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Context: No corporation that is not an investment company wants to cross a line that would make it subject to the Investment Company Act of 1940. The ’40 Act regulates mutual funds and other companies that engage primarily in investing and trading securities and may also issue securities. Falling under it would require time-consuming, costly reporting and disclosure to comply with Securities and Exchange Commission rules, among other unwanted consequences.
- “We have had discussions with our management and legal to agree we do not want to be an investment company and subject to the regulatory oversight and filings,” one treasurer told NeuGroup Insights.
A key metric in determining that a company is not subject to the Act “is the composition of the assets on its balance sheet and, in particular, whether it owns ‘investment securities’ exceeding 40% of the value of its total assets on an unconsolidated basis, excluding ‘government securities’ and certain ‘cash items,’” according to the law firm Latham and Watkins.
But what if a company is a cash machine that owns lots of securities but not many hard assets? As the law firm notes, “Rule 3a-1 provides a safe harbor from investment company status for issuers that fail the 40% test but are not primarily engaged in an investment business…An issuer seeking to rely on Rule 3a-1 must satisfy two 45% tests:
- “No more than 45% of the value of the issuer’s total assets (excluding government securities and cash items) must consist of certain types of investment securities.
- “No more than 45% of the issuer’s net income after taxes (for the last four fiscal quarters combined) must derive from Rule 3a-1 investment securities.
- “Unlike the 40% test, though, an issuer may compute these two 45% tests on a consolidated basis with its wholly-owned subsidiaries.”
Member question: “Does anyone in the group have a requirement in your investment policy guidelines to comply with Investment Company Act safe harbor tests or something similar? For context, we’re conducting the annual review of our investment policy and are curious whether this is a broadly accepted requirement or not.
- “For background, our investment policy was originally written by a consulting company that primarily dealt with pension funds. Most of my team has not seen it in prior investment policies from other companies where we’ve worked. If anyone is willing to share if this is or is not something included in your investment policy, it’d be greatly appreciated!”
Peer answer 1: “We do not have those requirements in our investment policy. At the corporate level, our investing activity is immaterial vs. our operating business, and our treasury center subsidiaries do not issue securities. At one point in the past, we had a financial affiliate which issued securities and did not have an operating business. In that case, we made sure that its activities fell under a safe harbor.”
Peer answer 2: “Similarly, we don’t have such requirements in our investment policy. We in fact just went through the exercise of drafting an investment policy. What it covers is essentially the kinds of instruments we would invest in, tenors and some operational considerations.
- “As we were going through the process, we got some inputs from a few of our key banking partners; they shared helpful policy statements and frameworks that we could leverage. I would suggest checking with your existing banks/investment counterparties as an option.”
Member response: “Thank you for the feedback; I shared your comments with our capital markets team. We had similar thoughts to what you mentioned, as our investments are also fairly immaterial compared to our operating business.
- “It sounds like this was recommended by outside counsel before my team took over our investment policy, so we’re trying to track down why and if we’re OK removing this provision.”
Templates and attention. A member of NeuGroup for Cash Investments told NeuGroup Insights his company has “proprietary templates to ensure compliance with the safe harbor tests of the Investment Company Act of 1940 that were developed in partnership with both internal and external counsel.
- “The trackers are updated on a monthly basis to ensure compliance; however, this process and workflow is independent of the investment policy and I don’t expect that to change.”
- A different member said, “We have language in our investment policy statement around the 1940 act that we will periodically review our status.”
Words to the wise. A former member of the group said none of the investment polices he had overseen included references to safe harbor tests related to the ’40 Act. “I wouldn’t mention anything about the Investment Company Act in my investment policy,” he said. “Why call attention to it?” He added that companies concerned about failing the 45% test should seek private counsel from their auditors.
- A current member offered this perspective: “If you are not close to the line drawn in the Act or think you are exempt, then it makes no difference if it is in the policy.
- “But if you are close to the line, be very careful—regardless of what the policy says. Even if you think you are appropriately invested, something in the financials could change and trip you up.”
