Shark Week: The Investment Company Act of 1940, Part 2

As we promised, it’s time for a new species of shark. In particular, what happens if your issuer cannot pass the 40% test we discussed last time? Has your deal turned into chum or are there other answers?

Rule 3a-1

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. The Rule takes into consideration the nature of an issuer’s assets and the sources of its income.

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 (which we call “Rule 3a-1 Investment Securities”); and
  • 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. This can streamline some of the complexities of the 40% test, particularly for companies with many subsidiaries.
What are Rule 3a-1 Investment Securities?

Rule 3a-1 Investment Securities are almost identical to investment securities under the 40% test. For example, Rule 3a-1 Investment Securities exclude government securities, cash items, investments in registered money market funds, securities issued by majority‑owned subsidiaries that are not themselves investment companies and securities issued by an employees’ securities company. However, Rule 3a-1 Investment Securities also exclude securities issued by companies that are “controlled primarily” by the issuer and are neither investment companies nor companies through which the issuer engages in an investment business.

Unlike the 40% test, the subsidiary need not be majority‑owned. Instead, 25% or more will typically work for these purposes. See Health Communications Services, Inc. (avail. Apr. 26, 1985); Section 2(a)(9) (providing that “control” is assumed if the issuer holds 25% or more of the subsidiary’s outstanding voting securities).
How do you calculate the percentage of an issuer’s investment income?

The percentage of an issuer’s investment income is determined by comparing, for the last four fiscal quarters combined, the issuer’s:

  • net income from investment securities (i.e., after‑tax investment income minus investment expenses) to
  • total net income (i.e., after‑tax income minus all business expenses)

For net losses, the SEC Staff has stated that Rule 3a-1 requires an issuer to match its investment expenses with investment income to “ensure that only income or loss generated by investment activities are compared to” the issuer’s total net income or loss. As a result, the relevant comparison for purposes of the income test would be net investment loss (i.e., investment expenses minus investment income) to total net loss (i.e., expenses minus income). See DRX, Inc. (avail. Jan. 28, 1988).

Stay tuned for our next installment where we cover some of the relief available for "inadvertent investment companies."