ABA Section of Business Law

By VICTOR SICLARI

D o you take security in your securities-related legal advice? That’s fine, but to round out your knowledge, be sure you’re up to date on an old law that still has a lot of teeth.

This article provides a road map for lawyers who deal in structured financing arrangements on how they can avoid regulation under the Investment Company Act of 1940 (the 1940 Act). Even though the 1940 Act is one of the lesser-known of the federal securities laws, it regulates the operations of more than $9 trillion in assets of mutual funds, closed-end funds, unit investment trusts, and, in part, variable life insurance separate accounts. Therefore, it plays an important regulatory part in the finance world. And if you are in the business of structured financing arrangements, beware of the 1940 Act because, to the unfamiliar, it can kill a deal.

You may ask, "What is an investment company, and why do I care?" Well, the definition of an investment company is exceedingly broad and would subject most structured financing arrangements to 1940 Act regulation, but for the availability of definitional exceptions or exemptions available by an SEC rule or exemptive order. And, like a drug that can cure the sick, the 1940 Act has a potentially fatal side effect that can kill the unwary when misapplied. Therefore, it is critical that lawyers understand the definitional pitfall of being labeled an investment company and how to avoid it.

Structured finance arrangements fall under the definition of an investment company because they issue securities to the public (typically in the form of bonds or equity interests), and invest in, own, hold or trade securities within the meaning of the 1940 Act (such as open accounts receivable, mortgage notes, mortgage-backed securities, government loans).

To be more precise, the following two definitions capture most structured financing arrangements:

• Any issuer that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in "securities."

• Any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percent of the value of such issuer’s total assets (exclusive of government securities and cash items) on an unconsolidated basis.

As used above, an "issuer" need not be a separate legal entity. It can include a pool of collateral established by a financial institution, such as the issuance of nonrecourse debt secured by securities owned by an entity (such as a bank, thrift or insurance company) otherwise exempt from the 1940 Act. (However, issues of the U.S. government, states and their instrumentalities are exempt under separate exceptions.)

Also, a "security" is applied more broadly under the 1940 Act than under the Securities Act of 1933 or the Securities Exchange Act of 1934. Thus, this term includes virtually all types of financial assets that might be used in a structured financing transaction.

It is worth noting that the first definition contemplates some sort of management or trading of the portfolio in order to trigger the "engaged primarily in the business" requirement. The second definition is specifically designed to cover static pools (which may merely "engage" rather than be "engaged primarily").

Thus, these two definitions capture not only mutual funds, but also many other issuers because of their structure or their balance sheet composition (for example, pass-through or participation pools, and issuers of collateralized mortgage obligations or other asset-backed debt). High-tech, start-up companies who hold or temporarily invest cash they raise in IPOs before putting it to work in their business often run the risk of getting captured in the second, statistical definition. Fortunately, a temporary exemption is available for these so-called transient or inadvertent investment companies.

Because drafters of the 1940 Act could not and did not contemplate today’s types of structured financings, Congress and the SEC authorize exceptions and exemptions under the 1940 Act. These would be for situations or transactions when it is "necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions" of the 1940 Act.

The 1940 Act imposes a myriad of requirements, restrictions and prohibitions that pervade the structure and operation of investment companies. As discussed in some detail below, these regulations affect the organization of the investment company, the composition of its board of directors, the rights of shareholders to vote on certain matters, its capital structure, transactions in portfolio assets, and prohibited transactions with affiliates and other interested persons. Many of these regulations present unresolvable conflicts for structured financing arrangements.

For example, if an investment company is organized under a trust indenture with a depositor or sponsor that provides certain limited portfolio management, then it must issue redeemable securities (which most structured finance arrangements do not) or else fall under the management company subcategory of an investment company.

Most management companies are organized in a corporate or business trust form with a board of directors or trustees. Then, the 1940 Act regulates the shareholder election and composition of investment company directors, such as requiring a minimum percentage of directors to be independent (that is, without affiliation to the adviser, the underwriter, a 5 percent or more voting security owner, any investment banker, and any broker/dealer).

The requirement of a governing board with all its attendant restrictions and duties creates unresolvable structural and operational problems for most structured financing arrangements.

Also problematic are the 1940 Act regulations over the form, terms, approval requirements and automatic termination of investment advisory (management) contracts and principal underwriter contracts. Among other things, a majority of the independent directors must annually approve those contracts together in the flesh in the same room (video conferencing doesn’t cut the mustard). Also, these contracts automatically terminate if there is a 25 percent or more change in ownership of the adviser or underwriter, and shareholders must approve any changes to the advisory fees.

As if that isn’t enough, the 1940 Act imposes a statutory fiduciary duty on the investment company’s directors, officers, investment adviser and principal underwriter with respect to their dealings with the investment company and any compensation the adviser and its affiliates receive for their services.

And don’t even think about what happens if an officer, director, investment adviser or principal underwriter of the investment company or their affiliates are enjoined or convicted of any felony or misdemeanor involving securities. They are automatically disqualified under "bad act" provisions, and can be subject to revocation of their registration, injunctive action, monetary fines and penalties.

Another problem is that the 1940 Act prohibits an investment company from buying, selling or otherwise transferring securities and other property to or from an affiliate, its principal underwriter and affiliates of the underwriter as well as from engaging in joint transactions (enterprises for profit) with its affiliates, its principal underwriter and affiliates of the underwriter. This prohibition is a key example of why 1940 Act regulation would wreak havoc with structured financings. Ultimately, these provisions would prohibit a sponsor from selling assets to the financing trust (the issuer) and substituting assets, both of which are common features in structured financing arrangements.

The 1940 Act also would restrict the ability of financing trusts to create tranches or classes of securities with different cash flow rights and principal/interest priorities because it prohibits the issuance of most forms of senior or preferred security classes. While the 1940 Act is designed to ensure fair and equitable treatment of the investment company’s shareholders, financing arrangements are structured with the specific intent of creating differences in the rights, privileges and dividends of its investors.

These and many other 1940 Act regulations present insurmountable challenges to the nontraditional investment company and make it abundantly clear why regulation as an investment company would be a "deal-killer" for structured financing arrangements.

Fortunately, the 1940 Act and the SEC have established a number of exclusions and exemptions for structured financing arrangements that recognize the public purpose they fulfill and the irreconcilable conflicts that 1940 Act regulation would pose.

Following is a summary of the available exemptions for structured financing arrangements. Until fairly recently, the exemptive relief available was limited, restrictive, required individual written submissions to the SEC, and involved time frames that stretched to years at the worst, and several months in the best of circumstances. This made planning and patience critical factors in the structuring and offering of such arrangements.

Today, however, there are many self-executing exemptions that do not entail the regulatory review and delays associated with individual applications for exemptive orders. But they do require careful consideration and exacting compliance with their conditions.

The Exemptive Rule 3a-7 for Issuers of Asset-Backed Securities was adopted in 1992, and excludes virtually all structured financing arrangements from the definition of an investment company. Like all regulatory gifts, there are criteria that need to be met in order to reap the benefits. In order to obtain the exemption provided by the rule, the issuer must meet the following conditions (the bolded phrases are defined terms in the rule):

• be in the business of acquiring and holding eligible assets (fixed or revolving financial assets that convert into cash in a finite time period),

• must not issue redeemable securities, and

• must issue securities that entitle their holders to receive payments that depend primarily on the cash flow from these eligible assets.

The issuer may issue the following types of securities:

• fixed income securities with an independently assigned investment grade rating;

• nonrated fixed income securities sold only to "accredited investors"; or

• any other type of security sold only to "qualified institutional buyers" (QIBs) or to persons involved in the organization or operation of the issuer or an affiliate of such person.

The rule further provides that the issuer may acquire or dispose of its eligible assets only if:

• the assets are acquired or disposed of in accordance with the terms and conditions set forth in the agreements, indentures or other instruments according to which the issuer’s securities are issued;

• the acquisition or disposition of the assets does not result in a downgrading in the rating of the issuer’s outstanding fixed-income securities; and

• such actions are not made primarily to recognize gains or losses resulting from changes in market value.

Finally, unless the issuer only issues commercial paper, then it must appoint a trustee independent of the issuer or any person involved in the organization or operation of the issuer. This trustee must execute an agreement or instrument that prohibits resignation without a replacement trustee unless all assets are liquidated and proceeds distributed.

This trustee also must take reasonable steps to perfect a security or ownership interest in the eligible assets that principally generate the cash flow to pay the security holders. If there is an issue of rated fixed-income securities, the trustee must periodically deposit the supporting cash flows in a segregated account that it maintains or controls.

While the conditions may seem numerous and onerous, they are an improvement over the previous types of available exemptions. In addition, the SEC established these conditions so as to replicate as closely as possible the customary business practices followed in the asset-backed financing industry.

Prior to Rule 3a-7, most issuers of structured financing arrangements had to live within the confining SEC interpretations of three statutory exceptions to the investment company definition. While still available today, they are not relied on as frequently. Under these statutory exceptions, an issuer must not be engaged in the business of issuing redeemable securities, but be primarily engaged in one or more of the following businesses:

• purchasing or otherwise acquiring notes, drafts, acceptances, open accounts receivable and other obligations representing part or all of the sales price of merchandise, insurance and services;

• making loans to manufacturers, wholesalers and retailers of, and to prospective purchasers of, specified merchandise, insurance and services; and

• purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.

The last clause has been widely relied on by mortgage-backed securities arrangements. The other two exemptions have been heavily relied on by other traditional nonmortgage-related financing arrangements, such as equipment leases, open account receivables, royalty and franchise fees, loans to refinance debt incurred for the purchase of military equipment and construction of airfields, airline credit card receivables, mobile home installment sales contracts as well as advances to finance purchases of cattle, feed and other farm products.

As applied to the last clause, the SEC has interpreted "primarily engaged" to mean that at least 55 percent of the issuer’s assets be in the specified types of assets, and most of the other 45 percent be invested in real estate-related investments (the SEC applies different interpretations of "primarily engaged" with respect to the first two clauses). Also, the SEC has interpreted "engaged in the business" to include passive entities that acquire a specified fixed pool of financial assets and then merely collect the amounts due on such assets. Most, if not all of these distinctions are now academic because of the availability of Rule 3a-7.

The Private Investment Company Exception in Section 3(c)(1) of the 1940 Act was expanded in 1996 and became an even more important exemption available to structured finance issuers. Commonly called the "private investment company exception," it is the 1940 Act equivalent of a 1933 Act private placement exemption. (Coincidentally, it is an exception available to most small investment clubs — whether or not they know it — that pool their cash and invest in securities. Without this exception, these investment clubs would be subject to 1940 Act regulation since they are indistinguishable in concept from the common mutual fund.)

This exception is available to any structured financing arrangement "whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons and which is not making and does not presently propose to make a public offering of its securities."

For purposes of calculating the 100-person limit in the case of a company that owns 10 percent or more of the issuer’s outstanding voting securities, you must look through to and count each of the company’s underlying shareholders (other than those holding the company’s short-term paper). You must do this if the company itself is an investment company, or would be an investment company but for its reliance on Section 3(c)(1) or Section 3(c)(7), which is discussed next. This attribution rule prevents the interposition of a company as a way to get around the 100-person limit.

The Qualified Purchaser Exception in Section 3(c)(7) of the 1940 Act was enacted in 1996 as an alternative exception to the private placement exclusion. It is the 1940 Act equivalent to the 1933 Act sophisticated investor exception. It was designed to expand the Section 3(c)(1) private placement exclusion beyond the 100-holder limit for investment companies that sell their securities solely to "qualified purchasers." A qualified purchaser includes:

• any natural person or family-owned company that owns at least $5 million in investments;

• any trust that was not formed for the specific purpose of acquiring the securities offered, provided that each trustee, settlor and any other person with investment discretion or who has contributed assets to the trust, is a qualified purchaser; and

• any other person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate invests on a discretionary basis, at least $25 million in investments.

Additionally, this qualified purchaser exception is applicable to an issuer that, in addition to offering interests to qualified purchasers, also has outstanding securities that are beneficially owned by not more than 100 persons who are not qualified purchasers, but acquired their securities on or before Sept.1, 1996.

Ultimately, this feature allows a pre-1996 Section 3(c)(1) issuer the ability to convert to a Section 3(c)(7) issuer while leaving intact its relationship with no greater than 100 original investors who are not qualified purchasers. However, the Section 3(c)(1) issuer must first disclose to the original investors its intent to expand its offerings beyond the 100 investors to "qualified purchasers" and allow such original investors the ability to redeem all or part of their investment in the issuer in cash or, if so offered by the issuer and accepted by the investor, in assets of the issuer.

Generally, the exceptions provided by Sections 3(c)(1) and 3(c)(7) afford a variety of private investment vehicles, such as venture capital pools, acquisition entities, structured finance entities, and so-called hedge funds, the operational flexibility to attract capital from institutional and individual investors who have the capability to evaluate and the financial means to assume the inherent risk of their investment. These vehicles add substantial depth and liquidity to domestic and international financial markets, but would be unable to function under the constraints imposed by 1940 Act regulation.

As a final note, the 1940 Act contains a laundry list of other exemptions. For example, while banks, insurance companies, thrifts and similar entities are exempt from 1940 Act regulation, a separate exemption or exclusion must be found if these entities create a separate issuer in a structured finance transaction.

Also, while there is an exemption for any person whose business is confined to making small loans, industrial banking or similar businesses, this exemption has been narrowly construed to cover only those entities actively engaged in the origination of small loans. It is not available to a trust or similar passive entity that acquires loans as part of a structured financing transaction.

In conclusion, because the drafters of the 1940 Act could not have foreseen all the developments that would occur down the road, they had the foresight to allow the 1940 Act to be interpreted and applied in such a way that compromised neither the public interest nor the protection of investors. They imbedded within the act a mechanism and authorization to exempt transactions or arrangements that did not raise the concerns that led to the 1940 Act’s implementation, and would otherwise be unable to bear its imposing regulatory mantle.

Structured financing (and, in particular, asset-backed financing) is a market that continues to rapidly evolve thanks to exceptions and exemptions afforded by the 1940 Act. However, a business lawyer must realize that the 1940 Act is both friend and foe, and bear in mind the importance of structuring these financing arrangements with wariness to the benefits of the exemptions and the consequences of regulation.

Siclari is senior corporate counsel and vice president at Federated Investors Inc. in Pittsburgh. His e-mail is vsiclari@federatedinv.com.

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