One Important Math Question in Securities Law: How to Count Investors


Many attorneys choose law so they can be done with math. Unfortunately, attorneys still need to perform some calculations, especially when practicing securities law. For example, counting investors is a legal and mathematical question of great importance. Its outcome decides whether a company will be exempt from investment company regulations.[1] To put it in another way, counting investors decides whether a company needs to spend an additional six figures or more annually to comply with investment company regulations. Thus, it is paramount for attorneys to count a company’s investors accurately.

The Investment Company Act of 1940 (the 1940 Act) provides a few exemptions, one of which is Section 3(c)(1).[2] Section 3(c)(1) exempts any private issuer whose outstanding securities are beneficially owned by no more than one hundred persons.[3] The 1940 Act defines  “person” as “a natural person or a company,” and “a company” is defined broadly to include “a corporation, a partnership, an association, a joint-stock company, a trust, a fund, or any organized group of persons whether incorporated or not.”[4] This exemption excludes from the 1940 Act private companies for which there are no significant concerns of public interest.[5] Although one hundred was chosen arbitrarily, it has served as a benchmark in deciding whether there is sufficient public interest in a company that warrants federal regulation.[6]

Counting Investors who are Natural Persons

When the security holder is a natural person, the application of the 100-investor test is straightforward with few exceptions. The first exception applies to interest jointly owned by spouses.[7] While the traditional approach is to count each individual separately even if investors are related by blood or marriage, the current approach treats husband and wife who jointly own interest as one single investor.[8] Conversely, if  a husband and a wife each own interest separately, they will be counted as separate investors.[9] Another exception excludes knowledgeable employees who participate in the investment activities from being counted towards the 100-investor limit.[10] Knowledgeable employees include executive officers, directors, trustees, general partners, advisory board members, and other similarly situated individuals.[11] Lastly, to prevent issuers from involuntarily losing its exemption status upon its interest holder’s use of gifts, trusts, and other estate-related transfers, the 1940 Act provides that a donee, estate, or related entity, together with the transferor, will be treated as a single investor.[12] In contrast to the counting of natural person investors, counting “companies” raises a more difficult question.

Counting “Companies”

As an initial proposition, an investing entity is generally counted as one investor.[13] Surely, blindly counting a company as one investor will create a loophole, inviting exploitation by promoters of financial schemes. For example, promoters of financial schemes may create companies with the sole purpose of investing in a section 3(c)(1) company. By placing investors in these companies instead of directly under a section 3(c)(1) company, the section 3(c)(1) company can stay exempted, circumventing investment company regulations, while having hundreds of investors.[14]

To eliminate the loophole, the look-through rule was created to decide whether an investing company’s interest in a section 3(c)(1) company warrants counting interest holders of the investing company towards the 100-investor limit.[15] The current look-through rule, amended in 1996, requires pass-through counting when the investing company (i) is a private investment company, and (ii) owns ten percent or more voting security of the section 3(c)(1) investment company.[16] The term “voting security” is defined as any security “presently entitling the holder thereof to vote for the election of directors thereof.”[17] It is further clarified by The U.S. Securities and Exchange Commission (SEC) that whether an interest constitutes voting security is a question of fact.[18] Ultimately, the test is whether an interest owner has de jure or de facto power to influence an entity’s management.[19] The SEC has consistently presumed that a holder with ten percent interest or more likely has a controlling influence over the management, absent contrary evidence.[20] Thus, under the current rule, the look-through test is most likely triggered once the interest surpasses the benchmark of ten percent.

Integration Doctrine

Through practice, the SEC has developed the integration doctrine, which is a staff-made doctrine that allows the SEC to integrate two or more separate section 3(c)(1) issuers when: (i) they belong to the same company, and (ii) the interest offered is not materially different.[21] Once integrated, the issuers will be treated as one entity for the purpose of applying the 100-investor test.[22] Through a series of no-action letters, the SEC established an analytical framework to decide whether the issuers should be integrated.[23]

The analysis consists of two inquiries: (1) whether the issuers intend to attract distinct groups of investors, (2) whether the investment profiles are sufficiently different.[24] The SEC will first look at the group of investors.[25] The first line of defense is to prove that the funds are intended for distinct group of investors.[26] The SEC has traditionally treated U.S. taxable investors and U.S. tax-exempt investors as two distinct groups. [27] A defense based on other differences among investors is a riskier approach that requires predicting how an SEC staff member will respond.[28]

If the company cannot persuade the SEC, that the issuers intended to attract distinct groups of investors, the SEC  turn to the second inquiry– whether the investment profiles are sufficiently different.[29] The decisions regarding this inquiry have not established a bright line rule.[30]  Companies have attempted to defend themselves on the ground that the funds’ portfolios did not overlap.  In Frontier Capital Management Company, the SEC rejected such defense, and ordered integration for three funds with distinct investment portfolios consisting respectively of, common stocks of the 1000 largest U.S. companies, common stocks of smaller U.S. companies, fixed-income security and common stocks of various companies.[31] According to the SEC, those three funds, despite the different portfolios, shared similar profiles because all three funds attempted to gain long term capital appreciation by investing in primarily common stocks.[32]

The 1940 Act imposes various disclosure and record maintaining requirements on issuers that do not meet the exemption requirements. Compliance with the requirements can be burdensome. Thus, it is important for companies to stay exempt. Unfortunately, the requirements for exemptions have been less than clear. As investment companies continue to rely on the exemptions and as creative investment structures continue to proliferate, the exemptions will likely continue to raise issues.

[1] 15 U.S.C. § 80a-3(c)(1).

[2] Id.

[3] Id.

[4] 15 U.S.C. § 80a-2(a)(8).

[5] See H.R. REP. NO. 1341, 96th Cong., 2d Sess. 35 (1980); S. REP. NO. 958, 96th Cong., 2d Sess. 20 (1980).

[6] The Task Force on Hedge Funds, Report on Section 3(c)(l) of the Investment Company Act of 1940 and Proposals to Create an Exception for Qualified Purchasers, 51. Bus. Law 773 (May, 1996) (citing In re Maritime Corp., Exchange Act Release No. 40-190, at 3 n.2 (Aug. 15, 1941)) (“limitation of 100 stockholders in Section 3(c)(l) obviously is an arbitrary figure.”)

[7] See Investment Co. Act Rel. No. IC-22597, n.69.

[8] Jeffrey B. Cobb & Jason M. Pratt, Section 3(c)(1) and the 100-Investor Test: An Unofficial Counter’s Manuel, The Inv. Law, Vol. 8, Jan. 2001, at 3, 8.

[9] Id.

[10] 15 U.S.C. § 80a-3(c)(5).

[11] See Managed Funds Association, SEC No-Action Letter (Feb. 6, 2014),

[12] 15 U.S.C. § 80a-3(c)(6).

[13] 15 U.S.C. §80a-3(c)(1)(A).

[14] See Cobb & Pratt, supra, at 4.

[15] Id. at 5.

[16] 15 U.S.C. § 80a-3(c)(1)(A).

[17] 15 U.S.C. § 80a-1(a)(42).

[18] See Cobb & Pratt, supra, at 4.

[19] Id.

[20] Id.

[21] See SEC Release No. 33-4552 (Nov. 6, 1992),

[22] Id.

[23] Scott C. Budlong & Jahangier Sharifi, The SEC’s Integration Doctrine: A Potential Trap for a Manager Launching a Second §3(c)(1) Fund (Oct. 2, 2013),

[24] Id.

[25] See, e.g., Pasadena Investment Trust, SEC No-Action Letter (Jan. 22, 1993) (Two funds should not be integrated despite the identical portfolio and return strategy if one intends to attract U.S. investors and another intends to attract non-U.S. investors).

[26] Id.

[27] Id.

[28] See Budlong & Sharifi, supra, at 8.

[29] Id.

[30] Id.

[31] Frontier Capital Management Company, Inc., SEC No-Action Letter (July 13, 1998).

[32] Id.


About Author

Comments are closed.

Fordham Journal of Corporate & Financial Law