Intrastate and Small Fund Exemptions to the 1940 Act: Now Is the Time

Imagine a typical American community in these very untypical times. COVID-19 has taken a heavy toll. Many small businesses have closed — temporarily, it is hoped. Unprecedented numbers of workers have been laid off or furloughed as businesses conserve cash in the face of sharply declining revenues.

But in time, when the shelter-in-place orders are finally lifted and businesses are free to resume operations, everything quickly gets back to normal, right? No. It’s clearly not going to be that simple. Some businesses may be able to quickly ramp up to pre-COVID-19 levels, but others will need a boost.

But in this community we are imagining, something magical starts to happen. The community pools its resources and invests in its own recovery. A community investment fund is established, and anyone in the community can invest in it, from the wealthiest to anyone with a few hundred dollars. Many people invest the full amount of the stimulus check they receive from the government.

This fund then makes investments in local businesses to help them get back up and running and to help them grow. These are mostly equity investments, because that’s what entrepreneurs often need, and that’s the kind of investment that’s often hardest to get. And these equity investments can help entrepreneurs get more traditional loans, which amplifies the potential boost to their business. The fund also makes revenue-sharing investments, which help to ensure a financial return to the fund, while automatically adjusting for the entrepreneur’s cash flow.

This fund isn’t demanding extractive returns, and it isn’t searching for unicorns. But all of its investments offer upside potential, meaning that when the businesses succeed, the fund succeeds. And that upside is shared with its many local investors, because those investors are equity owners in the fund and share in its profits. That helps build wealth for all those local investors, regardless of their economic status. That means investors are incentivized to patronize the businesses in which the fund invests. It’s a win-win.

Except that it can’t happen, not under our existing laws.

Now to be sure, there are several types of community investment funds that can be formed under existing law. And by “community investment fund” we mean a fund that can take investment from anyone in its community, including both accredited and non-accredited investors. At Cutting Edge, we’ve been writing and speaking about these funds for years because they have the potential to dramatically scale up community capital, while the diversification inherent in community investment funds can reduce the risk to investors, which is particularly important with non-accredited (and often unsophisticated) investors. And I’m honored to be on the board of directors of the National Coalition for Community Capital, which has just published a handbook on community investment funds.

The long and short of it is this: There are laws that allow for the formation of charitable loan funds and real estate funds without being burdened by the heavy compliance obligations of the Investment Company Act of 1940. But a simple equity investment fund such as what I described earlier cannot be done economically at a community scale because it will be subject to all of the same compliance burdens that apply to multi-billion dollar mutual funds.

The first exemption would provide for intrastate funds — that is, funds in which all investors are residents of the same state where the fund is based. This type of fund would have no size limit and would be self-executing, meaning that it would not require the fund to seek permission from the SEC. Such a fund would not need SEC regulation or oversight, because it would be sufficiently regulated at the state level. State securities regulators are in a better position than the SEC to determine whether and to what extent intrastate funds would need to be regulated.

A second new exemption is needed in view of the fact that many communities consist of a metropolitan area that spans two or more states — like Kansas City, Portland, and Washington DC. For those communities, an intrastate fund would not work because it excludes a portion of their community. What those communities need is a small fund exemption, just like the intrastate exemption except that instead of limiting all investors to residents of one state, the fund would be limited by size to $50 million.

We believe these two new exemptions, taken together, would dramatically change the investing landscape in America. Not only would that fund in our hypothetical American city become a reality, but we believe funds like that would, in time, be launched in every community across America. And why not? If given the choice between investing in Wall Street or investing in one’s own community, we can expect that most investors would move at least a significant portion of their investments into their community. All together, we’re talking about moving potentially trillions of dollars out of the financial centers and back to the communities that earned that money and where it can be put to use locally.

We’re not aware that any action has been taken by the SEC in response to our September proposal. But September seems so long ago, after the enormous upheavals brought about by COVID-19. We think the time is now to push for this change in the law. Not only would this put much-needed money in the hands of small businesses everywhere across America, but it would do so without any effort or tax dollars from the federal government and with minimal regulatory oversight at the state level. And this is not a red-versus-blue or conservative-versus-liberal kind of issue. We can all unite together in our support of local communities.

But we’ll have to push for it, because the Investment Company Act is relatively obscure and seldom discussed by policy-makers. Fortunately, the changes we are seeking are not complicated and shouldn’t require more than a single page of text.

There are two ways these changes in the law can come about. The first is through an act of Congress. That sounds daunting, but there has never been a better time than now, when Congress is searching for ways to solve the financial woes of small businesses across the country. We encourage anyone who cares about community capital to reach out to their Senator or Representative about this.

The second approach is to push the SEC, which has the power to create new exemptions on its own, without an act of Congress. We think the SEC may also be amenable to this type change, since the potential benefits are huge, while the burden on the SEC and on taxpayers is negligible, if anything. The challenge is to get this on the radar of the right people at the SEC. Ultimately, we believe the best course of action is to push both Congress and the SEC, and hope that this two-pronged approach will lead to conversations between lawmakers and SEC staff about how to get this done efficiently and effectively.

If we all use whatever connections we have, with regulators or lawmakers, we can make this happen. Now is the time.