Investment Companies

Investment Companies

Professor Bradford

Spring 2003

Exam Answer Outline

The following answer outlines are not intended to be model answers, nor are they intended to include every issue students discussed. They merely attempt to identify the major issues in each question and some of the problems or questions arising under each issue. They should provide a pretty good idea of the kinds of things I was looking for. If you have any questions about the exam or your performance on the exam, feel free to contact me to talk about it.

I graded each question separately. Those grades appear on the front cover of your blue books. To determine your overall average, each question was then weighted in accordance with the time allocated to that question. The following distribution will give you some idea how you did in comparison to the rest of the class:

Question 1: Range 0-9; Average 6.47

Question 2: Range 4-9; Average 7.06

Question 3: Range 3-9; Average 6.24

Question 4: Range 3-9; Average 6.12

Total (of exam, not final grades): Range 4.24-8.57; Average 6.53

Question 1

Section 12(d)

Section 12(d)(1)(B) does not apply. It makes it unlawful for an registered open-end investment company to sell securities to another investment company. Vandal, the seller, is a registered investment company, but it is a closed-end company. Therefore, the sale does not violate section 12(d)(1)(B). [It would, if subsection (B) applied because after the sale, more than 10% of Vandal’s outstanding voting stock (11%) is owned by Felony and other investment companies.]

Section 12(d)(1)(A) does apply. Felony, a registered investment company, is purchasing the securities of another investment company. Subsection (A) says Felony cannot do that if it violates the provisions in (i), (ii), or (iii).

The purchase does not violate subsection (A)(i) because Felony is only purchasing 2.5% of the stock of the acquired company, Vandal, below the 3% limit.

The purchase does violate subsection (A)(ii). The aggregate value of the Vandal securities—the $2.5 million purchase price—is more than 5% of the value of the total assets of Felony, the acquiring company. Felony’s total assets have a value of $30 million; 5% of that is $1.5 million.

The purchase does not violate subsection (A)(iii). These are the only investment company shares Felony, the acquiring company, owns. Their aggregate value, $2.5 million, is not in excess of 10% of the value of Felony’s total assets. Ten percent of $30 million is $3 million.

Section 12(d)(1)(C) applies because Felony, an investment company, is purchasing the securities of a closed-end investment company, Vandal. After the acquisition, felony and other investment companies own more than 10% of Vandal’s outstanding voting stock. However, it’s a violation only if investment companies with the same investment adviser exceed the 10% level. We don’t know if Felony and the other investment companies that own the Vandal stock share the same investment adviser. If not, there is no violation of section 12(d)(1)(C).

Section 17

Felony and Vandal are related closely enough for their transaction to be covered by section 17(a). Biz, as a director of Vandal, is an affiliate of Vandal. Section 2(a)(3)(D). As an officer of Felony, Biz is also an affiliate of Felony. Section 2(a)(3)(D). That makes Vandal and Felony affiliated persons of affiliated persons (second-tier affiliates), each subject to the prohibitions of section 17(a) as to the other, since the other is a registered investment company.

Section 17(a)(2) applies to Felony, since Felony purchased a security from a registered investment company. Felony’s purchase does not violate section 17(a)(2) because the securities purchased were “securities of which the seller is the issuer,” and those are excepted from the prohibition in section 17(a)(2).

Section 17(a)(1) applies to Vandal, since Vandal sold a security to a registered investment company. The subsection (A) exception does not apply because Felony, the buyer, was not the issuer. The subsection (B) exception applies only if, in addition to Vandal being the seller, which it was, this was part of a general offering to the holders of a class of Vandal’s securities. This was a private purchase by Felony, not part of a general offering to Vandal’s existing security holders. Therefore, Vandal has violated section 17(a)(1).

This also appears to be a violation of section 17(e)(1) by Biz. Biz, as an officer of Felony, is an affiliate of Felony. Section 2(a)(3)(D). She was acting as its agent in purchasing the Vandal stock, and it was not in connection with her business as an underwriter or broker. She received compensation for doing so. Her normal wages, which presumably include the usual 1% “bonus,” are excluded from this prohibition. The payment of the extra $500 to her for, according to the note, “work handling the Vandal purchase” is compensation for the transaction, and therefore a violation of section 17(e)(1).

Question 2

Plus is an “Issuer”

To be an “investment company” at any of these times, Plus must be an “issuer.” Section 3(a)(1). Plus clearly is, at all times, an issuer, which section 2(a)(22) defines as every person who issues, proposes to issue, or has outstanding any security it has issued. Plus is a corporation, and stock which it has issued is outstanding and traded on NASDAQ. Stock clearly is a security. Section 2(a)(36); Landreth Timber. Moreover, Plus is a person. “Person” includes a company, section 2(a)(28), and “company” includes a corporation. Section 2(a)(8).

November 1, 2000

At this time, Plus clearly is not an investment company. It is not within section 3(a)(1)(A) because it is not primarily engaged “in the business of investing, reinvesting, or trading in securities.” The manufacture of computer software accounts for 70% of its assets, revenues, and income and clearly is its primary business. It does not appear that Plus trades securities at all; it merely holds the stocks of the computer companies.

Plus is not an investment company under subsection (B), since it has not issued and does not propose to issuer face-amount certificates. Subsection (B) does not apply at any time in this question.

Subsection (C) also does not make Plus an investment company. Given its ownership of the stock of the computer companies, Plus is in the business of owning or holding securities. However, “investment securities” do not account for 40% of the value of its total assets. The computer company stock only accounts for 30% of Plus’s value.

December 1, 2000

At this point, Plus still does not appear to be an investment company under subsection (A). Active trading of securities (the stock trading account) only accounts for 15% of its assets, revenues, and income, so “investing, reinvesting, or trading in securities” is not its primary business. Subsection (A)’s language doesn’t include merely holding securities, as Plus is doing with the CDs and the computer companies.

Subsection (C) does seem to apply here. Plus clearly is in the business of owning, holding, and trading securities. That does not have to be its primary business under subsection (C). Moreover, “investment securities” have a value exceeding 40% of the value of Plus’s total assets (excluding government securities). The SEC takes the position that CDs are securities for purposes of the Investment Company Act, Merrill Lynch, even though they are not for purposes of other securities laws. Marine Bank. Those CDs, plus the stocks Plus owns, account for 80% of the value of Plus’s assets. The CDs are government securities, since they are insured by the U.S. government. See section 2(a)(16). Therefore, they are not “investment securities.” Section 3(a)(2). None of the stocks Plus owns are majority-owned subs, so they are not excluded. Therefore, investment securities still constitute 42% of Plus’s total assets, and an even greater percentage of its total assets excluding government securities (42/62 = 70%).

Section 3(b)(1) does not help Plus. It has no wholly-owned subs, and its direct operations, although not securities-related, only account for 20% of its assets, revenues, and income. Section 3(b)(2) also is not helpful, as Plus has no majority-owned subs or controlled companies. Plus is presumed not to control a company if it owns less than 25% of the voting stock, and it doesn’t own more than 10% of any of the computer companies.

Neither section 3(c)(1) nor section 3(c)(7) will help Plus. Its stock is publicly traded on NASDAQ, so it must have more than 100 beneficial owners. And it is highly unlikely that these public owners are all qualified investors as required by section 3(c)(7).

Plus appears to be an investment company. However, Plus may fall within Rule 3a-2. It provides that Plus is not an investment company for up to one year if it has a bona fide intent to be engaged in some other business as soon as possible. Plus might argue that its securities investments are merely a temporary disposition of its antitrust judgment money and that its long-term goal is to be a non-securities operating company. However, to use Rule 3a-2, there must be a board resolution to this effect. Rule 3a-2(a)(2). Even absent such a resolution, Plus might still win if it can convince a court it is in a transitional stage and has not yet made investing or holding securities its primary business. See Fifth Avenue Coach Lines.

August 1, 2002

Plus is clearly now an investment company, for the reasons discussed above. Rule 3a-2 no longer applies because it only protects Plus “during a period of time not to exceed one year.” After 18 months, Plus’s argument that it is still in transition is unlikely to succeed.

May 1, 2003

Plus still does not fall within subsection (A) of section 3(a)(1). It holds securities, but does not trade them. It does, however, fall within subsection (C). It is in the business of owning and holding securities—the Flyways, Honk, and Food stocks. And “investment securities” are more than 40% of the value of its total assets. The Flyways stock is not “investment securities” because Flyways is a majority-owned sub of Plus. Section 3(a)(2)(C). But the stock of the other two companies constitutes 60% of the value of Plus’s total assets.

Section 3(b)(1) does not help Plus. Plus has no wholly-owned subs. Section 2(a)(43) requires 95% ownership, and Plus owns only 60% of Flyways. Plus’s direct operations account for only 20% of its assets, revenues, and income, clearly not enough to establish a primary business unrelated to securities investments.

Section 3(b)(2) might be helpful. Flyways is a majority-owned sub since Plus owns 60% of its voting stock. Section 2(a)(24). Honk is a controlled company, since Plus owns 40% of its voting stock. Ownership of more than 25% of a company’s voting securities presumptively establishes control, absent an SEC order to the contrary. Section 2(a)(9). Food is not a controlled company, since Plus only owns 20% of its stock. Section 2(a)(9).

Directly, through a majority-owned sub, and the only controlled company, Plus is engaged in a primary business other than “investing, reinvesting, owning, holding, or trading in securities.” Section 3(b)(2). Computer software, an airline, and trucking clearly are not securities-related businesses. Thus, Plus would not be an investment company if it obtains an SEC order pursuant to section 3(b)(2). But note that section 3(b)(2) is not self-enforcing. Absent the order, Plus is an investment company.

Question 3

The definition of “investment adviser” is in section 202(a)(11) of the Investment Advisers Act. To be an investment adviser, Prof must be engaged in one of two activities: (1) “advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities,” or (2) “issu[ing] or promulgat[ing] analyses or reports concerning securities.” In addition, under either prong of the definition, this must be part of a “business” or “regular business” and she must be doing it “for compensation.”

Prof is clearly offering her seminars for compensation. She receives $100 per person. She may not profit from the seminars, but section 202(a)911) does not require that she profit, merely that she receive compensation.

Prof also appears to meet the “business” requirement. Her primary job is being a college professor, but investment advice does not have to be her principal business activity, or meet any percentage test, to meet the “business” requirement. Investment Adviser Act Release No. 1092. It is enough if she gives advice with “some regularity. Id. This is not a one-time action on Prof’s part; her seminars appear to occur with at least some regularity. The SEC has indicated that she is in the business of advising if, among other possibilities, she receives any separate compensation for providing advice about securities or if she provides specific investment advice. Id. Specific investment advice, for purposes of this requirement, would include recommendations about specific categories of securities, as in the example concerning the person in his fifties.

The advice requirement is met if Prof advises clients concerning the advantages and disadvantages of securities generally, as opposed to other investments. Id. Prof doesn’t have to be recommending specific securities. Prof appears to meet this requirement as well.

For the foregoing reasons, Prof appears to fall within the general section 202(a)(11) definition. But she might fall within one of the exceptions to the definition.

Prof does not qualify for the section 202(a)(11)(D) exception because she isn’t really publishing anything except her course materials and, even if they’re excepted, the same advice occurs in the oral component of her seminar, which clearly is not a publication.