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.

Community Capital Spotlight: Oregon’s Community Public Offering Exemption

In early 2015,  the Oregon Department of Consumer and Business Services used its authority under Oregon Revised Statute Section 59.035(15) to establish the Oregon Intrastate Offering Exemption through the rulemaking process, which is commonly called the Community Public Offering (CPO). The CPO was the culmination of efforts of a team of people led by Amy Pearl of Hatch Innovation that began earlier in 2014. See this timeline for a breakdown of the events that led to the new administrative rules.

Just days after the rules became effective, Hatch Innovation helped launch the first 9 companies to use the new exemption, and also launched HatchOregon.com, a platform where Oregon residents can get more information about current community public offerings. If you are an Oregon resident you can see current offerings here.

The Key Elements of the CPO

To be eligible for this exemption, the issuer must be an existing Oregon business and have fewer than 50 employees. An offering under this exemption can be up to an aggregate of $250,000, but an issuer may not accept more than $2,500 from any individual investor. Offers and sales must be limited to natural persons who are residents of Oregon, and the offering must be conducted in accordance with the Federal Intrastate Exemption. The offering period can last for up to 12 months unless the issuer applies for an extension.  

Business Technical Service Provider Requirement

To be eligible for the exemption, the issuer must also meet with a business technical service provider and have their business plan reviewed before advertising, offering, or selling securities under this exemption. A business technical service provider is defined as a Small Business Development Center, an Economic Development District, or a not-for-profit incubator, accelerator, or business resource provider approved by the Director.

Key Restrictions of the Exemption

This exemption has some restrictions. For example, the exemption is limited to offerings of notes, stocks, and debentures and is unavailable for offerings involving petroleum exploration or production, mining, or any other extractive industries

Advertising and Solicitation

Advertising and solicitation is permitted under this exemption, but with some conditions. Most notable is that an interested person must affirmatively declare that he or she is an Oregon resident before the person can view the advertising materials.

An internet based third-party platform provider, which can either be a business technical service provider or other entity approved by the Director, may be used to post advertising and offering documents. The platform must segregate the information relating to the securities offering separate from what is accessible to the general public, and may not solicit, sell, or effect transactions unless it is a registered broker-dealer. The rules also state that the platform may only charge a nominal flat fee for the upkeep of the website and may not take an interest in the issuer in exchange for use of the platform

Want More Information?
For more information on Oregon’s Community Public Offering, click here. You can also check out HatchOregon and Oregon’s Department of Consumer and Business Services.

Is Delaware the Best Place to Incorporate a Nonprofit?

By Devin McDougall, SELC Volunteer

Most nonprofit corporations are formed under the laws of their “home state,” that is, the state in which the incorporators reside or in which the nonprofit plans to conduct most of its operations. This is quite different from for-profit corporations, as more than 50% of publicly traded companies in the United States are incorporated in Delaware. Many of the advantages that Delaware provides to for-profit corporations, such as a specialized legal system well-versed in business law, are less applicable for nonprofit corporations.

However, incorporating as a nonprofit under Delaware law can offer certain advantages over other states.

To start, it is important to note that unlike most states, Delaware does not have a separate nonprofit corporations statute. Instead, Delaware nonprofits are governed by the applicable provisions of the Delaware General Corporation Law (“DGCL”).

One advantage provided to corporations under the DGCL is flexibility in internal structure, especially for smaller corporations. Unlike some states such as New York, the DGCL requires a corporation to have only one director. A nonprofit corporation in Delaware must have members, but directors can serve as the only members. Unlike California, there is no requirement for a majority disinterested board. Finally, Delaware does not require the naming of corporate officers.

Delaware also generally applies less cumbersome regulation to the formation and operation of nonprofit corporations than some other states. Unlike New York, which requires in certain circumstances the approval of various state agencies prior to the formation of a nonprofit, an individual can form a Delaware nonprofit corporation simply by filing a certificate of incorporation. Delaware also does not require nonprofit corporations formed under Delaware law to register with its Attorney General’s office or file annual separate financial reports to the state (though if the nonprofit operates in Delaware, it may be required to file a copy of its federal Form 990 with the Delaware Attorney General). Finally, unlike some states, Delaware does not require any state government approvals for nonprofit corporate changes such as amendments to the certificate of incorporation, mergers, and dissolutions.

If you choose to incorporate in Delaware instead of your home state, please be aware of the following requirements. You must retain a Delaware registered agent to received service for you in Delaware. Fees for this service can run from $165 – $250 annually. Additionally, you may need to duly qualify to operate as a charity or corporation in whichever states you work in, and you may be subject to some registration or regulation requirements by virtue of your operations there. However, due to the “internal affairs” principle of American corporate law, internal matters such as the governance and structure of the corporation would generally still be governed by Delaware law.

Despite these requirements, Delaware incorporation can be an attractive choice, especially for would-be incorporators from states such as New York, which heavily regulate nonprofit formation and operation. For example, the New York Lawyers for the Public Interest guide to incorporating a nonprofit provides instructions for incorporation under both New York and Delaware law, and notes that “[i]t is not uncommon for a not-for-profit corporation operating in New York to be incorporated in Delaware.”

Further Resources:

Public Advertising to Wealthy Investors: The New SEC Rule 506(c) vs. California’s Qualified Purchaser Exemption

November 4, 2013

By Caroline Lee, SELC Legal Fellow

The materials available at this web site are for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any particular issue or problem.

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Photo Credit Colleen Simon for opensource.com

Many are excited for the latest Jumpstart Our Business Startups (JOBS) Act amendments to the Securities Act of 1933. Rule 506(c) took effect on September 23, 2013, opening up an exemption for emerging growth companies to solicit and advertise an investment opportunity to accredited investors in certain circumstances. Historically, accessing capital from wealthy investors required involvement with the tight-knit angel and venture capital networks that came through connections or the sheer luck of a pre-existing relationship.  Now, small businesses can advertise through social media, the newspaper or otherwise, to connect and to offer investment opportunities to these high net-worth individuals.

Read more

Investment Crowdfunding: One Step Closer

ObamaCROWDFUND

The Sustainable Economies Law Center at the signing of the 2012 JOBS Act

October 24, 2013

By Caroline Lee, SELC Community Enterprises Law Fellow

The Securities and Exchange Commission (SEC) released the long-awaited Crowdfunding proposed regulations on October 23, 2013, over nine months after its deadline. The 585 pages of rules are open for public notice and comment for 90 days, and were supposed to come 270 days after the April 5, 2012 enactment of Title III of the Jumpstart Our Business Startups Act (JOBS Act). Title III mandated the SEC to draft an exemption to the registration requirements of Section 5 of the Securities Act of 1933 for certain crowdfunding transactions. The new Securities Act Section 4(a)(6), commonly referred to as the crowdfunding exemption, allows for the offer and sale of securities without formal registration provided that certain specific requirements are satisfied. The goal of the exemption is to provide additional financing mechanisms for small businesses, to stimulate job growth, and to open up the opportunity for middle- and lower-income individuals to invest and to participate directly in our capital markets. Read more

Delaware’s New Benefit Corporation Legislation

September 5, 2013

By Devin McDougall

Overview

On August 1, 2013, Delaware’s new benefit corporation law came into effect,1 making Delaware the 19th state2 to authorize the formation of benefit corporations. Benefit corporations, as discussed in further detail here,3 are a special type of corporation that requires directors to consider the advancement of certain specified public benefits when making management decisions for the company.

Delaware’s adoption of the benefit corporation model is significant, because Delaware has historically been a leader in American corporate law. Although Delaware is the second smallest state, more than 50%4 of publicly traded companies in the United States are Delaware corporations, in part due to the predictability and flexibility which characterize Delaware corporate law.

Read more

  1. Delaware 147th General Assembly, Senate Bill # 47 w/SA 1 (2013), http://legis.delaware.gov/LIS/LIS147.nsf/vwLegislation/SB+47?Opendocument
  2. Daniel Fisher, “Delaware ‘Public Benefit Corporation’ Lets Directors Serve Three Masters Instead Of One,” Forbes.com (07/16/13), http://www.forbes.com/sites/danielfisher/2013/07/16/delaware-public-benefit-corporation-lets-directors-serve-three-masters-instead-of-one/
  3. Sustainable Economies Law Center, “New Types of For-Profit Entities” (2013), http://communityenterpriselaw.org/new-types-of-for-profit-entities/#Benefit_Corporation
  4. Delaware, “About the Division of Corporations” (2013), http://corp.delaware.gov/aboutagency.shtml

Welcome to Community Enterprise Law!

The Community Enterprise Law project shares legal tools to help support community-owned economies.  Our Community Law Library takes a broad look at laws on forming and financing community-based entities, as well as the legal issues surrounding employment, land, and housing. Our Enterprise Blog provides analysis of new laws and policies, as well as community enterprise case studies and nuggets of legal wisdom. If you are a policymaker, take a look at our City Policies page under the “Learn More” links.

This website has legal information to help start and grow your organization, but is not a substitute for legal advice. To get legal advice, talk to an attorney or visit one of our weekly legal clinics in the San Francisco Bay Area. 

What is a community-owned economy?
Traditional economic development models focus on attracting business and real estate investments from outside of a community. The unfortunate result is that wealth leaves the community, rather than remaining available for the community’s benefit. In a community-owned economy, community members have access to ownership interests in local businesses and real estate and local workers participate in the governance and growth of the enterprises in and affecting their communities. Through education and advocacy, the SELC Community Enterprise Law Project seeks to adapt existing laws and implement  legal policies that support people’s ownership, both on paper and in practice, in the wealth existing in their communities.