securities to 100 or fewer beneficial owners resident in the United States, as well as offer and sell its securities to an unlimited number of non-US investors, so long as none of the issuer’s outstanding securities that are originally placed in the United States are resold in the United States in such a manner as to leave the issuer with more than 100 US resident beneficial owners of its securities.

The calculation of the number of US resident beneficial owners to whom an issuer’s securities can be sold includes all US resident beneficial holders of each class of the issuer’s securities (including all debt and equity securities of the issuer, other than short-term debt securities) who have purchased or will purchase such securities from the issuer in private offerings in the United States, together with any subsequent US resident transferees of such securities (such purchasers and transferees, US Purchasers). In addition, the SEC’s staff has determined that the 100-person limitation applies at the time of the issuer’s first offering in the United States and on a going-forward basis, as a maintenance test (i.e., an issuer is required to maintain its 100-person limitation on US Purchasers on a continuing basis). As such, an issuer may violate the Investment Company Act if subsequent resales of any of its securities by US Purchasers result in an increase in the number of US Purchasers of all its securities above the 100-person threshold. This could occur, for example, upon the sale by one US Purchaser to several US investors who would then become US Purchasers. Non-US persons that purchase an issuer’s securities from US Purchasers selling the issuer’s securities outside the United States in reliance on Regulation S under the Securities Act would not be considered US Purchasers and would therefore not be counted towards the issuer’s 100-person limitation. In addition, purchases of an issuer’s securities by investors (whether or not US residents) who acquired such securities outside the United States in a secondary market transaction without the involvement of the issuer, its affiliates or agents would not be considered to be US Purchasers and would not be counted towards the 100-person limitation.

Accordingly, if an issuer intends to make a Rule 144A offering of securities in the United States in reliance on the 100-person limitation exemption, it should establish procedures to ensure that, at any given time, not more than 100 beneficial owners of its securities originally sold in the United States are US Purchasers. The procedures should provide the issuer with a means of controlling or limiting the number of US Purchasers who own its securities and a mechanism by which it can void any transfer that causes a violation of the 100-person limitation. Offerings of securities by such issuers frequently are structured so that:

  • initial sales of the securities are limited to 100 or fewer persons in the United States (more typically to say 75 or fewer persons in the United States in order to be cautious), each of whom has executed a letter agreeing to comply with the transfer restrictions described below;
  • initial US purchasers are permitted to resell their securities only outside the United States in reliance on Regulation S under the Securities Act;
  • legends are placed on the securities (to the extent permitted by applicable laws, rules and regulations) describing the restrictions on transfer of the securities;
  • provisions are added to the issuer’s articles of association that permit the issuer or its agents to void or refuse to recognise a transfer of securities made in violation of the Investment Company Act;
  • where feasible, procedures are adopted to enable depositaries and/or transfer agents to stop or void any transfer of securities if such transfer would result in a violation of the Investment Company Act.

Market participants have not developed procedures intended to enable issuers relying on the 100-person limitation exemption to make their securities eligible for deposit into the DTC clearance system in the United States.  

Will there be changes to the Investment Company Act as a result of the recent financial crisis?

As a consequence of the recent global economic crisis and the perceived role of hedge funds in precipitating it, in 2009 various US politicians have introduced proposed legislation which, if passed into law, would increase regulation of the US financial markets and would alter the regulation of investment companies and investment advisers in the United States. For example, under the proposed Hedge Fund Transparency Act introduced in January 2009, the current exemptions available under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act would be abolished, and companies which had previously made use of those exemptions would be deemed to be “investment companies”. Such companies which would be deemed to be “investment companies” under the new legislation and which have greater than $50 million in assets would be required to register with the SEC, meet certain record-keeping requirements and make annual disclosures to the SEC. While this bill is still being considered, the focus of many politicians seems to have recently shifted away from regulating private funds directly in this way. Instead, the focus now appears to be on regulating the investment advisers to private funds, and through the investment advisers acquiring information concerning the private funds they advise. Accordingly, proposed legislation, including the Private Fund Investment Advisers Registration Act of 2009 proposed by President Obama, seeks to change the regulation of investment advisers under the Investment Advisers Act rather than to amend the Investment Company Act. It should be noted that the US Congress is currently in the early stages of considering all of the proposed legislation and, given the differences amongst the various proposals, it is unclear what form final legislation might take or when such legislation, if any, would be passed into law.  

Please click here to view Appendix A.