This memorandum summarizes a recent no-action letter issued by the SEC staff that took the position that operating companies can exclude investments in registered money market funds from "investment securities" for purposes of applying the 40% Test and the 45% Tests under the 1940 Act.

The 1940 Act sets out a three-pronged definition of investment company. The prong that causes operating companies the most trouble is the 40% Test contained in Section 3(a)(1)(C). Under this section, companies with "investment securities" comprising more than 40% of their "total assets (exclusive of Government securities and cash items)" can fall within the definition of investment company. Under Rule 3a-1, a company that fails the 40% Test will nevertheless be excluded from the definition of investment company if no more than 45% of the value of its "total assets (exclusive of Government securities and cash items)" are derived from "investment securities," and no more than 45% of its net income after taxes is attributable to "investment securities." In applying both the 40% Test and the 45% Tests, Government securities and cash items are excluded from investment securities. The term "cash items" is not defined in the 1940 Act or the rules thereunder, which has led to uncertainty and inconsistency in characterizing certain short-term assets.

Because both "Government securities" and "cash items" are excluded from investment securities under the 40% Test and the 45% Tests, shifting assets into either category can help an operating company avoid being deemed an investment company under the 1940 Act. Currently, many public companies that hold a large amount of funds for short-term business purposes invest their excess funds in Government securities because their returns exceed the yield on deposit accounts and other assets that are clearly cash items. Government securities, however, typically earn a lower return than other liquid investments, and the requesting party in the Willkie Letter argued that there were significant opportunity costs associated with investing in Government securities rather than money market funds. These arguments are similar to those raised in the early 1990s by the biotechnology industry in prevailing upon the SEC staff to apply a modified Tonopah test to research and development companies.

The requesting party also argued that registered money market fund shares, although technically "securities," should be treated as "cash items" rather than "investment securities," because registered money market funds are highly liquid and subject to many risk-limiting conditions, including limitations on portfolio duration, and requirements regarding quality and diversification of portfolio holdings. The SEC staff agreed.

The SEC staff declared that it would not object if a company, in calculating the 40% Test or the 45% Tests, excluded the value of investments in registered money market funds from both "total assets" and "investment securities." The SEC staff noted that this position would give operating companies some additional flexibility in managing their cash holdings, and it clearly gives counsel additional certainty in applying the Tests. The SEC staff warned, however, that a company with a "very high percentage" of its total assets in money market funds could still be deemed to be an investment company under Section 3(a)(1)(A) if its "primary" business consisted of investing, reinvesting or trading in money market funds.

The most direct effect of this letter is that operating companies with significant investment securities (particularly minority interests in other companies) on their balance sheets that have invested primarily in Government securities to comply with the 40% Test or the 45% Tests can now shift those assets, in whole or in part, to money market funds without affecting their status under the 1940 Act. Thus, under this letter, investments in money market funds will be treated the same as deposit accounts or investments in Government securities.

Although this letter gives some additional flexibility to issuers in managing their cash positions, it stopped short of addressing some of the broader issues that could have substantially helped in this area, such as allowing operating companies to include the value of internally generated intellectual property in applying the Tests or modifying the Tonopah standards to focus more on the use of assets rather than their composition. Ultimately, the effect of this letter may be negative in that it may relieve some of the pressure on the SEC to address these broader issues because the opportunity costs of complying with the Tests have been reduced. Overall, the enhanced focus of the SEC staff on these issues suggests that companies that have consciously or unconsciously skirted this issue in the past may wish to revisit their approach.

In sum, Clients and Friends that are seeking to avoid failing the 40% Test or the 45% Tests now have greater flexibility in doing so. Clients and Friends that offer registered money market funds now have an additional market opportunity for their products. If you have any questions or would like additional information regarding the above matters, please do not hesitate to contact us.