An Introduction to the Investment Company Act of 1940

Written by Geoffrey Gilbert, Sustainable Economies Law Center Intern

What is the Investment Company Act of 1940?

The Investment Company Act of 1940 regulates investment companies. It defines an “investment company” as any issuer which:

  • “A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading securities;
  • B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificates outstanding; or
  • C) 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 exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.”1

In plain language, an investment company is a company whose primary activity is to invest in other companies or 40 percent of whose total assets consist of investment securities. 2 If an investment entity falls under this definition of an investment company, it will be subject to numerous regulations for which compliance can be expensive. The Act casts a wide net, so any investment entity must account for it.

Key Exemptions from the Act

Companies and funds making investments in other companies typically look to two exemptions: Section 3(c)(1) and Section 3(c)(7). Additionally, real estate funds can potentially utilize the exemption under Section 3(c)(5)(C), and the exemption under Section 3(10)(A) covers any company operating exclusively for religious, educational, charitable, or reformatory purposes. Other exemptions exist, but are harder to fit under.

Section 3(c)(1) requires that the issuer have one hundred or fewer holders of beneficial interest in outstanding securities and that it not be participating in a public offering.3 A Section 3(c)(1) issuer must also pass the “look-through” provision, which goes into effect if an entity/investor owns more than 10 percent of the company or fund.4 If an entity/investor owns more than 10 percent, its investors count toward the 100 investor limit.

Section 3(c)(7) allows a issuer to exceed 100 investors, but only if each of the investors is a “qualified purchaser,” the wealth requirements for which exceed even those for the designation of an “accredited investor.”5

Section 3(c)(5)(C) defines a real estate fund as any person who is primarily engaged in “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”6 A real estate fund qualifies for the exemption if at least 55 percent of its assets consist of mortgages and other liens on or interests in real estate and the remaining 45 percent of its assets consist primarily of real-estate related investments, meaning that more than half of the 45 percent of ‘real estate related investments’ must be primarily in real-estate related assets and the remaining assets may be investments that are entirely unrelated to real estate. To satisfy the Section 3(c)(5)(C) exemption, an issuer may not invest more than 20 percent of its assets in miscellaneous investments unrelated to real estate.7

Section 3(10)(A) exempts “[a]ny company organized and operated exclusively for religious, educational, benevolent, fraternal, charitable, or reformatory purposes….”8

Some Examples of When Application of the Act Should be Considered

The Investment Company Act has extensive reach. Investment clubs, investment cooperatives, and revolving loan funds all must consider the Act.

An investment club is a group of people who pool their money together to make investments. Investment clubs are typically organized as partnerships where, after each member studies agreed upon investments, the group decides to buy or sell on the basis of a majority vote of the members. Investment clubs can be exempt from the Investment Company Act if any of three conditions do not apply: 1) the club invests in securities; 2) the club issues membership interests that are securities; 3) the club is not able to rely on an exclusion from the definition of an investment company.9 They can usually avoid the second requirement – that the investment club issue membership interests that are securities – because the SEC only considers memberships interests to be securities if members are passive, meaning that they don’t participate in the club’s investment decisions. So, if investment club members are actively involved in investment decisions, then the club is typically exempt from the Investment Company Act.

Investment cooperatives also must account for the Investment Company Act. Like investment clubs, investment cooperatives pool together many different people’s money for collective investment, but they are typically incorporated as a cooperatives. Members buy memberships in the investment cooperative. Investment decisions are usually made on a one-person-one-vote basis, regardless of the number of shares a member might own. This means that, like with investment clubs, personhood, not capital investment, establishes the same right for all members to one vote regarding investment decisions.

Unlike investment clubs, investment cooperatives are not expressly acknowledged by the SEC, though they can avoid registration as an investment company under the Act by satisfying any of the aforementioned exemptions. Real estate investment cooperatives may satisfy Section 3(c)(5)(C), the real estate exemption, so long as at least 55 percent of its assets consist of mortgages and other liens on or interests in real estate and the remaining 45 percent of its assets consist primarily of real-estate related investments (see above for more extensive explanation).

Even nonprofit loan funds must consider the Investment Company Act. Nonprofit loan funds can raise money through grants and donations. They can then make loans, likely at below-market rates, without turning a profit. Nonprofit loan funds must satisfy one of the aforementioned exemptions in order to avoid the reporting requirements of the Investment Company Act. If the nonprofit operates exclusively for religious, educational, charitable, or reformatory purposes it may qualify for the exemption under Section 3(10)(A) of the Act.

  1.  15 U.S.C. § 80a-3.
  2.  15 U.S..C. § 80a-3(a)(1).
  3.  15 U.S.C. § 80a-3(c)(1).
  4.  http://www.pfsglobal.com/#!Section-3c1-and-3c7-Funds/c1f8x/6F59B4B1-2D31-4E95-A5D2-AB0CB43CB881.
  5.  15 U.S.C. § 80a-3(c)(7).
  6. 15 U.S.C. § 80a-3(c)(5)(C).
  7.  http://www.hf-law.com/images/uploads/Real_Estate_Programs_Article_(3).pdf; Citytrust, SEC Staff No-Action Letter (Dec. 19, 1990); Greenwich Capital Acceptance Inc., SEC Staff No-Action Letter (Aug. 8, 1991).
  8.  15 U.S.C. § 80a-3(10)(A).
  9. https://www.sec.gov/investor/pubs/invclub.htm.
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