Operating Holding Companies and Transient Investment Company Status Clarified
On March 20, the SEC Division of Investment Management issued IM Guidance (No. 2017-3) in response to inquiries regarding operating holding companies that are engaged in various operating businesses through wholly-owned or majority-owned subsidiaries (“Holding Company”) to avoid Investment Company Act of 1940, as amended (the “1940 Act”) registration.
Holding Companies that experience “extraordinary events” in their organizational life such as business model transition or start up financing issues may be found to be an inadvertent “investment company.” Further, a company that holds interests in other operating companies (subsidiaries) that it may or may not control, or an operating company that temporarily holds investment securities or cash constituting a large percentage of its assets may find itself to be an inadvertent “investment company”.
The definition of “investment company” under the 1940 Act is very broad and covers companies whose assets consist largely of “investment securities,” which itself is a broadly defined term in the 1940 Act. The implications of being found an investment company includes registration as such under the 1940 Act, with substantive disclosure documentation and reporting obligations, having an independent board, certain investment restrictions be met, SEC enforcement action or private litigation, among other things.
There are two main exemptions from 1940 Act regulation typically relevant for operating companies:
- the Rule 3a-1 exemption for “prima facie investment companies”; and
- the Rule 3a-2 “transient investment company” exemption, which provides temporary relief.
Section 3(a)(1)(C) of the 1940 Act regulates any company as an investment company whose assets meet the following objective “prima facie” test:
Investment Securities
Total Assets minus Cash and
US Government Securities is greater than 40% (“40% Threshold”).
The Guidance addresses and clarifies the application of Rule 3a-2 with respect to Holding Companies.
The purpose of Rule 3a-2 is to provide temporary relief from 1940 Act registration and other requirements to a company that, on a transient basis, could be deemed to be an investment company because of an unusual business occurrence (i.e. in situations where the 1940 Act was not intended to apply). Rule 3a-2 provides a safe harbor for such transient investment companies if certain conditions are satisfied. The transient investment company exemption may be relied upon for a one year period if the Holding Company can demonstrate a bona fide intent to be, as soon as is reasonably possible, engaged primarily in a business other than an investment company.
While the SEC has addressed Rule 3a-2 factors Rule 3a-2 factors in case law1 and no-action positions2 previously, the determination as to whether an issuer has the requisite non-investment intent to fit within the transient investment company exemption is based on the particular facts and circumstances. In determining whether a company is “primarily engaged” in a non-investment company business under Section 3(b)(2), the SEC considers: (a) the company’s historical development, (b) its public representations of policy, (c) the activities of its officers and directors, (d) the nature of its present assets, and (e) the sources of its present income.
One-Year Safe Harbor Period
The Rule 3a-2 one-year period begins on the earlier of:
- 40% Threshold or
- the date on which the issuer owns securities and/or cash having a value exceeding 50 per cent of the value of the issuer’s total assets on either a consolidated or unconsolidated basis (“50% Threshold”).
This guidance clarifies that the one year safe harbor period does not begin until the occurrence of an extraordinary event causes a Holding Company to have certain characteristics of an investment company.
The occurrence of an extraordinary event may temporarily alter the composition of the Holding Company’s total assets such that securities other than the equity securities of its majority- or wholly-owned subsidiaries (“Subsidiaries”) now comprise a significant portion of the Holding Company’s total assets.
As discussed above, Rule 3a-2 provides that a company may rely upon the Rule for one year from the earlier of the date it triggered either the 50% Threshold or the 40% Threshold. The 50% Threshold may be problematic for a Holding Company because the threshold is based on the cash and securities it holds which includes the security holdings of any Subsidiaries, not simply its investment securities.
The SEC Staff believes that a Holding Company may not have the characteristics of an investment company until it fails the 40% Threshold. Accordingly, the Staff believes that, generally, Rule 3a-2’s one-year safe harbor should not begin until the occurrence of an “extraordinary event” and thus when the Holding Company may seek to rely on the Rule. Finally, a company can make use of this Rule 3a-2 exemption only once in any three year period so any future transactions by the company should bear this in mind to avoid registration under the 1940 Act at a later date.
In this regard, the Staff believes that the one-year period for transient investment companies should be available to issuers that have a bona fide intent to be engaged primarily in a non-investment company business (i.e. not engaged in the business of “investing, reinvesting, owning, holding or trading” in securities”), regardless of whether they operate directly or through a holding company structure. This result should further the SEC’s mandate to facilitate capital formation as well as not limit Holding Companies from relying on Rule 3a-2 due to their organizational structure.
Endnotes:
- SEC v. National Presto Industries, 486 F.3d 305 (7th Cir. 2007) and In re Tonopah Mining Co., 26 S.E.C. 426 (1947).
- ACS Wireless, Inc. No Action Letter IC-30602 (July 19, 2013) and Rio Tinto plc No Action Letter IC-29921 (January 17, 2012).
Upcoming ComplianceCast Focuses on Recent SEC Custody Guidance
Ascendant’s ComplianceCast series returns on Friday, March 24 with a hot topic: recent SEC guidance on custody.
Last month, the Division of Investment Management issued a Guidance Update related to inadvertent custody of client funds or securities. The SEC also issued a long-awaited no-action letter that offered deeper clarity on the rule. ComplianceCast goes in depth on the topic, discussing all of the following:
The Impact on Thousands of Advisory Firms
Ways an Adviser May Inadvertently Have Custody
Practical Implications
Next Steps
More Surprise Examinations: Client Communications and Agreements
This ComplianceCast will address the complex topic, tackling practical implications of what circumstances now will constitute custody. New coverage of the following:
- SLOAs (authority to transfer client money to a third party)
- First Person Transfers (authority to transfer money to the same client)
- Custodial Agreement Provisions with Advisory Clients (which impute advisers with custody)
- Avoid Inadvertent Custody with Written Consent
Analyzing Recent SEC Guidance:
- Investment Adviser Association No-Action Letter, February 21, 2017
- IM Guidance Update February 2017, “Inadvertent Custody: Advisory Contract versus Custodial Contract Authority.”
- FAQs, prior no-action letters
Next steps: Good-faith effort and timing; adapting policies and procedures, written consent and IMAs.
Bonus coverage of more industry questions.
The panelists for the webinar will be: Christopher Gilkerson, SVP & General Counsel, Charles Schwab & Co.; Laura L. Grossman, Assistant General Counsel, Investment Adviser Association; Robert E. Plaze, Partner, Stroock & Stroock & Lavan LLP; and Jacqueline Hallihan, Partner, Ascendant Compliance Management
To register for this ComplianceCast, click here and fill out the registration form.
ComplianceCast Goes In-Depth on BCP & Transition Planning
Business continuity planning (BCP) and transition planning derive from an adviser’s fiduciary duty the SEC’s desire to push back against banking regulators who want to impose prudential regulations on asset management firms, but the devil is in the details.
Ascendant’s recent ComplianceCast “Planning for the Worst: Business Continuity and Transition Planning,” goes in-depth on the SEC-proposed BCP/transition planning Rule 206(4)-4, including concerns about it from the industry, the impact of the new presidential administration, and likely next steps.
With implications for both compliance and operations, the rule is intended to ensure that your firm’s services to its clients continue when you’re faced with a business disruption. This ComplianceCast covers:
- Breaking down the proposed rule requirements
- Dealing with natural disasters, cyber-attacks, IT failures, and the loss of key personnel
- Transition planning for small firms and large firms
- Managing critical vendors and the risks they pose to your firm
- Why the SEC can bring enforcement actions even before the rule is adopted
To download the ComplianceCast, please click here and fill out the download request form.
Acting SEC Chair Signals Interest in Revising Accredited Investor Threshold
In remarks by Acting SEC Chair Michael S. Piwowar, he signals his interest in revising the accredited investor threshold in an effort to level access to higher risk, higher return investments.
At the February 24 “SEC Speaks Conference 2017,” Piwowar’s theme focused on “The Forgotten Investor.” He stated there is a glaring need to move beyond the artificial distinction between “accredited” and “non-accredited” investors, questioning whether non-accredited investors are truly protected by regulations that prevent them from investing in high-risk, high-return securities available to others.
An accredited investor must earn $200,000 or more in annual income or have a net worth of more than $1 million, exclusive of their personal residence. He points out the current threshold prohibits non-accredited investors from investing in high-risk securities which amounts to a blanket prohibition on their earning the very highest expected returns.
Previously, in Remarks at the Meeting of the SEC Advisory Committee on Small and Emerging Companies, he stated, “Remarkably, if you think about it, by allowing only high-income and high-net-worth individuals to reap the risk and return benefits from investing in certain securities, the government may actually exacerbate wealth inequality and hinder job creation and economic growth.”
NIST Proposes Update to Cybersecurity Framework to Address Service Provider Oversight
Many investment advisers and broker-dealers have embraced the NIST Cybersecurity Framework since it was first released in 2014, using it to formalize the mapping of risks and controls as part of a comprehensive cybersecurity program. Alas, cybersecurity risks continue to grow, and so too must the response to those risks keep pace. What has become clear from the SEC’s cybersecurity enforcement actions to date is that vendors and service providers to advisers and broker-dealers have access to a wealth of information and data about a firm and its clients, and that a breach or security incident involving the service provider can have privacy impacts for the IA or BD.
- Adding a new section on cybersecurity measurement to help define consistent terminology for aligning business actions, results, cybersecurity expenditures, and cybersecurity metrics
- Updating the Framework Core by adding a new category within the Identify function for Supply Chain Risk Management (ID.SC), which is essentially a focus on the policies, procedures, and controls to manage the risks posed by a firm’s third party vendors and service providers. The new category will include, among other things, an assessment of whether vendors are appropriately identified, prioritized, required to adhere to certain contractual obligations for information security, monitored for compliance with such terms, and included within the scope of business continuity testing.
- Enhancing the Protect -> Access Control category (PR.AC) to include authentication, authorization, and identity verification, and renaming the category as “Identity Management and Access Control” to reflect that access is closely tied to an understanding of the identity of the party requesting access
- Adding explanatory text throughout the Framework to describe how Implementation Tiers can be used in conjunction with the Current Profile and Target Profile. A tier is a way to benchmark the strength of a firm’s cybersecurity program, with higher tiers reflecting a more comprehensive and proactive program. The tiers are: Tier 1 (Partial), Tier 2 (Risk Informed), Tier 3 (Repeatable), and Tier 4 (Adaptive).
A redlined version of the NIST Cybersecurity Framework as updated by the proposed draft is available here.
Compliance Points for Insider Trading, MNPI
The news headlines continue to be filled with insider trading scandals. Insider trading is based on a simple, well-established principle: if you receive material, nonpublic information about a public company from any source, you are prohibited from discussing or acting on that information.
Under the Advisers Act, the SEC may sue any person (or any person who controls or supervises such person) who trades while in possession of “material, nonpublic information” or who communicates or “tips” such information. Trading the securities of any company while in possession of material, nonpublic information about that company is generally prohibited by the securities laws of the United States and firm policy. Under insider trading laws, a person or company that illegally trades in securities of a company while in possession of material, nonpublic information about that company may be subject to severe sanctions, including civil penalties, fines and imprisonment.
Please refer to your Code of Ethics and Compliance Policies and Procedures Manual, along with the SEC for additional information on who is an insider and what is considered material, nonpublic information.
Here are some ways to identify sources of insider information:
- Employees must report all business, financial or personal relationships that may result in access to material, nonpublic information;
- The CCO should review all reportable personal investment activity for Supervised Persons and related accounts;
- The CCO should periodically review firm trading activity (e.g., trade blotter review); and
- The CCO should prepare a written report to management and/or legal counsel, as necessary, of any possible violation of the firm’s Insider Trading Policy for the purpose of implementing corrective and/or disciplinary action.
During routine e-mail surveillance, review communications to identify any wrongdoing or sharing of non-public information. In addition, conduct a review of the Firm’s trade blotter and document any anomalies in clients’ trading.
SEC enforcement actions demonstrate that persons with no intention of receiving MNPI may have relationships with the potential to lead to the sharing of MNPI, and that some persons attempt to take advantage of the information. A cursory search of “insider trading” results will include recent cases in which accountants, investor relations personnel, auditors, and investment representatives have shared MNPI.
Insider Trading Compliance Points:
- Your Code of Ethics may require reporting of Supervised Persons’ positions on the board of directors of a public company or other governing board of a public company. Such service with a public company could subject a person to inside information and therefore restrict such employee’s ability to trade such security or securities.
- The compliance reporting requirement and compliance reviews of personal securities transactions are, in part, designed to detect personal trading based on inside information.
- The portfolio holdings of client accounts and trading activity within such accounts are considered inside information by the Firm.
- Supervised Persons should be aware that inside information about public companies may be acquired from a broad range of sources, potentially including clients, accounting-firm clients or brokers with which the firm conducts securities activities. Supervised persons should be cognizant that it should not act on any third-party information that it believes may be inside information regardless of the source of such information.
Compliance Training Tip: Now is a great time to provide employees with additional training on what constitutes insider trading and the potential repercussions of acting on such information. Even an email communication to employees highlighting this section of the Code of Ethics can bring awareness of the topic to the forefront. We have also provided a link to download a ComplianceCast presentation on the topic of insider trading that you might find helpful.