In shark cage diving, you surely don’t want to discover at the last minute that your cage is not shark-proof. It’s the same for the Investment Company Act – you don’t want to wait until the opinion negotiations start to do your analysis.
So, what should you do if your deal involves a company that fails the 40% test and cannot take advantage of Rule 3a-1 despite being an operating company? There are a number of possible solutions for so-called “inadvertent investment companies.”
Issuers primarily engaged in non-investment activity: Sections 3(b)(1) and 3(b)(2)
Sections 3(b)(1) and 3(b)(2) provide that an issuer that fails the 40% test is not an investment company if it is primarily engaged in non-investment activity either directly or through wholly-owned subsidiaries (Section 3(b)(1)) or through majority‑owned subsidiaries and controlled companies (Section 3(b)(2)). An issuer seeking to rely on Section 3(b)(1) or 3(b)(2) initially must establish that it is engaged in some non-investment business. If a non-investment business exists, the inquiry shifts to whether that non-investment business is the primary business of the issuer. And if that business is found to be primary, the issuer may then be eligible to rely on Section 3(b)(1) or 3(b)(2).
To test whether an issuer is primarily engaged in a non-investment company business for purposes of both Sections 3(b)(1) and 3(b)(2), the SEC has traditionally looked to a five-factor test laid out in the SEC’s 1947 declaratory order in Tonopah Mining Co.:
- an issuer’s historical development;
its public representations of policy; - the activities of its officers and directors;
- the nature of its present assets; and
- the sources of its present income.
The last two factors (nature of assets and sources of income) are often the most important. The SEC interprets the factors in essentially the same way as the 45% tests of Rule 3a-1.
As a practical matter, Section 3(b)(1) is difficult to rely upon because of the subjective nature of the determination as to the primary business of the issuer. The SEC regards Section 3(b)(1) as self-operating, and the SEC Staff ordinarily will not issue no-action or interpretive guidance under Section 3(b)(1). In turn, this makes it impractical for counsel to issue conclusive legal guidance on an issuer’s status under that section. Accordingly, an issuer intending to list its securities generally cannot rely on a Section 3(b)(1) analysis.
By contrast, Section 3(b)(2) requires that issuers submit an application to the SEC for an order granting relief. Section 3(b)(2) provides that a good-faith filing of an application for exemptive relief by an issuer (other than a registered investment company) exempts the applicant from all provisions of the Investment Company Act for a 60-day period, and the SEC has also been willing to grant temporary orders extending the 60-day exemptive period. Note, however, that the SEC has stated that it “ordinarily would be unwilling to issue an order” under Section 3(b)(2) when Section 3(b)(1) “provides an automatic exclusion.
Transient investment companies: Rule 3a-2
Rule 3a-2 provides temporary relief from investment company status for “transient investment companies” – i.e., operating companies that temporarily fall within the definition of investment company because of unusual corporate events (e.g., securities issuances or asset dispositions). Under Rule 3a-2, an issuer will not be deemed to be an investment company under the Investment Company Act for a period of time not exceeding one year, provided that the issuer has a bona fide intent to be engaged primarily in a non-investment business “as soon as is reasonably possible” and in any event within the one-year period. This intent must be evidenced by (i) the issuer’s business activities and (ii) an appropriate resolution of the issuer’s board of directors or by an appropriate action of the person or persons performing similar functions for any issuer not having a board of directors. A resolution or action of this sort must be recorded contemporaneously in the issuer’s minute books or comparable documents.
The one-year period of time begins on the earlier of two dates. The first is the date on which an issuer owns or proposes to own securities and/or cash having a value exceeding 50% of the value of the issuer’s total assets, on either a consolidated or unconsolidated basis. The second is the date on which the issuer owns or proposes to owns or proposes to own investment securities in an amount that would lead it to fail the 40% test.
Although Rule 3a-2 provides up to one year of exemptive relief, it provides only a temporary exemption, and an issuer can rely on the Rule only once in any three-year period. In addition, the SEC Staff generally refuses to grant no-action relief under this rule.
A word about exemptive orders
The SEC has authority (for example, under Section 6(c)) to exempt companies and transactions from the Investment Company Act. As a result, a company that is unable to take advantage of one of the exceptions or exemptions under the Investment Company Act can consider applying to the SEC for an exemptive order. An application for an exemptive order typically involves a detailed written submission to the Staff of the Division of Investment Management. Depending on the complexity of the relief sought, the process can take anywhere from six months to one year.