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Why You Need to Understand the Investment Company Act

By Bill Wise


The Investment Company Act of 1940 (ICA) is an act of congress that protects investors by establishing rules and regulations that govern the investment company industry. An investment company generally holds large amounts of securities in other companies, and the appreciation of such assets may even make up a large amount of company income. The investment company designation can potentially be assigned to companies that do not consider themselves to be investment companies. Due to the burdensome restrictions and reporting requirements that the ICA imposes, companies will want to avoid being classified as an investment company whenever possible.


The ICA lays out several tests that could classify a business as an investment company. Section 3(a)(1)(C) defines the balance sheet test, the primary standard, and in summary states that a business will be considered an investment company if more than 40% of its total assets consist of investment securities. Additional factors that are considered are below, a company may still be an investment company if it:


· Has a balance sheet that contains a substantial amount of financial assets (Securities and other financial assets that may be considered investment securities such as receivables, loans, and leases).

· Conducts substantial operations through non-majority owned subsidiaries (joint ventures or variable interest entities).

· Utilizes funds raised by finance subsidiaries.


Another test simply states that if a company holds itself out to be geared towards the business of investing, reinvesting, or trading in securities it will also be considered an investment company under the ICA. Regulations have always had a particular focus on a company’s public statements and marketing, and the ICA is no different.


Companies will have to prove a negative to demonstrate that it does not fall under the definition of investment company in the ICA. The company’s financial balance sheet will need to be analyzed in depth on an unconsolidated basis to ensure that it does not fail the balance sheet test. To make things even more difficult, the SEC interprets its language to be broad in scope and definition. The SEC leans more towards broadening the scope of the ICA as opposed to taking a more charitable interpretation. Fortunately, there are several exemptions a company can utilize to escape the grasp of the ICA without the challenge of proving a negative. While the exemptions are numerous, below are some of the most commonly relied upon exemptions:


· Section 3(b)(1): Issuers Primarily Engaged in a Business Other Than Investing in Securities

o The most common exemption, a company does not fall under the ICA if it is: "[An] issuer primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities…"


· 3(c)(1) and 3(c)(7): Private Investment Companies

o Commonly relied on by most hedge funds, private equity funds, and venture capital funds. Non-US companies can rely on both these exceptions even if they are conducting public offerings outside the US, if the participation of US citizens is limited to accredited investors and only represents a small portion of the total offering.


o 3(c)(1) exempts any issuer that meets both below factors:


§ “Whose outstanding securities (other than short term paper) are beneficially owned by fewer than 100 persons (or, in the case of a qualifying venture capital fund with less than $10 million in aggregate capital contributions and uncalled capital commitments, 250 persons).

§ “Which is not making or currently proposing to make a public offering of its securities.”


o 3(c)(7) exempts any issuer that meets both below factors:

§ “Whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers.”

§ “Which is not making or currently proposing to make a public offering of its securities.”



The red tape that comes with the label of investment company can severely hamper a new business. Companies that seek to hold securities in large amounts will need to diligently assess how to avoid falling under the authority of the ICA.

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