Tag Archives: Investment Company Act of 1940

A Summary of the Investment Company Act for Crowdfunding

Hardly a day goes by without someone asking a question that involves the Investment Company Act of 1940. Although the Act is hugely long and complicated, I’m going to try to summarize in a single blog post the parts that are most important to Crowdfunding.

Why the Fuss?

If you’re in the Crowdfunding space, you don’t want to be an “investment company” within the meaning of the Act:

  • As an investment company, you’re not allowed to raise money using either Title III (Regulation Crowdfunding) or Title IV (Regulation A).
  • Investment companies are subject to huge levels of cost and regulation.

What is an Investment Company?

An investment company is company in the business of holding the securities of other companies. That statement raises many interesting and technical legal issues that have consumed many volumes of legal treatises and conferences at the Waldorf. But almost none of it matters to understand the basics.

All that matters from a practical perspective is that stock in corporations, interests in limited liability companies, and interests in limited partnerships are all generally “securities” within the meaning of the Act.

And that means, in turn, that if you hold stock in corporations, interests in limited liability companies, and/or interests in limited partnerships, then assume you’re an “investment company” within the meaning of the Act, unless you can identify and qualify for an exception.

How Much is Too Much?

Holding some securities doesn’t make you an investment company. Under one of the many technical rules in the Act, a company won’t be considered an investment company if:

  • No more than 45% of its assets are invested in securities, as of the end of the most recent fiscal quarter; and
  • No more than 45% of its income is derived from investment securities, as of the end of the most recent four fiscal quarters.

Does That Mean a Typical SPV is an Investment Company?

Unless the SPV can find an exception, yes.

Many Crowdfunded investments use a “special purpose vehicle,” typically a Delaware limited liability company. Investors acquire interests in the SPV, and the SPV invests – as a single investor – in the actual operating company. Because the only asset of the SPV is the interest in the operating company, which is a “security,” the SPV is indeed an investment company, unless it qualifies for one of the exceptions below.

Simple Exceptions

The definition of “investment company” is so broad, most of the action is in the exceptions. I’m not going to talk about all of them, only those that are most relevant to Crowdfunding.

  • No More Than 100 Investors – A company with no more than 100 investors (who do not have to be accredited) isn’t an investment company. That’s the exception used by SPVs in Crowdfunding. Which means that as the size of deals in Crowdfunding grows, SPVs will no longer be used.
  • All Qualified Investors – A company with only “qualified investors” isn’t an investment company. A “qualified investor” is generally a person with more than $5 million of investable assets. Many hedge funds rely on this exception, but it’s not going to be used widely in Crowdfunding.

NOTE:  A company that would be an investment company but for either of those two exceptions is still not allowed to use Title III or Title IV.

  • Companies That Invest In Mortgages – A company that invests in or originates mortgages is usually not an investment company.
  • Wholly-Owned Subsidiaries – A company that conducts its business through wholly-owned subsidiaries isn’t an investment company, as long as the subsidiaries are not investment companies. For these purposes, “wholly-owned” means the parent owns at least 95% of the voting power.
  • Majority-Owned Subsidiaries – A company that conducts its business through majority-owned subsidiaries usually isn’t an investment company, as long as the subsidiaries are not investment companies. For these purposes, “majority-owned” means the parent owns at least 50% of the voting power.

The 45% Exception

Some companies, including some REITs, own interests in subsidiaries that are not wholly-owned or even majority-owned. To avoid being treated as investment companies, those companies typically rely on an exception that requires more complicated calculations. Under this exception, a company is excluded from the definition of “investment company” if it satisfies both of the followings tests:

  • No more than 45% of the value of its assets (exclusive of government securities and cash items) consist of securities other than what I will refer to as “allowable securities.”
  • No more than 45% of its after-tax income is derived from securities other than those same “allowable securities.”

For these purposes, the securities I am calling “allowable securities” include a number of different kinds of securities, but the two most important to us are:

  • Securities issued by majority-owned subsidiaries of the parent; and
  • Securities issued by companies that are controlled primarily by the parent.

So think of those securities as being in the “good” basket and other kinds of securities as being in the “bad” basket.

In determining whether a security – such as an interest in a limited liability company – is an “allowable security,” and therefore in the “good” basket, the following definitions apply:

  • A subsidiary is a “majority-owned subsidiary” if the parent owns at least 50% of the voting securities of the subsidiary.
  • A parent is deemed to “control” a subsidiary if it has the power to exercise a controlling influence of the management or policies of the subsidiary.
  • A parent is deemed to “control primarily” a subsidiary if (1) it has the power to exercise a controlling influence of the management or policies of the subsidiary, and (2) this power is greater than the power of any other person.

Summary

If your business model involves investing in other companies and you plan to raise money from other people, the Investment Company Act of 1940 should be on your To Do List.

As a rule of thumb, you can feel comfortable investing in wholly-owned subsidiaries, majority-owned subsidiaries, and subsidiaries where you have exclusive or at least primary control. If you find other investments making up, say, more than 25% of your portfolio, measured by asset value or income, look harder.

Questions? Let me know.

Will Someone Please Offer Investment Advice For Crowdfunding?

business handshake

Very few retail investors have the skill to pick a great deal from a mediocre deal. I know I don’t, and I’ve been representing real estate developers and entrepreneurs my whole career.

Taking a cue from the public stock market, one way to address the retail market is to create the equivalent of a mutual fund for Crowdfunding investments. You would create a limited liability company to act as the fund, raise money from investors using Crowdfunding, and the manager would select investments from Crowdfunding portals.

Great idea conceptually, but it doesn’t work legally:

  • The LLC would, by definition, be an “investment company” under the Investment Company Act of 1940. As such, you would be prohibited from using Title III or Title IV to raise money for the fund.
  • You could use Title II to raise money for the fund, but as an investment company the fund would be subject to extremely onerous and costly regulation, e., the same regulation that applies to mutual funds. To avoid the regulation, you would have to limit the fund to either (1) no more than 100 accredited investors, or (2) only investors with at least $5 million of investments. In either case, you defeat the purpose.

But there is another way! A licensed investment adviser could offer investment advice with respect to investments in Crowdfunding projects and, for that matter, make the investments on behalf of his or her retail customers, charging an annual fee based on the amount invested. The adviser would allow each retail investor to effectively create his or her own “mutual fund” of projects based on individual preferences.

Not only would the investment adviser make money, the availability of unbiased advice would draw retail investors into the space – a win for the industry.

To quote Pink Floyd, is there anybody out there?

Questions? Let me know.

Crowdfunding Legal Resources

I really appreciate the time you spend on my blog. To make the blog more useful, I’ve added a Legal Links button, up there to the right. To start, you’ll find links to:

I plan to add more links in the future and welcome your suggestions.

Questions? Let me know.

%d bloggers like this: