The Securities and Exchange Commission recently issued an order allowing an unnamed company, under certain conditions, to hold securities in excess of 40% of its total assets without having to register as an investment company.
Under the Investment Company Act of 1940, companies which hold more than 40% of their assets as securities must register with the SEC as an investment company. If they fail to do so, they cannot take on debt or sell stock in their company, and the SEC is even empowered to void their contracts, according to Amy Caiazza, a partner and head of the fintech and financial services group at the Wilson Sonsini Goodrich & Rosati law firm. Treasuries are not counted toward the 40% threshold.
Operating companies are sometimes swept up by this law if they have few tangible assets. Caiazza explains that many tech firms do not have a lot of equipment or inventory, so even relatively small investments can reach the 40% threshold quickly. Additionally, many tech firms hold much of their worth in less tangible assets not counted by the SEC, such as intellectual property rights. Their trouble lies not in having a high numerator of securities, but in having a low denominator of non-securities by which to divide out their securities into a sub-40% total.
Caiazza explains that the 40% threshold was designed in 1940 to distinguish operating companies from investment companies, but the threshold does not make sense for certain tech firms in 2023. Many tech companies will invest in low-return securities, such as corporate bonds, as a cash management and consequently, exceed the 40% threshold and run into trouble with the SEC.
As an alternative to registering or going out of business, companies can apply for a cash management order, which is an exemption from this requirement. In this case, Wilson Sonsini was able to acquire an order from the SEC for a client which permits that company to invest “without limit in ‘capital preservation instruments’ such as invest-grade corporate bonds, commercial paper, certificates of deposit, and other highly liquid, investment-grade securities,” without having to register as an investment company.
The SEC set certain conditions on the exemption. The company must use these cash management instruments to fund its business operations, it cannot engage in speculative investing and no more than 10% of its assets can be in non-exempt securities.
Caiazza is optimistic this order can be used as a model for similar orders, and she says staff at the SEC wrote this order with an eye toward standardization, though Caiazza notes that companies cannot rely on orders and exemptions given to other companies and must secure their own in the absence of a rule.
Caiazza acknowledges that the SEC order reads like a rule proposal and that a rule would certainly make life easier for other tech firms concerned about the 40% threshold.
When asked why the SEC relies on orders of this kind instead of a rule change, Caiazza said, “It probably is time for the SEC to consider adopting a new rule that would apply to tech companies.”