We know an “investment company,” as defined in the Investment Company Act of 1940, can’t use Title III Crowdfunding. For that matter, an issuer can’t use Title III even if it’s not an investment company, if the reason it’s not an investment company is one of the exemptions under section 3(b) or section 3(c) of the 1940 Act. By way of example, suppose a a company is engaged in the business of making commercial mortgage loans. Even if the company qualifies for the exemption under section 3(c)(5)(C) of the 1940 Act, it still can’t use Title III.
We also know that, silly as it seems, a company whose only asset is the securities of one company is generally treated as an investment company under the 1940 Act. That’s why we can’t use so-called “special purpose vehicles,” or SPVs, in Title III Crowdfunding, to round up all the investors in one entity and thereby simplify the cap table.
Put those two things together and you might conclude that only an operating company, and not a company that owns stock in the operating company, can use Title III Crowdfunding. But that wouldn’t be quite right.
A company that owns the securities of an operating company – I’ll call that a “parent company” — can’t use Title III if it’s an “investment company” under the 1940 Act. However, while every investment company is a parent company, not every parent company is an investment company. Here’s what I mean.
Section 3(a)(1) of the 1940 Act defines “investment company” as:
- A company engaged primarily in the business of investing, reinvesting, or trading in securities; or
- A company engaged in the business of investing, reinvesting, owning, holding, or trading in securities, which owns or proposes to acquire investment securities having a value exceeding 40% of the value of its assets.
Suppose Parent, Inc. owns 100% of Operating Company, LLC, and nothing else. If Parent’s interest in Operating Company is treated as a “security,” then Parent will be an investment company under either definition above and can’t use Title III. However, it should be possible to structure the relationship between Parent and Operating Company so that Parent’s interest is not treated as a security, relying on a long line of cases involving general partnership interests.
These cases arise under the Howey test, made famous by the ICO world. Under Howey, an instrument is a security if and only if:
- It involves an investment of money or other property in a common enterprise;
- There is an expectation of profits; and
- The expectation of profits is based on the efforts of someone else.
Focusing on the third element of the Howey test, courts have held that a general partner’s interest in a limited partnership generally is not a security because (1) by law, the general partner controls the partnership, and (2) the general partner is therefore relying on its own efforts to realize a profit, not the efforts of someone else.
If Operating Company were a partnership and Parent were its general partner, then the arrangement would fall squarely within this line of cases and Parent wouldn’t be treated as an investment company. As a general partner, however, Parent would be fully liable for the liabilities of Operating Company, defeating the main purpose of the parent/subsidiary relationship, i.e., letting the tail wag the dog.
Fortunately, Parent should be able to achieve the same result even though Operating Company is a limited liability company. The key is that Operating Company should be managed by its members, not by a manager. That should place Parent in exactly the same position as the typical general partner: relying on its own efforts, rather than the efforts of someone else, to realize a profit from the enterprise.
If Parent’s interest in Operating Company isn’t a “security,” then Parent isn’t an “investment company,” and can raise money using Title III.
Questions? Let me know.