Traps for the Unwary: What Every Operating Company Should Know to Avoid Regulation Under the Investment Company Act

• Pages: 97-131
• Date: 01 January 2025
• Published date: 01 January 2025
• Author: Rochelle Kauffman Plesset
• Subject Matter: Derecho Público y Administrativo

Traps for the Unwary: What Every Operating

Company Should Know to Avoid Regulation Under

the Investment Company Act

By Rochelle Kauffman Plesset*

While the Investment Company Act was enacted to regulate investment vehicles such

as mutual funds and closed-end funds, certain operating companies can f‌ind themselves

at risk of falling within the scope of that Act’s extensive regulatory regime. Such oper-

ating companies may need to frequently assess their status under the Investment Com-

pany Act. This article provides a roadmap for operating companies and their counsel

when analyzing the company’s status and provides potential options a company may

wish to consider to avoid triggering Investment Company Act regulation.

For some companies, avoiding regulation underthe Investment Company Act of

1940 (Investment Company Act, 1940 Act, or Act)

1

can be the bane of their exis-

tence. The Investment Company Act was enacted to provide for the registration

and regulation of investment vehicles.

2

However, operating companies,

3

depend-

ing on their business model, composition of assets,or organizational structure, can

f‌ind themselves within the scope of the Act’s extensive regulatory regime, the po-

tential of which could have signif‌icant consequences to their operations. Such

companies often include those that are not perceived to be of the type that the In-

vestment Company Act was intended to regulate.

4

* Rochelle Kauffman Plesset recently retired from the staff of the U.S. Securities and Exchange

Commission’s Division of Investment Management where she focused much of her time on status

issues under the Investment Company Act. She would like to thank Brian M. Kaplowitz and Robert

H. Rosenblum in addition to her former colleagues at the Commission for their helpful comments.

This article, however, expresses the author’s views only.

1. Investment Company Act of 1940, 15 U.S.C. §§ 80a-1–80a-64 (2024).

2. The Investment Company Act’s legislative history suggests that the Act is intended to regulate

entities that serve as a means for the public to invest in securities. See, e.g.,S.R

EP.NO. 76-1775, at 2

(1940) (“Investment trusts and investment companies are essentially institutions which provide a me-

dium for public investment in common stock and other securities.”); H.R. REP.NO. 76-2639, at 5

(1940) (“Investment trusts and investment companies are in essence institutions for the investment

of the savings of small investors in securities, particularly the common stocks of industrial and other

companies.”).

3. For purposes of this article, an operating company, directly or indirectly, provides goods or fur-

nishes services to customers or clients. Holding companies that operate through subsidiaries are in-

cluded in this def‌inition.

4. For examples of some of these types of companies, see infra text accompanying notes 152–57

and notes 172–75.

97

Companies at risk of falling within the scope of the Investment Company Act

may need to frequently assess their status under that Act. At times these compa-

nies may require a legal opinion that the company is not an investment company,

such as when offering securities or engaging in other f‌inancing arrangements. In

addition, Securities and Exchange Commission (Commission) staff will often re-

quest that a company provide its Investment Company Act status analysis while

conducting selective reviews of disclosures f‌iled with the Commission in accor-

dance with the Securities Act of 1933 (Securities Act)

5

and the Securities Exchange

Act of 1934 (Exchange Act),

6

or during examinations of any aff‌iliated investment

advisers, registered investment companies, or broker-dealers, if the staff decides

such information would be relevant. In the event that the staff is unsatisf‌ied

with the analysis provided, the staff could, depending on the facts and circum-

stances, require the company to address in its disclosures the company’s risk

that it might be an investment company, request the Commission’s Division of Ex-

aminations to conduct examinations of the company’s aff‌iliated entities (if such

entities are subject to the Commission’s examination authority),or refer the matter

to the Commission’s Division of Enforcement.

The purpose of this article is to provide a roadmap for operating companies

and their counsel when analyzing the company’s status under the Investment

Company Act. The article will also provide insight and present potential options

a company may wish to consider in order to avoid triggering potential Invest-

ment Company Act regulation.

7

I. BACKGROUND:WHAT IS THE INVESTMENT COMPANY ACT AND WHY

SHOULD COMPANIES CARE?

The Investment Company Act was among the federal securities laws enacted

following the market crash of 1929. The Act, which was drafted in collaboration

with the Commission and members of the investment company industry,

8

pre-

scribes an extensive regulatory scheme for companies that fall within the scope

of the Act.

9

Such companies are also subject to a disclosure and reporting regime

5. Securities Act of 1933, 15 U.S.C. §§ 77a–77aa (2024).

6. Securities Exchange Act of 1934, §§ 78a–78rr (2024).

7. This article is not intended to be an exhaustive discussion of all the issues that an operating

company might encounter when considering its investment company status. In this regard, a com-

pany and its counsel may wish to review, among other things, any Commission or staff statements,

releases, or guidance that may relate to the company’s particular facts and circumstances. Many of

these documents can be found on the Commission’s website. See https://www.sec.gov/ (last visited

Oct. 20, 2024). Similarly, a company and its counsel might wish to consider whether an extremely

complicated or novel legal or factual question warrants consultation with those with particular exper-

tise in Investment Company Act status issues. The information in this article is current as of October

22, 2024.

8. For more information regarding the drafting and adoption of the Investment Company Act, see,

e.g., Alfred Jaretzki, Jr., The Investment Company Act of 1940,26W

ASH. U. L.Q. 303, 303–11 (1941);

Brian J. Lane & Gillian McPhee, Investment Company Act of 1940: Why the Time Has Come to Revive

Section 3(b)(1),2V

ILL. J.L. & INV.MGMT. 16, 17–23 (2001).

9. Investment Company Act of 1940, 15 U.S.C. §§ 80a-1–80a-64 (2024). For example, companies

that are subject to Investment Company Act regulation must register with the Commission and

98 The Business Lawyer; Vol. 80, Winter 2024–2025

that differs from non-investment companies. The Investment Company Act re-

f‌lects the view that the disclosure and reporting requirements set forth in the

previously enacted Securities Act and Exchange Act did not go far enough in ad-

dressing the abuses found in the investment company industry during that time

period.

10

The regulatory regime prescribed by the Investment Company Act is incom-

patible with the activities of most operating companies.

11

To comply with the

Act, an operating company would likely need to signif‌icantly restructure its busi-

ness and be subject to limitations to its operations. Thus, whether to register

under the Act is not a decision to be taken lightly. Rather, companies that choose

to be subject to the requirements of the Investment Company Act generally do so

because they want to be an investment company.

Companies that fall within the scope of the Investment Company Act but con-

tinue to operate without complying with the Act’s requirements could suffer ad-

verse consequences. Such companies may f‌ind their contracts voidable under

Section 47(b) of that Act.

12

They could also be subject to Commission enforce-

ment action

13

or private litigation

14

that alleges that they are unregistered invest-

ment companies.

II. THRESHOLD QUESTION:DOES THE COMPANY MEET THE

DEFINITION OF INVESTMENT COMPANY?

The threshold question facing operating companies is whether they, or any of

their subsidiaries, fall (or is at risk of falling) within one of the def‌initions of in-

vestment company set forth in Section 3(a) of the Investment Company Act. Of

the three def‌initions, two—Section 3(a)(1)(A) and Section 3(a)(1)(C)—are rele-

vant to operating companies.

15

comply with requirements that, among other things, restrict transactions with aff‌iliates, govern the

composition of boards of directors, limit the use of leverage, regulate the payments of dividends, im-

pose limitations on the custody of assets, prescribe the creation and preservation of records (which

are subject to examination by the Commission and its staff), and affect plans of reorganization.

10. See, e.g.,D

IV.OF INV.MGMT., U.S. SEC.&EXCH.COMM’N,PROTECTING INVESTORS:AHALF CENTURY OF

INVESTMENT COMPANY REGULATION xvii (1992) [hereinafter PROTECTING INVESTORS REPORT].

11. See supra note 9.

12. 15 U.S.C. § 80a-47(b). Section47(b) generally provides that a contract that is made, or whose

performanceinvolves, a violation of the InvestmentCompany Act or the rules thereunder is unenforce-

able by either party unlessa court f‌inds that enforcement would produce a more equitable result. An

unregistered investment company could be in violation of Section 7(a), which generally prohibits an

investment company from directly or indirectly offering or selling securities or engaging in other ac-

tivities by use of the mail or through other meansof interstate commerce unless the company is reg-

istered under the Act. 15 U.S.C. § 80a-7(a).

13. See, e.g., SEC v. Fiore, 416 F. Supp. 3d 306 (S.D.N.Y. 2019) (denying motion to dismiss);

Daxor Corp., Initial Decision Release No. 428, 2011 SEC LEXIS 3040 (ALJ Aug. 31, 2011), f‌inalized

by SEC Release No. IC-29948, 2012 SEC LEXIS 504 (Feb. 10, 2012).

14. See, e.g., Moses v. Black, No. 78 Civ. 1913, 1981 U.S. Dist. LEXIS 10870 (S.D.N.Y. Feb. 3, 1981);

Cone Mills Corp. v. W. Pac. Indus., No. C-83-1181-G, 1983 U.S. Dist. LEXIS 11060 (M.D.N.C. Sept.

22, 1983).

15. Investment Company Act of 1940 § 3(a)(1), 15 U.S.C. § 80a-3(a)(1). Section 3(a)(1)(B) de-

f‌ines an investment company to include companies that issue face-amount certif‌icates of the install-

ment type. It is rare for any company to fall within this def‌inition. Note that these three provisions

Traps for the Unwary 99