Investment Company Act exemptions

If your ABF vehicle is classified as an “investment company” under the Investment Company Act of 1940, you must register with the SEC, comply with extensive governance and operational requirements, and limit leverage. For most ABF structures, registration is not viable. You need an exemption.

This guide covers the four primary exemptions used in ABF and how to maintain compliance throughout the deal’s life.

Why Investment Company Act matters

Being classified as an investment company triggers requirements that are incompatible with most ABF structures:

Registration requirements:

SEC registration and ongoing reporting
Independent board of directors (majority independent)
Strict affiliate transaction rules
Custody and valuation requirements

Leverage limits:

300% asset coverage for senior securities (effectively 33% debt-to-equity)
ABF structures routinely use higher leverage

Operational restrictions:

Limits on management contracts
Detailed prospectus requirements
Shareholder voting requirements

Bottom line: An ABF vehicle that fails to qualify for an exemption cannot function as intended. The exemption analysis is deal-critical.

Section 3(c)(1): 100 beneficial owner exemption

An issuer is not an investment company if:

It has no more than 100 beneficial owners, and
It is not making (and doesn’t propose to make) a public offering of securities

When 3(c)(1) works

Ideal scenarios:

Small, closely held structures with limited investor count
Single-investor warehouses
Family office vehicles
Structures where investor count will remain low

Advantages:

No asset composition requirements
No investor qualification requirements (beyond not making public offering)
Simple to document and maintain

Look-through rules

The 100-owner limit sounds simple, but counting gets complicated:

General rule:

Count each beneficial owner of the issuer’s securities

Fund look-through:

If an investing fund holds 10% or more of the issuer, look through to the fund’s beneficial owners
The fund itself must rely on 3(c)(1) or 3(c)(7) for this to work
If the investing fund has more than 100 owners, integration could blow the limit

Employee benefit plans:

Generally count as one owner (not look-through to participants)
Special rules for unfunded plans

Corporations and partnerships:

Count as one beneficial owner unless formed for the purpose of investing in the issuer

Warning: “Formed for the purpose” is a facts-and-circumstances test. A fund that raises capital specifically to invest in your vehicle may be integrated for counting purposes.

Practical limitations

Why 3(c)(1) rarely works for larger ABF deals:

100-investor limit constrains capital raising
Look-through rules make counting difficult
Subsequent syndication may breach the limit
Not practical for term securitizations with multiple tranches and broad distribution

When to use:

Initial warehouse with single bank lender
Captive funding vehicle for single capital provider
Bridging structure before moving to 3(c)(7)

Section 3(c)(5)(C): Mortgage and real estate exemption

For mortgage and real estate-backed structures, Section 3(c)(5)(C) is the go-to exemption. It excludes issuers “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.”

The 55/25/20 test

The SEC’s no-action position establishes the asset composition test:

At least 55% qualifying interests:

“Mortgages and other liens on and interests in real estate”
First-lien whole mortgage loans (primary qualifying asset)
Second-lien loans with adequate equity cushion
Participation interests in whole loans (if you have meaningful control over the loan)

At least 25% real estate-type interests:

Either qualifying interests (from the 55% bucket) or
Additional real estate-related assets that don’t fully qualify

No more than 20% miscellaneous:

Cash and cash equivalents
Hedging instruments
Other non-qualifying assets

What qualifies as a 55% asset

Clear qualifiers:

First-lien residential mortgage loans (performing)
First-lien commercial mortgage loans (performing)
Construction loans with adequate controls
Bridge loans secured by real estate

Partial qualifiers (may go in 25% bucket):

Second liens with insufficient equity
Participation interests without control rights
Mezzanine loans (depending on structure)

Non-qualifiers:

Subordinated CMBS/RMBS positions (securities, not real estate interests)
Residual interests in securitizations (too remote from real estate)
REO after extended holding period
Cash, hedges, receivables

CMBS and RMBS positions

How securities backed by real estate are treated is critical:

What the SEC has said:

Senior positions in RMBS may qualify if you have significant control rights
Subordinated positions generally don’t qualify (you’re investing in a security, not directly in real estate)
The more remote from the underlying loans, the less likely to qualify

Practical approach:

Whole loans: 55% bucket
First-loss or mezzanine positions in securitizations: likely 20% bucket or 25% bucket depending on control
Senior CMBS/RMBS: case-by-case analysis required

REO treatment

Real estate owned (property acquired through foreclosure) requires careful tracking:

Initial treatment:

REO acquired through foreclosure on a qualifying loan initially qualifies
You took the property in enforcement of your real estate interest

Holding period:

Extended holding (typically beyond 2 years) may reclassify the property
If you’re holding for investment rather than disposition, it looks like real estate investment, not lending

Best practice:

Actively market REO for sale
Document disposition efforts
Track holding periods for compliance testing

Maintaining 3(c)(5)(C) compliance

Quarterly testing:

Calculate asset composition at least quarterly
Use fair value or book value consistently
Document the calculation and methodology

Drift prevention:

Monitor prepayments (paying off qualifying loans concentrates cash)
Watch for REO accumulation
Reinvest in qualifying assets promptly

Cure mechanisms:

Sell non-qualifying assets
Acquire additional qualifying assets
Avoid new investments that would breach the test

Important: 3(c)(5)(C) compliance is ongoing, not a closing-day exercise. Portfolio drift can cause you to lose the exemption mid-stream.

Section 3(c)(7): Qualified purchaser exemption

For most ABF vehicles that don’t have a 3(c)(5)(C) strategy, Section 3(c)(7) is the default. It exempts issuers that:

Sell securities only to “qualified purchasers”
Do not make a public offering

Qualified purchaser thresholds

The thresholds are higher than accredited investor:

Individuals:

$5 million or more in investments (not net worth)
“Investments” has a specific definition (publicly traded securities, certain contracts, real estate held for investment, etc.)

Family companies:

Entity owned directly or indirectly by 2 or more natural persons who are related
Family company owns at least $5 million in investments

Trusts:

Not formed for the purpose of investing in the issuer
Trustee and each settlor/grantor that can revoke is a qualified purchaser

Institutional investors:

Entity that owns and invests on a discretionary basis at least $25 million in investments
Includes most credit funds, insurance companies, pension funds

Knowledgeable employees:

Directors, executive officers, and certain employees of the fund or fund adviser
Can invest without meeting QP thresholds

Why 3(c)(7) dominates ABF

Advantages:

No asset composition test (unlike 3(c)(5)(C))
No numerical limit on investors (unlike 3(c)(1)‘s 100-owner limit)
Most institutional ABF investors are qualified purchasers anyway
Flexible for multi-tranche structures with broad syndication

The tradeoff:

You exclude any investor that doesn’t meet the QP threshold
Retail investors and smaller institutions are locked out
Some family offices and smaller funds may not qualify

In practice:

Institutional ABF deals rarely have non-QP investors
QP certification at subscription catches any issues
The constraint is usually theoretical, not practical

Documenting 3(c)(7) compliance

At subscription:

Investor completes qualified purchaser questionnaire
Questionnaire includes specific representations about investment ownership
Review for completeness and red flags

For entities:

Confirm entity owns $25 million in investments
If close to threshold, may need supporting documentation
Consider annual reconfirmation for long-dated structures

Transferee compliance:

Transfer restrictions require new purchaser QP certification
Trustee/transfer agent should not record transfer without certification
Lost exemption if non-QP purchases

Rule 3a-7: Securitization exclusion

Rule 3a-7 provides an exclusion specifically designed for structured financings. Unlike the exemptions above, 3a-7 is an exclusion from the investment company definition entirely.

Qualifying criteria

An issuer qualifies under 3a-7 if:

1. Fixed-income securities:

Issues fixed-income securities or other securities entitling holders to receive payments that depend primarily on cash flow from a pool of financial assets

2. Self-liquidating assets:

The financial assets generate cash flow sufficient to pay the securities
Assets naturally pay off without active management

3. Trustee administration:

A trustee maintains the assets and enforces holder rights
Independent trustee role (not just paying agent)

4. Limited activities:

The issuer engages in very limited activities
No active management of assets (buy-and-hold, not trading)
Reinvestment is limited and mechanical (not discretionary)

When 3a-7 works

Ideal for:

Traditional term securitizations (auto, credit card, mortgage)
Static pool deals
Structures where assets are fixed at closing and run off naturally
Pass-through structures with minimal discretion

Examples:

Auto loan ABS (pool fixed at closing, no reinvestment)
Credit card master trust (revolving but reinvestment is mechanical)
RMBS (loans run off naturally)

When 3a-7 doesn’t work

Active management disqualifies:

Managed CLOs with active trading
Any structure where the manager exercises discretion over asset selection post-closing
Revolving facilities where sponsor picks which assets to add

What’s allowed:

Limited substitution (replacing defective assets)
Reinvestment during a limited prefunding period
Mechanical reinvestment based on objective criteria

3a-7 vs. 3(c)(7) in practice

Belt-and-suspenders approach:

Many ABF deals rely primarily on 3(c)(7) for flexibility
Cite 3a-7 as an alternative basis
Provides protection if QP status questions arise
Addresses different investor concerns

Why both?

3(c)(7) is more flexible (no asset composition or activity restrictions)
3a-7 may be required for certain regulated investors
3a-7 is also relevant for Volcker Rule analysis (securitization exclusion from covered fund)

Compliance monitoring and documentation

Pre-closing requirements

Exemption analysis:

Counsel prepares Investment Company Act memorandum
Analysis covers all applicable exemptions
Documents the facts supporting qualification
Usually part of 10b-5 opinion process

Opinion letter:

For rated deals or sophisticated investors, may require ICA opinion
Opinion confirms vehicle is not an investment company
Relies on facts represented by the parties

Ongoing compliance by exemption

3(c)(1) monitoring:

Track beneficial owner count
Evaluate look-through for new fund investors
Document integration analysis for related offerings

3(c)(5)(C) monitoring:

Quarterly asset composition testing
Track prepayments, REO, and cash accumulation
Document compliance calculations
Establish remediation procedures if drift occurs

3(c)(7) monitoring:

Investor QP certification at subscription
Transferee certification at secondary sale
Consider annual reconfirmation for long-dated vehicles
Maintain certification records

3a-7 monitoring:

Limited activity covenant compliance
No prohibited discretionary trading
Trustee independence maintained
Reinvestment within permitted parameters

When exemption fails

3(c)(1) breach (too many owners):

Cannot cure by reducing owners
Must qualify under another exemption (3(c)(7)) if available
May need to restructure or unwind

3(c)(5)(C) breach (asset composition):

Cure possible by adjusting portfolio
Sell non-qualifying assets or acquire qualifying assets
Document the breach and cure
Establish procedures to prevent recurrence

3(c)(7) breach (non-QP investor):

Serious issue if investor refuses to sell
May need to repurchase the investor’s position
Document the breach and remediation
Evaluate litigation risk

3a-7 breach (active management):

Generally cannot cure retroactively
May need to fall back on 3(c)(7) if available
Document the analysis

Compliance checklist

Pre-closing:

Primary exemption identified (3(c)(7), 3(c)(5)(C), or 3a-7)
Investment Company Act analysis completed
Investor questionnaires collect required certifications
Transfer restrictions address exemption requirements
Offering documents include appropriate disclosures
Opinion letter obtained (if required)

Ongoing (3(c)(5)(C)):

Quarterly asset composition testing established
Testing methodology documented
Drift prevention procedures in place
REO tracking implemented

Ongoing (3(c)(7)):

QP certifications filed for all investors
Transfer procedures require QP certification
Knowledgeable employee status documented (if applicable)

Ongoing (3a-7):

Limited activity covenants monitored
Reinvestment within permitted parameters
Trustee independence maintained

Interaction with other regulations

Volcker Rule:

3a-7 qualification also provides securitization exclusion from covered fund definition
Important if bank investors are targets

Risk retention:

ICA exemption is separate from risk retention
Can rely on 3(c)(7) and still be subject to risk retention

Securities Act:

ICA exemption doesn’t affect securities registration requirements
Need both ICA exemption and Securities Act exemption