An analysis of the Section 3(a)(10) exemption under the Securities Act of 1933 in the context of the public offering component of Section 3(c)(1) of the Investment Company Act of 1940

Fordham Journal of Corporate & Financial Law, 2003 by Holzapfel, Marc F

INTRODUCTION

The stock market boom of the 1990s fueled growth not only for mergers and acquisitions, but also for investments by venture capital companies around the world.1 Cross-border work has now "become the norm, rather than the exception."2 When different jurisdictions are involved, however, compliance with each country's securities and other disclosure related laws can be challenging.3 As more U.S. shareholders invest in foreign companies, and as more foreign companies seek to raise capital in the U.S., potential conflicts arise between foreign and domestic securities laws and within the U.S. securities laws themselves. While each of the six principal U.S. securities statutes administered by the U.S. Securities and Exchange Commission ("SEC") attempts to address a specific area of securities regulation,4 these statutes can, in certain instances, overlap.5

This Article will focus on the relationship between section 3(c)(1) of the Investment Company Act of 1940 (the "1940 Act")6 and section 3(a)(10) of the Securities Act of 1933, as amended (the "1933 Act").7 Specifically, this Article examines whether or not shares issued in reliance on the section 3(a)(10) exemption of the 1933 Act ("section 3(a)(10)") can be considered a "public offering" for purposes of section 7(d) and 3(c)(1) of the 1940 Act ("section 3(c)(1)"). The rapid growth of hedge funds and venture capital companies, coupled with the increase in international investment, has made resolution of this uncertainty a necessity. This Article is meant to provide some background and guidance to the practitioner who encounters this issue.

Parts I and II will provide brief descriptions of the relevant provisions of both the 1933 Act and the 1940 Act. Part III will discuss the relationship between the two Acts, and Part IV will analyze this relationship. Part V will conclude with a discussion of the implications of section 3(c)(1) companies being able to-or not being able to-rely on the section 3(a)(10) exemption.

I. 1940 ACT

The focus of the 1940 Act8 is on "pooled investment vehicles, such as mutual funds, closed-end funds, and unit investment trusts."9 In the 1920s, the SEC found such investment vehicles especially prone to "manipulation and self-dealing."10 As a result, Congress enacted the 1940 Act,11 which provides, in part, that:

No investment company organized or otherwise created under the laws of the United States or of a State and having a board of directors, unless registered under section 8, shall directly or indirectly-(1) offer for sale, sell, or deliver after sale, by the use of the mails or any means or instrumentality of interstate commerce, any security....12

Once registered, an investment company is substantially restricted in its activities.13 Although the term "investment company" is broadly defined in the 1940 Act,14 Congress specifically exempted certain entities from regulation.15 One common exception is found in section 3(c)(1),16 which excepts an issuer "whose securities (excluding short-term paper) are beneficially owned by not more than one hundred persons . . . [so long as] it is not making or proposing to make a public offering."17 Various entities rely on this exception, including trust funds,18 leveraged buyout funds,19 venture capital funds,20 acquisition vehicles, and hedge funds.21

A. Prong 1: Number of Persons

Section 3(c)(1) has essentially two requirements:22 an issuer cannot have "over 100 beneficial owners"23 and it cannot be "making or proposing to make a public offering of [its] securities."24 Although counting the number of beneficial owners to satisfy the first prong seems relatively simple, since the inquiry relates to "beneficial owners" and not just to stockholders, such an approach is complex.25 While neither "the 1940 Act nor the rules [promulgated] pursuant to it define 'beneficial ownership,'"26 no-action letters have generally interpreted beneficial ownership broadly27 in order to "prevent investment company sponsors from forming a public company that itself invests its assets in a private investment vehicle."28 Thus, if a company holds "[ten] percent or more of the outstanding voting securities of a section 3(c)(1) entity, and in addition, has more than ten percent of its assets invested in section 3(c)(1) entities, all of the shareholders of that company will be considered beneficial owners of the entity."29

Focusing on the "public offering" prong of section 3(c)(1), if the number of beneficial owners is fewer than 100, then the next step in the section 3(c)(1) inquiry requires an analysis of the "public offering" component.30

B. Prong 2: A "Public Offering"

Scant legal precedent guides issuers in determining what constitutes a public offering under section 3(c)(1).31 The SEC does not "as a matter of policy, issue a no-action or interpretive letter on the question of whether [an] offering is nonpublic. [Rather], it is the issuer's responsibility to determine whether the offering is nonpublic."32 The SEC has, however, "taken the position that, for purposes of section 3(c)(1) of the 1940 Act, an offering is nonpublic if it complies with section 4(2) of, or Rule 506 under, the Securities Act of 1933."33