The USA Common Sense Notion Of Investment Company

Most people in the USA have an idea of what an investment company does. Essentially it pools money from the general public and invests the money in securities. Usually it provides some type of management of the investment pool. In the USA, the most common type of investment company is a mutual fund. Mutual funds control a huge amount of assets and invest in a broad range of securities – the most common types of which are money market securities, bonds, and stocks. Investment companies generally hold themselves out to the public as being in the investment company business.

USA Investment Companies Are Subject To SEC Registration And Regulation

In 1940, in order to regulate the investment company industry, the U.S. Congress passed the Investment Company Act of 1940 (the "Act"). The cornerstone of the Act is that U.S. investment companies are required to register as such with the Securities and Exchange Commission. In turn the SEC administers the Act to ensure that investment companies are in compliance with it. Very broadly speaking the goals of the Act are: (i) to ensure that investors receive adequate information before and while investing (ii) to ensure that investment companies are run in the best interest of the public investors (iii) to ensure that investment companies are run by responsible persons and (iv) to make sure that investment company accounting is sound and subject to independent oversight.

The penalties for failure to register with the U.S. SEC as an investment company are severe. An unregistered US investment company may not engage in interstate commerce in the US and the contracts of such a company are voidable in the US. When applied, these penalties make it virtually impossible to run a business and can have ruinous results.

The Inadvertent Investment Company

Let’s take a hypothetical situation where, rather surprisingly, the company involved would be deemed an investment company under the Act. Assume a publicly owned U.S. holding company, we’ll call it Medivest Inc., is established to acquire HMO’s (Health Maintenance Organizations). Medivest finds that several of the HMO’s it acquires are losing money so Medivest needs to keep as reserves large amounts of liquid assets (cash and securities) to cover the costs of these operations. In order to get the best market returns possible most of the liquid assets are invested in bonds and stocks and eventually these stock and bond assets exceed 40% of Medivest’s total assets. At that point, Medivest is an investment company and may be required to register under the Act unless it can get exemptive relief from the SEC.

This could be a bit of a shock as the normal assumption might be that to be required to register as an investment company in the US a company would have to be holding itself out to the US public as having expertise in investment management. Unfortunately, this is not the case. The basic rule, in the absence of an applicable exclusion, is that any US company that holds investment securities having a value in excess of forty percent of its total assets is an investment company required to register under the Act. The key point to remember is that intention to be an investment company or holding out to the public as an investment company is irrelevant to the fundamental inquiry.

This inadvertent investment company problem can arise in a number of contexts such as:

  • A USA company that has sold off its operating assets
  • A USA company that has raised money in anticipation of use for a non-investment business
  • A USA company that has a non-profitable operating business and substantial reserves
  • A USA research and development company which has mostly investment assets on its balance sheet
  • A USA company in liquidation.

The Private Investment Company Exclusion

Fortunately, the general rule is subject to numerous exclusions, most of them beyond the scope of this discussion. However, the major one that will save the vast majority of inadvertent USA investment companies is the so-called "private investment company" exclusion. This excludes US companies that are owned by not more than 100 persons from the definition of investment company.

The precise application of the exclusion is a bit technical and a company relying on the exclusion that otherwise meets the definition of investment company is ill advised to do so without expert legal advice. For example, no one wants to find out that they’ve undercounted the number of owners and that the company is deemed to have over 100 owners.

Interestingly enough the "private investment company" is the primary one relied upon by the so-called "hedge funds". These are unregistered USA investment companies, generally available to only affluent investors. Even though these companies hold themselves out to their investors (but not to the general public) as having expertise in investment management they do not have to register under the Act.

Caveat

The question of whether a given company which has US operations is an investment company required to register under the Act can be extremely complex and technical. If you have any questions as to how the Act might apply to your company seek professional advice.