One of the worse situations a company may face to be determined to be an investment company under the Investment Company Act of 1940, as amended (the act). If determined to be an investment company, the company is subject to the full regulation under the act. In addition, a company may inadvertently become an investment company; in such a case, all of its contracts are potentially voidable and it cannot engage in any other business. Generally, companies inadvertently become investment companies by virtue of their investments in certain securities which trigger the act’s 40 percent test.

Many times a number of companies fall within the definition of an investment company because operating companies have large amounts of assets invested in cash management instruments, government securities and money market funds.

The act is draconian in its regulation and can change the entire business of a company. If a company inadvertently becomes an investment company, it must defend itself from SEC regulation and change its investment policies.

Section 3(a)(a)(A) of the act defines an investment company as an issuer that is or holds itself out as being engaged primarily in an investment company business; Section 3(a)(1)(B) defines an investment company as an issuer that is a face-amount certificate company; and Section 3(a)(1)(C) defines an investment company as an issuer that holds more than 40 percent of its assets (other than cash and government securities) in investment securities.

An issuer is any person who issues or proposes to issue any security or has outstanding any security that he or she has issued. A security is defined in Section 2(a)(36) of the act to be any of the following: any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas or other mineral rights, any put, call, straddle, option, or privilege on any security, or any put, call, straddle, option or privilege entered into on a national securities exchange relating to foreign currency or, in general, any interest or instrument commonly known as a security.

Inadvertent investment companies

Under Section 3(a)(1(C) of the act, an issuer may become an investment company if it is engaged, or proposes to engage, in the business of investing, reinvesting, owning, holding or trading in securities and it owns or proposes to acquire, investment securities having a value exceeding 40 percent of the value of its total assets, exclusive of government securities and cash items, on a consolidated basis.

Avoidance of regulation under the act

Fortunately, there are exceptions to registration under the act which issuers can fall under. In addition, there are a number of exemptions from registration available to issuer.

Section 3(c)(1) of the act excepts from the definition of investment company “any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 person and which is not making and does not presently propose to make a public offering of it securities.”

In order to take advantage of this exception, no more than 100 persons may beneficially own the issuer’s outstanding securities, other than short-term paper. In addition, the beneficially owned securities may be voting or non-voting securities. A beneficial owner is generally determined by whether such person has the ability to decide whether, or how much, to invest in those securities. In addition, securities that are jointly owned by spouses are considered to be owned by one beneficial owner.

The various exceptions from the definition of an investment company include the following:

  • Any person primarily engaged in the business of underwriting and distributing securities issued by other persons, selling securities to customers, acting as a broker, and acting as market intermediary, or any other or more of such activities, whose gross income normally is derived principally from such business and related activities
  • A depository institution or a branch or agency of a foreign bank, a member bank of the Federal Reserve System, any other banking institution or trust company, whether incorporated or not, doing business under the laws of any state or of the United States, and a receiver, conservator, or other liquidating agent of any institution or firm included above
  • Any common trust fund or similar fund maintained by a bank exclusively for the collective investment and reinvestment of moneys contributed thereto by a bank in its capacity as a trustee, executor, administrator or guardian, if such funds are employed by the bank solely as an aid to the administration of trusts, estates, or other accounts created and maintained for a fiduciary purposes; except in connection with the ordinary advertising of the bank’s fiduciary services, interests in such fund are not advertised or offered for sale to the general public; and fees and expenses charged by such fund are not in contravention of fiduciary principles established under applicable federal or state law
  • Any person substantially all of whose business is confined to making small loans, industrial banking or similar businesses
  • A company organized as an insurance company, whose primary and predominant business activity is the writing of insurance or the reinsuring of risks underwritten by insurance companies, and which is subject to the supervision of the insurance commissioner or a similar official or agency of a state, or any receiver or similar official or any liquidating agent for such company, in his capacity as such
  • Any person who is not engaged in the business of issuing redeemable securities, face-amount certificates of the installment type or periodic payment plan certificates, and who is primarily engaged in one or more of the following businesses: purchasing or otherwise acquiring notes, drafts, acceptances, open accounts receivable, and other obligations representing part or all of the sales price of merchandise, insurance, and services; making loans to manufacturers, wholesalers, and retailers of, and to prospective purchasers of, specified merchandise, insurance and other services; and purchasing or otherwise acquiring mortgages and other liens on and interests in real estate
  • Any company primarily engaged, directly or through majority-owned subsidiaries, in one of more businesses, e.g., majority-owned subsidiary, holding companies, or in one or more of such businesses (from which not less than 25 percent of such company’s gross income during its last fiscal year was derived) together with an additional business or businesses other than investing, reinvesting, owning, holding, or trading in securities
  • Any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities
  • Any person substantially all of whose business consists of owning or holding oil, gas, or other mineral royalties or leases, or fractional interests therein, or certificates of interest or participation in or investment contracts relative to such royalties, leases or fractional interests


Companies active in investing or reinvesting in companies need to be aware of the act in order to avoid registering as an investment company. Many companies who inadvertently become investment companies must stop their current activities and rearrange their investment strategies. However, due to the number of exceptions available to issuers, companies need to take advantage of them and modify their practices to avoid registration under the act.