Aswe promised, it’s time for a new species of shark. In particular, what happens if your issuer cannot pass the 40% test we discussedlast time? Has your deal turned into chum or are there other answers?
Rule3a-1
Rule3a-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 Ruletakes into consideration thenatureof an issuer’s assets and the sourcesof its income.
An issuer seeking to rely on Rule3a-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 “Rule3a-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 Rule3a-1 Investment Securities.
Unlike the 40% test, though, an issuer may compute these two 45% tests on aconsolidatedbasis with its wholly-owned subsidiaries. This can streamline some of the complexities of the 40% test, particularly for companies with many subsidiaries.
What are Rule3a-1 Investment Securities?
Rule3a-1 Investment Securities are almost identical to investment securities under the 40% test. For example, Rule3a-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, Rule3a-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.SeeHealth Communications Services, Inc. (avail. Apr. 26, 1985); Section2(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 Rule3a-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).SeeDRX, Inc. (avail. Jan. 28, 1988).
Stay tuned for our next installment where we cover some of the relief available for "inadvertent investment companies."
