Determining the Optimal Legal Structure for Your Fund
Determining the Optimal Legal Structure for Your Fund
The following is an excerpt from “Community Investment Funds: A How-To Guide for Building Local Wealth, Equity, and Justice,” a joint project of the National Coalition for Community Capital and Solidago Foundation. The handbook can be downloaded in its entirety here.
Many different kinds of funds are possible under the Investment Company Act of 1940, and this section aims to provide a brief overview. A more thorough description can be found in “Community Investment Funds: A How-To Guide for Building Local Wealth, Equity, and Justice.”
Nearly 100 years of legislation and regulations determine what is and isn’t possible, as well as the likely costs and difficulties of setting up and operating a fund. While state laws matter, the field’s framework is largely set by the federal Investment Company Act of 1940 (the 1940 Act). The costs of setting up and meeting ongoing compliance burdens for funds, such as mutual funds, can be extremely high. The key to structuring a fund that can be economically operated at a community scale is to find an exemption in the 1940 Act so that it will not be subject to its heavy compliance burden. The good news is that a number of exemptions are available for communities — at least 15, in fact!
We’ll describe a few of the most commonly used models or “compliance strategies” here. A more comprehensive description of all 15 compliance strategies, along with examples (if they exist), can be found in the community investment fund handbook (CIF handbook) referenced above.
The compliance strategies described here fall into one of two categories: nonprofit funds and funds not primarily in the securities business. All of the strategies below raise community capital through some kind of public offering, which means the offering can be publicized and non-wealthy investors can participate. In addition to complying with the 1940 Act, most of the strategies below involve issuing securities to investors, which means the fund also must comply with the Securities Act of 1933. In most cases, a community investment fund will do this through a direct public offering registered with state securities regulators (or through an exempt offering for charitable funds in many states). In some cases, this could be done through a crowdfunding offering (Regulation Crowdfunind of the JOBS Act) or Regulation A.
A detailed description of these offering strategies is beyond the scope of this website, so you’ll want to discuss them with an attorney before creating a fund. Right now, as you read about the available legal options, just think about which model fits most closely with your community’s needs.
Let’s begin with the two types of charitable funds:
Charitable Loan Fund
A fund that is itself a charitable organization, where the fund is used to carry out the charity’s mission, is exempt under the 1940 Act (see 1940 Act, Section 3(c)(10)(A)(i)). Because compliance is relatively simple, this is the most common type of community investment fund: By virtue of being a charity, it is automatically exempt not only from the 1940 Act but also from registration under the Securities Act of 1933. It is also exempt from registration under the securities laws of most (although not all) states. Some states allow a charitable loan fund to be launched on a public basis with no filings with any securities regulator, while others require a simple notice filing.
But a charitable loan fund has two key limitations: First, its outgoing investments must have a charitable purpose. A fund that is serving a predominantly disadvantaged population will probably meet this requirement easily, though the purpose must be more than just sustaining the charity. The second limitation is that investors in a charitable loan fund can only make loans to the fund, and there can be no sharing of profits with investors. Charitable loan funds typically issue investment notes with a fixed interest rate. Adding a revenue or profit share component to the notes would generally be inappropriate.
Real life examples:
Charitable Equity Fund
A lesser known variation is a fund managed by a charity that uses all the income from the investments as part of its charitable resources (see 1940 Act, Section 3(c)(10)(B)). In this case, the fund can make investments that don’t necessarily have a charitable purpose. An example of a fund that fits this model is the Pooled Income Fund (PIF).This structure has long been used as a planned giving vehicle. Contributors transfer assets to the fund, which is a trust administered by a public charity. Each contributor (or the life beneficiaries designated by the contributor) receives income for their life based on the fund’s performance. Upon the death of a life beneficiary, his or her assets are then distributed out of the trust to the charity.
The PIF is a promising vehicle for community investment because it allows anyone to participate, can invest in virtually any kind of asset, and distributes profits (but not capital gains) to its lifetime beneficiaries. The fund could take minority equity positions in local businesses, for example. While it does not allow investors to get their money back, it allows donors to do more with their money than just make a donation. It offers a tax deduction at the time of investment (measured by the actuarial value of the remainder interest that will eventually go to the charity). It also allows investors to avoid capital gains tax on the transfer of appreciated assets (but not land) into the fund. PIFs have the further advantage that their offerings are exempt from registration under federal and state securities laws, which makes them relatively easy to deploy.
Many PIFs have been established by universities, community foundations, and other charities, although they have seldom been deployed for local community investment.
Funds Not Primarily in the Securities Business
The 1940 Act was designed to regulate companies that raise capital from investors and are in the business of investing in securities. The law, however, carves out several categories of funds that are exempt because they’re not primarily in the business of investing.
If a company is primarily in a business other than investing in securities, it will be exempt from the 1940 Act (see 1940 Act, Section 3(b)(1)). For example, if a consulting firm wants to invest in its clients, it can raise community capital to fund both the primary consulting business and the supplemental investment fund. This would work in any number of primary business models, including a business incubator, a co-working space, or a food co-op.
The courts have established a 5-prong test to determine whether a company relying on this strategy really is in a primary business other than investing:
- Company history: A company with a history as an operating company in some primary business other than investing is less likely to be deemed an investment company subject to the 1940 Act.
- How it represents itself to the public: If investors are more likely to invest in the company because of the investment portfolio, investing is more likely to be considered its primary business.
- Activities of its officers and directors: Whatever the officers and directors spend most of their time doing is likely to be considered the primary business.
- Nature of its assets: The more of a company’s assets that are associated with its non-securities business, the more likely that will be considered its primary business. However, courts have recognized that some businesses are asset-light, and that fact should not by itself transform an operating company into an investment company.
- Sources of its income: Both net and gross income should be considered. An activity that produces a majority of both will likely be considered the primary business.
No single one of these factors is determinative. The SEC tends to look first at the last two factors, assets and income, as they’re the most objective. If the company’s primary business isn’t clear from those objective factors, the SEC will focus on the subjective factors, the most important of which is investors’ perceptions and motivation.
Note that the primary business could be conducted through one or more subsidiaries, but only if they are wholly-owned. The further requirement, however, is that the subsidiaries must be formed or acquired for the purpose of carrying out the business activity rather than being resold.
Section 3(a)(1) Holding Company or Diversified Business Fund
A variation on the supplemental fund is suggested in the definition of “investment company” in Section 3(a)(1) of the 1940 Act (see 1940 Act Section 3(a)(1)). An investment company is a company that is primarily in the business of investing in securities or holds investment securities valued at more than 40% of the total value of its assets (excluding government securities and cash). If a company does neither of these, it doesn’t meet the definition of an investment company under the 1940 Act and doesn’t need an exemption.
As a practical matter, this model is similar to the supplemental fund, since both rely on the company being in a primary business other than investing in securities. But in this model, that primary business could be conducted through majority-owned subsidiaries.
This model is sometimes called a diversified business fund, in recognition that since no more than 40% of its assets can comprise investment securities, it will likely have a fairly diversified portfolio of assets. It is important that the holding company’s investments be made for the purpose of entering into the subsidiary’s line of business, and with a view to selling the subsidiary for a profit.
Real life examples of Holding Company model:
Section 3(b)(2) Holding Company
This variant on the holding company model is based on Section 3(b)(2) (see 1940 Act Section 3(b)(2)). Under this model, if a fund controls or holds a majority stake in a subsidiary, the subsidiary’s activities are deemed to be the activities of the fund. As with the previous model, the holding company’s investments must be made for the purpose of entering into the subsidiary’s line of business, and not with a view to selling the subsidiary for profit.
This appears to be the model used by Berkshire Hathaway — which is why Warren Buffet’s company is not regulated as a mutual fund. Berkshire Hathaway, of course, is a large publicly-traded company registered with the SEC, but the model also could work for a community-scale fund.
This type of holding company is somewhat more flexible, since its focus is not on an allocation of assets but rather on the nature of the fund’s business. If, like Berkshire Hathaway, a fund invests mostly in controlling or majority interests for the purpose of actively engaging in those businesses, it’s deemed to be in the business of whatever those subsidiary companies are doing, and not in the business of investing in the securities of its subsidiaries.
For purposes of this model, ownership of 25% of the voting securities of a target company is presumed to constitute control. A qualifying holding company need only acquire 25% of most of its target companies. However, the wording of the exemption suggests that any portfolio company that is merely controlled (and not majority owned) should be in a type of business similar to that of a majority-owned company in the fund’s portfolio.
To rely on this exemption, the company would need to get an exemptive order from the SEC. This will add to the cost and cause some uncertainty. But unlike with exemptive orders under the intrastate exemption (discussed in greater detail in Chapter Three of the CIF handbook), the SEC doesn’t appear to have the power to impose additional rules on the fund, so this is a one-time ask and a one-time cost.
Two strategies, built around either Section 3(a)(1) or Section 3(b)(2), can be used for holding companies, but with two key differences: Section 3(b)(2) requires an exemptive order from the SEC, while Section 3(a)(1) does not. And Section 3(b)(2) affords more flexibility as to the composition of the fund’s portfolio, in that it doesn’t limit investment securities to 40% of the holding company’s assets. This suggests that if a holding company can meet the 60-40 test, Section 3(a)(1) is the preferable strategy. Section 3(b)(2) should be reserved for holding companies that don’t meet that test.
Under either strategy, it may be challenging for a fund structured as a small business holding company to find suitable investment targets that are willing to give up a majority or controlling interest in their company. However, the strategy may become increasingly useful over the next decade as baby-boomer business owners retire. Traditionally, mom-and-pop business owners have trouble finding a buyer, and many such businesses simply close, which often represents a significant loss to the community. A holding company model could acquire small businesses and strengthen them, perhaps incorporating an element of worker ownership. Eventually, the holding company could spin off these businesses and could facilitate an eventual transfer of ownership to their employees or to a cooperative of employees, but as noted earlier, it is important that they be acquired with an intestine to keep them and not with the intent to sell them. This would be a strategy to preserve the character of a community.
Real Estate Fund (or REIT)
The 1940 Act exempts a fund that is primarily in the business of acquiring mortgages and real estate (see 1940 Act, Section 3(c)(5)). We address it separately because of its importance. Housing and commercial properties lie at the very heart of community development, and shifting ownership of real estate is an important strategy for shifting power within a community.
A community real estate fund could be used for several different purposes:
- An urban revitalization fund could acquire blighted downtown properties, renovate them, and lease them to new tenants. This would have the effect of eliminating blight, increasing foot traffic, improving safety, and increasing sales tax revenues for the city.
- An affordable housing fund could develop housing in the “missing middle” between subsidized low-income housing and high-end “market rate” housing. In severely housing-constrained regions like California, this would meet a critical need and ease the upward pressure on housing prices.
- An agricultural land fund could acquire and hold land for agricultural uses, thus saving the land from development and thereby preserving a community’s agricultural character. This could be done alongside an agricultural land trust, which uses charitable money to acquire a preservation easement and reduces the net cost of the land to the fund. Land could be leased to farmers at affordable rates, while community investors earn a decent return.
The SEC has taken the position that this exemption strategy is available to a fund if three criteria are met:
- At least 55% of its assets consist of mortgages and interests in real estate (which appears to include holding real estate through an LLC as long as the fund is the managing member);
- Not more than 20% of its assets have no relationship to real estate; and
- The rest of the company’s assets consist of “real estate-type interests” — which includes securities issued by other real estate funds.
Even without this express exemption, a fund that’s primarily in the business of acquiring, improving, leasing, and selling real estate is probably not in the securities business, and therefore such a fund would also be exempt under Section 3(b)(1), even if some of its portfolio consists of securities investments. So a real estate fund could rely on either of these 1940 Act strategies. Of the two, the Section 3(b)(1) strategy is more ambiguous, as it depends on the analysis of what the “primary” business of the fund is. Therefore, a real estate fund that can meet the numerical criteria noted above may be better off using the express real-estate strategy.
Unfortunately, regulation crowdfunding (Reg CF, or Title III of the JOBS Act) is not available for any fund that relies on the real-estate exemption. Instead, a real estate fund that raises capital via Reg CF would need to rely on Section 3(b)(1).
When an offering for a real estate fund is registered with state regulators, there is typically an additional layer of regulation that can increase legal and compliance costs. The rules for real estate funds are more stringent, for example, if they haven’t yet identified their specific acquisition targets at the time they register the offering. For this reason, a real estate fund may want to start off with an identified property that it already owns or to which it has secured rights, perhaps through an option contract. These state rules for real estate funds, however, do not apply at the federal level. Therefore, a community real estate fund might consider raising capital via Reg CF or a Regulation A Tier 2 offering rather than a state-registered offering.
It should be noted that real estate investment trust (REIT) is a type of real estate fund. Most real estate funds are structured as partnerships or limited liability companies (LLCs), because of the tax pass-through treatment. But if a real estate fund has at least 100 equity investors and meets certain other requirements, it can convert to a REIT, which is a corporation but with some of the tax characteristics of a partnership or LLC.
Real life examples:
Unless you’re an attorney — and sometimes even if you are one — choosing among these options can be daunting. While most of the community investment funds we’re aware of use the charitable fund exemption, the more significant reality is that there’s too little experience with all these exemptions to know, with confidence, which will be best, easiest, and cheapest. The jury is still out. You and your team should review these options with your attorney, and choose based upon how you answered the various questions in the section on Steps to Create a Community Investment Fund. But more important, share your decision and experiences with other communities experimenting with their own funds — and with us!