Investment Company

Overview

Understanding whether or not your entity is considered an investment company or not is critical, as there are generally wide regulatory requirements of investment companies.  Hedge funds which primarily engage in investing in securities are considered to be investment companies under the Investment Company Act of 1940 (the “Act“), and as such, should understand what makes them an investment company and what the implications are.

What are the exact thresholds to be an investment company?

Under Section 3(a)(1)(C) (not to be confused with Section 3(c)(1), discussed below), there are three ways to be classified as an investment company, with two of the ways making it overwhelmingly likely for a securities hedge fund to be defined as such:

1. The issuer holds itself out as being engaged primarily in, or intends to engage primarily in, the business of investing or trading in securities; or
2. The issuer, regardless of its self-described purpose, holds or trades in securities having a value exceeding 40% of the total value of the entity’s assets, not including any cash (i.e. if a company has $100 and invests $39, but leaves the rest in cash, that does not let them stay under the 40% threshold).

Notably, however, non-securities activity such as non-security digital assets or assets that broadly fall under the purview of the CFTC/NFA – commodities, futures, forwards, swaps, forex, etc – are not counted towards these qualification criteria, although other regulatory acts and regulators may still apply.  As such, a commodities only fund or a digital asset only fund (assuming no digital assets defined as securities) is not subject to the Act.

An entity that invests without being an investment company?

A misconception, albeit uncommon, is that it is possible to form an entity whose primary purpose is to invest in securities, but for that entity to not be an investment company; typically, the idea is that instead of forming a typical fund structure (LLC/LP or similar), a different entity type can be used (C-Corp, etc) and therefore there is no investment company or hedge fund!  Not so fast: the legal structure and formation of an entity has generally little impact – it is the activity and purpose of the entity that defines its characterization.

Okay, so I have an investment company. Now what?

The investment company falls under the SEC’s regulatory framework vis a vis the Investment Company Act.  There are two very different paths that a company must take:

1. Registration.  Unless an investment company can claim an exemption from registration under the Act (see below), it must register with securities regulators and is subject to a robust regime relating to ongoing reporting, disclosures, compliance, and registration.  Examples of registered investment companies include exchange traded funds (“ETFs“), mutual funds, roboadvisers, most general investment advisory businesses, etc.
2. Qualify for Exemption.  Certain qualifying investment companies, such as hedge funds, may be able to claim exemption from registration under the Act if their purpose and scope is limited in certain ways.  Generally, hedge funds seek to be exempt.  For more information, read our articles on the Act and its two most common exemption frameworks, Section 3(c)(1) and Section 3(c)(7).

Wrap up

Hedge funds that trade securities are extremely likely to fall under the Act, and generally must fit into one of the Act’s provided exemption frameworks.  Failure to comply with the Act can subject an entity to serious adverse regulatory actions from regulators.