Legal and Political Issues
Section 3.5.
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The Perils of Becoming an Investment Company

William Gale

There was some recent discussion of operating a "mutual fund," and also some general discouraging words about that idea. Here are some of the gruesome specifics on why one does not want a small company to be an "investment company," the technical term used by the SEC.

An investment company is one that has more than 40 percent of its capital in "investment securities." An investment security is any security except a governmental security or a security of a majority owned corporation. An investment company cannot sell stock unless it has $100,000 of capital. Catch 22: the most likely way to raise $100,000 of capital is by selling stock. This is a terrific way to stop even upper middle class folks from forming their own investment company.

This means that if one does form a company to aggregate small contributions, that about 65 percent of the capital would need to be invested in governmental securities (bonds) or non-securities such as savings accounts until there was enough to act with. As I recall stocks have a historical (100 year) 5 +- 10 % after tax after inflation return, while short term bonds have a historical return of 0 +- 1 % after tax after inflation. Long term bonds were worse than short term bonds. Thus one must give up the expectation of any return on most of the capital in exchange for a relative security in order not to be operating an investment company.

There are also extreme requirements and restrictions on investment companies. All securities must be held in the custody of a bank, and anyone with access to the securities must be bonded. At least 90 percent of taxable ordinary income must be paid as a dividend. It may not borrow money, purchase real estate, or make loans. It may invest only 10 percent of its assets in other investment companies. It may not change its stated policy with respect to concentration or diversification, and finally (get this) it may not cease to be an investment company!

Does the SEC enforce these amazing regulations? You bet. This information is from "Securities Regulation", 5th edition, by David Ratner. It cites cases in which ordinary business companies inadvertently became investment companies [for instance, by not being careful with what they did with the procedes from selling part of the business]. They were successfully prosecuted by the SEC.

Legal and Political Issues

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