Investment Company Condition Considerations for Cash Positioning Following Bank Failures

With this week’s headlines in mind, many emerging companies may be asking themselves: “Why do I keep so much money?”

The Investment Companies Act 1940 (the 1940 Act) may be to blame.

“But I have no intention of being an investment company. Aren’t these mutual funds or hedge funds? I am an active company that produces goods or provides services.

The 1940 Act can apply to all companies, not just those with an investment-related business. The term “investment company” under the 1940 Act has two main meanings:

  1. A company that is or purports to be primarily engaged in the business of investing or trading in securities, which describes many investment funds; or
  2. A company whose total assets (excluding government securities and monetary items) constitute at least 40% “investment securities” (which is more broadly defined under the 1940 Act than “securities” is defined under the Securities Act books from 1933).

In other words, even if it is not considered an investment-related business, a going concern that has 40% or more of its assets invested in stocks, bonds or other securities (even conservative corporate bonds held for preservation purposes of cash ) is an “investment company” and is subject to the registration and other requirements of the 1940 Act unless it qualifies for an exemption under Section 3 of the 1940 Act or another relevant provision or rule under the 1940 Act .Intent is not an element of the second core meaning of “investment company,” and even a company that produces goods and services could inadvertently meet the definition simply by having a balance sheet that includes too high a percentage of “investment securities” relative to its total assets (excluding government securities and cash positions).

Importantly, along with government securities (as defined), federally regulated money market funds and “monetary items” such as cash and bank deposits are usually (but not always) removed from both the numerator of “investment securities” , as well as from the denominator of total assets when calculating the 40% test described above, or similar tests under exceptional provisions. Holding corporate assets in cash, as opposed to “investment securities,” helps the company avoid investment company status if an exemption is not available. Even holding cash can complicate matters, however, because excluding a large cash position from the 40% test can cause a company’s “investment security” holdings to disproportionately influence the results of this calculation.

Many startups find themselves in the position of holding fundraising revenue but with relatively few other compensating assets. Seeking to avoid becoming an unintended investment company, they may choose to hold the proceeds in cash or government securities. Rule 3a-8 excludes certain research and development companies (and certain other start-up companies) from the definition of an investment company if certain conditions are met, but many companies are unable to meet the conditions. This means that start-ups may be at particular risk of instability in the banking system, as they may be limited in their choice of investing their fundraising proceeds.

“What should I do if I’m worried about holding cash but want to avoid an investment company status problem?”

Even if the regulator does not approach a company, many significant transactions require representation or even an outside legal opinion on the company’s status under the 1940 Act. Significant securities holdings could delay the transaction or even require a restructuring of the business. So while it can be tempting to move liquid assets from bank accounts to securities or other assets, in light of recent banking developments, careful planning can help prevent inadvertent jumping from the frying pan into the fire.

Contact a securities attorney familiar with investment company status issues with any questions or inquiries.

© 2023 Perkins Coie LLP

Leave a Comment

Your email address will not be published. Required fields are marked *