Can I set up an investment fund open to the public?

A fund that invests in other businesses will generally be subject to regulation under the Investment Company Act of 1940.  Being regulated as an investment company is extremely onerous and expensive – this is the law that regulates mutual funds.  To avoid this, it is necessary to either qualify for an exemption from the Investment Company Act, or set up a Business Development Company, which enjoys less onerous regulation under the Act.

The definition of an investment company under the ’40 Act is:

any issuer which (A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities; (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or (C) 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 per centum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.[1]

To simplify, an investment company is a company whose primary activity is to invest in other companies or 40 percent of whose total assets consist of investment securities.[2]

The exemptions from the definition of an investment company include (1) a business with no more than 100 investors that does not plan to make a public offering and (2) a charitable organization.

Business Development Company

Business development companies (“BDCs”) are a category of investment funds under the 1940 Investment Company Act that are operated for the purpose of making investments in small and developing businesses and financially troubled businesses.  BDCs are required to make available significant managerial assistance to those portfolio companies.  BDCs are provided greater flexibility under the 1940 Investment Company Act than are other investment companies.

A BDC must register as a public company with the SEC.  This means that it must file annual reports with the SEC on Form 10-K (within 90 days of the end of the fiscal year with audited financial statements), quarterly reports on Form 10-Q (within 45 days of the end of a fiscal quarter with unaudited financial statements), and interim reports on Form 8-K (usually within five business days of a reportable event), all designed to keep the public information about the company and its material activities as current as possible.  ‘34 Act reporting companies are also required to comply with the SEC’s proxy rules for annual meetings.  Ongoing compliance costs incurred by a public reporting company are easily $100-$150,000 per year (preparation of quarterly filings, audit, etc.).

A BDC need not do a national level public offering.  It could do a state level public offering to residents of a single state.  This would not only promote local investment, it would also greatly reduce the cost of the public offering process.  BDCs usually list their securities on a stock exchange, but are not required to do so.

Nonprofit Fund

As noted above, charitable organizations are exempt from the definition of an investment company under the ’40 Act.  That is why so many small business funds are nonprofits.  In addition, in many states there are exemptions from registration requirements for nonprofits.  So, for example, in Massachusetts, a nonprofit can make a public offering of securities without doing a state or federal registration.

There are some limitations on nonprofit funds.  First, they must be operated for a charitable purpose.  This means that loans and investments must be targeted (1) to aid an economically depressed or blighted area; (2) to benefit a disadvantaged group, such as minorities, the unemployed or underemployed; and (3) to aid businesses that have actually experienced difficulty in obtaining conventional financing (a) because of the deteriorated nature of the area in which they were or would be located or (b) because of their minority composition, or to aid businesses that would locate or remain in the economically depressed or blighted area and provide jobs and training to the unemployed or underemployed from such area only if the assistance was available.  The organization must show its specific criteria used in determining whether businesses are eligible for its assistance and how such criteria relate to furthering public rather than private interests.

The other limitation is that nonprofits cannot offer equity investments – they can only offer debt or revenue sharing.

Co-op

Co-ops are not exempt from regulation under the Investment Company Act.  However, they can avoid being regulated under the Investment Company Act by ensuring that no more than 40% of their assets are invested in other businesses.

Cooperative memberships enjoy many state level exemptions from the requirement to do a full securities registration.  So, for example, in Colorado, cooperative memberships are completely exempt from securities registration requirements, making it very easy to do a public offering of co-op memberships.

Holding Company

If a company is the majority owner of other companies, those ownership interests are not counted in determining whether that company falls within the definition of an investment company under the ’40 Act.  That holding company could do a public offering of securities (using a state level qualification) and could invest the proceeds in the subsidiaries.



[1] Section 3(a)(1) of the Investment Company Act.

[2] “[A]ll securities except (A) Government securities, (B) securities issued by employees’ securities companies, and (C) securities issued by majority-owned subsidiaries of the owner which (i) are not investment companies, and (ii) are not relying on the exception from the definition of investment company in paragraph (1) or (7) of subsection (c).”  Section 3(a)(2) of the Investment Company Act.

Jenny

About Jenny

Jenny, CEO of Cutting Edge Capital, has over seventeen years of experience as an attorney for and creator of social enterprises. She has raised funds for and launched a public space cleaning and maintenance business, a landscapers’ cooperative, and a public market. She has extensive experience with direct public offerings, nonprofit-for-profit joint ventures, cooperatives, and creative financing tools. She has a law degree from Yale and a masters in city planning from U.C. Berkeley.

Jenny's full bio can be found at: http://cuttingedgecapital.com/team/jenny-kassan

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4 Responses to Can I set up an investment fund open to the public?

  1. ron patiro August 6, 2012 at 2:23 pm #

    Would you categorize investment clubs here as well? I have only done a little reading on them but it seems you don’t have to file much to get one started other than a partnership. I am curious how many people could be join before it risks SEC scrutiny.

  2. Jenny Kassan August 6, 2012 at 7:42 pm #

    Investment clubs are in a different category because all the members are actively involved in deciding what to invest in. So membership in an investment club is generally not considered a security. Here is a good resource on that topic: http://www.sec.gov/investor/pubs/invclub.htm

  3. ron patiro August 8, 2012 at 11:44 am #

    Thanks, that was helpful.

  4. Erin Ely June 21, 2013 at 12:32 am #

    What about peer to peer lending? Where does that fit in and how can “non” accredited investors participate in peer to peer lending opportunities?

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