On March 20, the SEC Division of Investment Management issued IM Guidance (No. 2017-3) in response to inquiries regarding operating holding companies that are engaged in various operating businesses through wholly-owned or majority-owned subsidiaries (“Holding Company”) to avoid Investment Company Act of 1940, as amended (the “1940 Act”) registration.
Holding Companies that experience “extraordinary events” in their organizational life such as business model transition or start up financing issues may be found to be an inadvertent “investment company.” Further, a company that holds interests in other operating companies (subsidiaries) that it may or may not control, or an operating company that temporarily holds investment securities or cash constituting a large percentage of its assets may find itself to be an inadvertent “investment company”.
The definition of “investment company” under the 1940 Act is very broad and covers companies whose assets consist largely of “investment securities,” which itself is a broadly defined term in the 1940 Act. The implications of being found an investment company includes registration as such under the 1940 Act, with substantive disclosure documentation and reporting obligations, having an independent board, certain investment restrictions be met, SEC enforcement action or private litigation, among other things.
There are two main exemptions from 1940 Act regulation typically relevant for operating companies:
- the Rule 3a-1 exemption for “prima facie investment companies”; and
- the Rule 3a-2 “transient investment company” exemption, which provides temporary relief.
Section 3(a)(1)(C) of the 1940 Act regulates any company as an investment company whose assets meet the following objective “prima facie” test:
Total Assets minus Cash and
US Government Securities is greater than 40% (“40% Threshold”).
The Guidance addresses and clarifies the application of Rule 3a-2 with respect to Holding Companies.
The purpose of Rule 3a-2 is to provide temporary relief from 1940 Act registration and other requirements to a company that, on a transient basis, could be deemed to be an investment company because of an unusual business occurrence (i.e. in situations where the 1940 Act was not intended to apply). Rule 3a-2 provides a safe harbor for such transient investment companies if certain conditions are satisfied. The transient investment company exemption may be relied upon for a one year period if the Holding Company can demonstrate a bona fide intent to be, as soon as is reasonably possible, engaged primarily in a business other than an investment company.
While the SEC has addressed Rule 3a-2 factors Rule 3a-2 factors in case law1 and no-action positions2 previously, the determination as to whether an issuer has the requisite non-investment intent to fit within the transient investment company exemption is based on the particular facts and circumstances. In determining whether a company is “primarily engaged” in a non-investment company business under Section 3(b)(2), the SEC considers: (a) the company’s historical development, (b) its public representations of policy, (c) the activities of its officers and directors, (d) the nature of its present assets, and (e) the sources of its present income.
One-Year Safe Harbor Period
The Rule 3a-2 one-year period begins on the earlier of:
- 40% Threshold or
- the date on which the issuer owns securities and/or cash having a value exceeding 50 per cent of the value of the issuer’s total assets on either a consolidated or unconsolidated basis (“50% Threshold”).
This guidance clarifies that the one year safe harbor period does not begin until the occurrence of an extraordinary event causes a Holding Company to have certain characteristics of an investment company.
The occurrence of an extraordinary event may temporarily alter the composition of the Holding Company’s total assets such that securities other than the equity securities of its majority- or wholly-owned subsidiaries (“Subsidiaries”) now comprise a significant portion of the Holding Company’s total assets.
As discussed above, Rule 3a-2 provides that a company may rely upon the Rule for one year from the earlier of the date it triggered either the 50% Threshold or the 40% Threshold. The 50% Threshold may be problematic for a Holding Company because the threshold is based on the cash and securities it holds which includes the security holdings of any Subsidiaries, not simply its investment securities.
The SEC Staff believes that a Holding Company may not have the characteristics of an investment company until it fails the 40% Threshold. Accordingly, the Staff believes that, generally, Rule 3a-2’s one-year safe harbor should not begin until the occurrence of an “extraordinary event” and thus when the Holding Company may seek to rely on the Rule. Finally, a company can make use of this Rule 3a-2 exemption only once in any three year period so any future transactions by the company should bear this in mind to avoid registration under the 1940 Act at a later date.
In this regard, the Staff believes that the one-year period for transient investment companies should be available to issuers that have a bona fide intent to be engaged primarily in a non-investment company business (i.e. not engaged in the business of “investing, reinvesting, owning, holding or trading” in securities”), regardless of whether they operate directly or through a holding company structure. This result should further the SEC’s mandate to facilitate capital formation as well as not limit Holding Companies from relying on Rule 3a-2 due to their organizational structure.
- SEC v. National Presto Industries, 486 F.3d 305 (7th Cir. 2007) and In re Tonopah Mining Co., 26 S.E.C. 426 (1947).
- ACS Wireless, Inc. No Action Letter IC-30602 (July 19, 2013) and Rio Tinto plc No Action Letter IC-29921 (January 17, 2012).
Written by: Peter R. Guarino