One of the bugbears of investment crowdfunding is the fact that the laws do not allow special purpose vehicles—legal structures that allow investors to be pooled into a single entity, which streamlines investor communications and management. You also cannot crowdfund an investment fund.
That said, there are exceptions to every rule. Real estate crowdfunding platforms and funds including Streetshares, American Homeowner Preservation and Force for Good Fund, for example, have used the JOBS Act to pool capital from investors. So it pays to understand The Investment Company Act of 1940, the law that governs mutual funds and other pooled investments. Like the Securities Acts of 1933 and 1934, it was created in the wake of the 1929 stock market crash and has been a pillar of financial law for decades. Some say it’s time for an update.
In the meantime, in this guest post, Mark Roderick of Flaster Greenberg explains the 1940s Act and how it can be used in 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.
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.
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.
Mark S. Roderick is an attorney with Flaster Greenberg in Cherry Hill, N.J., where he represents entrepreneurs and spearheads the firm’s crowdfunding practice. This article originally ran on his Crowdfunding & FinTech Law blog.