(Article from Registered Funds Alert, October 2019)
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The 1940 Act contains at least one conceptual oddity—a corporate issuer that clearly does not operate an investment company business can find itself unable to avoid falling within the 1940 Act’s definition of an investment company. The result for that company is harsh. It would be subject to the full panoply of regulations imposed by the 1940 Act, including requirements and restrictions related to capital structure, corporate governance, borrowing, and transactions with affiliates. Also harsh are some of the steps such a company must take to avoid being deemed an investment company. Many companies are forced to go so far as restructuring and committing to significant restrictions on how they manage their business to avoid inadvertently being deemed an investment company subject to the 1940 Act.
We are happy to report that the SEC and its staff have recently reengaged with an existing provision in the 1940 Act that can provide some relief by allowing the SEC to affirmatively declare that a corporate issuer is not an investment company. Simpson Thacher recently assisted Lyft, Inc. in obtaining such exemptive relief in connection with its initial public offering earlier in 2019. The relief effectively provides Lyft with a permanent exemption from the 1940 Act and the restrictions it would impose on Lyft’s business operations and cash management strategy. We think this underutilized tool could help more businesses put the 1940 Act behind them for good.
This Alert discusses issues that arise under the 1940 Act definition of the term “investment company,” how the exemptive relief obtained by Lyft works and the prospects and potential benefits for other businesses that might seek similar relief. The SEC’s recent renewed openness to these types of exemptive applications signals that there may be an opportunity for other interested applicants to resolve potential investment company status issues through the exemptive process, thereby removing artificial constraints on their businesses and clearing any doubt regarding its investment company status going forward.
The Definition of “Investment Company” Under the 1940 Act
The 1940 Act’s regulations and restrictions generally only apply to a company that meets the definition of the term “investment company.” The restrictions around investment companies are onerous and any business that does not purposefully intend to operate as a registered investment company should stridently seek to avoid falling within the term’s definition.
Several common scenarios exemplify the problem.
Asset-Lite Operating Companies and the Objective Test
Section 3 of the 1940 Act contains a multi-part definition of the term “investment company,” but the most relevant prong of that definition is often referred to as the “objective test.” Conceptually, the objective test is most easily discussed by referring to “good assets,” which do not count toward the limit of the investment company test, and “bad assets,” which do count toward that limit. Certain intangible assets are discarded as not assets at all for these purposes.[1] If, on an unconsolidated basis, more than 40 percent of the value of a business’s total assets (exclusive of any U.S. government securities and cash items) are bad assets, then the company is said to be a “prima facie investment company.”
“Bad assets” under the objective test is a broad category and essentially includes every kind of security other than U.S. government securities and securities issued by majority-owned subsidiaries. Investments commonly associated with investment funds, such as long-term debt investments and non-controlling equity stakes, would be considered bad assets. But so too are common cash management investments such as commercial paper and commercial bonds, even if they are only short-term investments, in many circumstances.
The objective test is meant to be an easy-to-apply, bright-line test, but it struggles to categorize many businesses appropriately today. The objective test presumes that more than 60% of a non-investment company’s value will be made up of its property, equipment, inventories, receivables and other good assets. This presumption about a business’ asset mix may have been an easy and effective way to distinguish investment companies from operating companies when the 1940 Act was written, but today the methodology presents significant challenges.
Increasingly, companies find that they are prima facie investment companies because the bulk of their value is actually intangible and intertwined with their internally developed intellectual property, or such other value that is intangible and therefore has no value as an “asset” for purposes of the 1940 Act test, even though the real-world value may be substantial (for example to a potential acquirer of the business).
The problem is further compounded when an asset-lite company has substantial cash on hand from a capital raise and that cash cannot be immediately deployed into the operations of the business. Cash is a “neutral asset” under the objective test. A company that holds substantial amounts of cash may find that a relatively small amount of bad asset investments may cause the company to fail the objective test.
Example: Imagine that a technology company with $60 million in tangible good assets raises $1 billion from investors to fund future operations. To simplify the exercise, assume this company has no debt. Under the objective test, if the company were then to invest more than $40 million into short-term corporate bonds, the company would exceed the 40% threshold for bad assets and inadvertently become an investment company. This is because all of the cash it raised would be excluded from the objective test calculations. The total value of the business, as per the 1940 Act, would be just the $60 million in good assets plus whatever bad assets it acquires after the fundraise, even though investors and management rationally perceive the value of the business to be much higher.
By investing just 4% of the $1 billion it raised into bad assets, the business would become subject to regulation as though it were a mutual fund. No reasonable investor would think that an investment in such a company is akin to investing in a mutual fund, but nevertheless the business would be a prima facie investment company in the eyes of the 1940 Act and need an exemption to avoid burdensome regulation.
Intercompany Loans Under the
Objective Test
A company with a complicated structure that involves internal lending may also find the objective test challenging. Under the objective test, an intercompany loan is generally considered a bad asset for the entity that makes the loan and holds the note. Two notable exceptions include where the loan is made by a parent company to its direct or indirect majority-owned subsidiary (in which case the parent company may treat the intercompany loan as a good asset) or where the entity that makes the loan qualifies for the “finance subsidiary” exception under Rule 3a-5 of the 1940 Act.
For many businesses, parent, subsidiary and sister entities make and receive loans to and from one another regularly for cash flow, tax and other important business purposes, and the finance subsidiary exception is not nearly broad enough to capture this common practice. The finance subsidiary exception was created to ensure a very specific type of subsidiary that borrows money and relends it internally would not itself be, and would not cause its parent to be, deemed an investment company. On the one hand, the existence of the exception demonstrates that the Commission is aware of the challenge in applying the objective test. On the other, the exception is too narrow to capture the vast majority of corporate subsidiaries. The result is that the general practice of intercompany lending, when not performed by one of these purpose-created finance subsidiaries, can very easily result in the lending entity being deemed an investment company. We can think of no policy rationale why the internal management of cash within an enterprise should result in a company being an investment company under the 1940 Act. Nevertheless, if more than 40% of a subsidiaries’ assets are intercompany loans, it would be a prima facie investment company and need an exemption, because without one the entire value of that subsidiary would be a “bad asset” for purposes of applying the objective test to the parent.
Businesses That Operate Through Certain Joint Ventures
Businesses that seek to operate through joint ventures also expose the objective test’s limitations. Under the objective test, securities issued by majority-owned subsidiaries are treated as good assets, but the 1940 Act’s definition of majority-owned subsidiaries is rigid and can be strained with respect to many joint ventures. The definition of majority-owned subsidiaries includes only those subsidiaries of which the parent owns 50% or more of the outstanding voting securities.
Many businesses do not need to consider the 1940 Act implications of entering a joint venture, but for some the joint venture will represent such a substantial part of their business that 1940 Act considerations become paramount. Joint ventures can be majority-owned subsidiaries with careful structuring and only two participants, but an unequal distribution of voting rights or more than two participants arguably prevents any joint venture from being treated as a majority-owned subsidiary. While there are still potential arguments to avoid treating such a joint venture as a bad asset, they are uncertain, and there is no good reason why a business that legitimately intends to enter into a joint venture should have to worry about potential regulation under the 1940 Act because of how the joint venture is structured.
This particular difficulty also impacts certain investment vehicles that should fall completely outside of the 1940 Act because they do not invest in securities. Many real estate investment trusts (“REITs”) invest only in interests in real property, and interests in real property are not securities under the 1940 Act. There is even a specific exemption for businesses that primarily invest in real estate in Section 3(c)(5)(C). The operation of the 1940 Act, however, also means that an issuer that wishes to make real estate investments through the use of a joint venture would potentially be unable to meet the requirements of that exception or otherwise pass the objective test. These results are counterintuitive. The same issuer could invest in the real estate directly (such as by jointly taking title to the property with other investors) and avoid being deemed an investment company, but cannot freely do so indirectly using a corporate structure (even if structuring the investment in this way is more beneficial from a business perspective) without falling under the scope of the 1940 Act. Accordingly, managers of REITs spend an inordinate amount of time structuring solutions to satisfy 1940 Act requirements and/or forego certain beneficial investment opportunities for the sole purpose of avoiding being deemed an investment company.
The Usual Approaches to Investment Company Status Issues
Many businesses currently work around or mitigate the investment company status problems described above without approaching the SEC directly, but those approaches come with drawbacks. In many instances, businesses choose to do nothing other than carefully monitor their balance sheets and limit their investments to avoid inadvertently becoming an investment company under the objective test. That solution is inefficient because it can dramatically limit the business’ investment flexibility. The decision to have a conservative corporate treasury investment program or avoid a joint venture should be motivated by legitimate operational concerns, not fear of an overreaching regulation that was never intended to constrain non-investment company businesses.
Alternatively, a business may choose to take certain interpretive positions with respect to key portions of the 1940 Act to reason their way out of compliance issues. A prima facie investment company might may rely on Section 3(b)(1) of the 1940 Act, which allows the entity to self-determine that it is primarily engaged in a non-investment company business and therefore excluded from the definition of an investment company. There is, however, only a limited amount of applicable guidance available on Section 3(b)(1) and not every issue has been explored fully.
The inherent uncertainty of self-determination can pose some practical barriers to operations and expansion. When accessing capital markets or engaging in other significant corporate transactions such as mergers and acquisitions, businesses are usually required to represent that they are not required to register as an investment company under the 1940 Act. When a business chooses to rely on self-determination, it must also accept that counterparties may not accept its reasoned determination that it is not an investment company.
Lyft and Section 3(b)(2) of the 1940 Act
Section 3(b)(2) allows the SEC to unambiguously declare that an individual applicant is not an investment company, full stop. An applicant interested in that relief provides the SEC with relevant information about its business, activities and assets, and asks that the SEC declare that it is not an investment company. If the SEC agrees, it publicly issues an order finding that the applicant is primarily engaged in a business other than that of an investment company (a “3(b)(2) Order”).
In theory, obtaining a 3(b)(2) Order is an attractive alternative to the approaches discussed above, but in practice it has been rarely used. Despite the clear advantages of having a formal and permanent decision regarding investment company status, applying for a 3(b)(2) Order has been a rarely utilized option in recent years. Before 2011, dozens of 3(b)(2) Orders had been granted, including to household names such as Microsoft and Yahoo!. Since 2011, and until Lyft’s 3(b)(2) Order, the SEC only issued four such Orders. Moreover, several well-known operating companies have applied for a 3(b)(2) Order without success. We believe that trend may be coming to an end.
Lyft successfully applied for and received a 3(b)(2) Order in a very short timeframe. Like many other technology companies with high valuations, the cash-heavy and asset-lite nature of Lyft’s business left uncertainty about whether it should technically be subject to regulation under the 1940 Act, especially if only its GAAP balance sheet is considered. As discussed in Lyft’s application, using only the company’s GAAP balance sheet, Lyft’s bad assets represented 78% of the company’s assets. But under Lyft’s own calculations, which account for intangible assets, bad assets represented just 26.5% of the company’s assets. Lyft argued that the exemptive relief was needed to clarify its 1940 Act status to counterparties, and so that it would not have uncertainty regarding its status after the influx of cash from its IPO.
An application for a 3(b)(2) Order is a public filing that details the reasons the applicant believes it is primarily engaged in a business other than owning or trading in securities. The argument in a 3(b)(2) Order application is primarily driven by the factors outlined in In re Tonopah Mining,[2] the formative case distinguishing operating companies from investment companies for purposes of the 1940 Act. The five-factor Tonopah test looks to:
(i) a company’s historical development;
(ii) its public representations of policy;
(iii) the activity of its officers and directors;
(iv) the nature of its present assets; and
(v) the sources of its present income.
Lyft argued that each of the five Tonopah factors demonstrates that it is an operating company and not an investment company. Notably, in discussing the nature of the company’s assets, Lyft’s application represented that it currently held no bad assets other than Capital Preservation Investments (“CPI”), which are short-term investment-grade and liquid fixed income and money market investments that earn competitive market returns and provide a low level of credit risk. CPI is not a concept unique to Lyft’s application, but Lyft’s circumstances were particularly clean in that all of its bad assets could be characterized as CPI. Even though CPI are bad assets under the objective test, the discretionary nature of 3(b)(2) Orders allows the SEC to make a determination about whether the company’s CPI investments truly should be deemed to make it an investment company.
Overall, the SEC concluded that Lyft is not primarily engaged in an investment company business. Lyft’s application for a 3(b)(2) Order contains certain representations about how Lyft will manage its assets going forward, including that no more than 10% of its total assets will be bad assets other than CPI and that Lyft will refrain from engaging in speculative investing practices. So long as it maintains compliance with those two representations, the SEC has declared that Lyft is not an investment company and will not be in the future.
Lessons From Lyft’s Success
We believe that Lyft’s success will allow others to follow suit. For a long time most of the significant developments with respect to investment company status questions have been delivered through no-action positions and staff commentary on offering documents. A few months before the SEC considered Lyft’s request, however, Chair Clayton reemphasized the SEC’s view that staff commentary and no-action positions are not binding on the Commission and create no legally enforceable rights. If the SEC wants to evaluate and opine on the applicability of the 1940 Act and the rules thereunder more directly, 3(b)(2) Orders are one clear path forward. Increased use of this type of exemptive relief would have substantial benefits in clarifying the scope of regulation and reducing ongoing compliance burden without the need for amending any parts of the 1940 Act or the rules and regulations thereunder.
From the perspective of businesses, 3(b)(2) Orders provide certainty and virtually maintenance-free compliance with the 1940 Act. Unlike alternative approaches to resolving 1940 Act status issues, a 3(b)(2) Order addresses the issue conclusively and would require far less ongoing 1940 Act-specific monitoring and compliance. Unlike the self-determination approach, the board of the company does not need to refresh its internal basis for deciding the company is not an investment company continually.
Lyft’s 3(b)(2) Order was somewhat of an ideal case for quick action, but Lyft is not the only business that is well-situated to receive relief. The SEC should embrace the opportunity to remove unnecessary burdens on businesses seeking to access capital markets by making it an ongoing priority to evaluate applications for 3(b)(2) Orders in all appropriate circumstances.
[1] Under U.S. Generally Accepted Accounting Principles (“GAAP”), intangible assets, such as internally developed intellectual property and goodwill, generally are not treated as “assets” unless obtained through an acquisition, and therefore often do not appear on a company’s financial statements.
[2] S.E.C. 426 (1947).