Investment Company Act of 1940 - Section 3a-6
Seward & Kissel

October 12, 2005

Your letter dated October 12, 2005 requests that we concur with your view that a foreign bank derives a substantial portion of its business from extending commercial and other types of credit, and accepting demand and other types of deposits for purposes of rule 3a-6(b) under the Investment Company Act of 1940 (the "1940 Act") if the average of the separate percentages obtained by computing the entity's: (1) credit extension revenues as a percentage of the foreign bank's revenues; (2) receivables from credit activities as a percentage of the foreign bank's assets; and (3) aggregate deposits as a percentage of the foreign bank's liabilities, exceeds ten percent (the "ten percent test"). While not providing guidance specifically with regard to the ten percent test, we do provide other interpretive guidance below, which should be helpful in this regard. In particular, we describe certain factors that generally would indicate that a foreign bank derives a substantial portion of its business from extending commercial and other types of credit and accepting demand and other types of deposits.

FACTS

You state that certain of your clients are banks that are incorporated or organized under the laws of a country other than the United States, or a political subdivision of a country other than the United States (each, a "foreign bank"). You state that each foreign bank takes deposits and extends commercial and other types of credit and is regulated as a bank, and with respect to deposit-taking and credit extension, by its country's government or an agency thereof. You represent that the foreign banks are not operated for the purpose of evading the provisions of the 1940 Act and that the foreign banks are not regulated as investment companies in their home jurisdictions.

You state that each foreign bank has issued, or intends to issue, securities in public offerings in the United States. You request guidance concerning whether the foreign banks may engage in public offerings of their securities in the United States, without registering with the Commission as investment companies under the 1940 Act.

ANALYSIS

Section 3(a)(1)(A) of the 1940 Act defines the term "investment company" as any issuer that holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities. Section 3(a)(1)(C) of the 1940 Act defines the term "investment company" as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percent of the issuer's total assets (exclusive of Government securities and cash items) on an unconsolidated basis. Foreign banks typically meet one or both of these definitions of investment company.¹ Section 7(d) generally prohibits any foreign entity that meets the definition of investment company, including a foreign bank, from making any public offering of its securities in the United States.²

Rule 3a-6 under the 1940 Act, however, essentially allows certain foreign banks to make public offerings of their securities in the United States without registering as investment companies under the 1940 Act.³ Specifically, rule 3a-6 provides that a foreign bank shall not be considered to be an investment company under the 1940 Act if the bank is:

[a] banking institution incorporated or organized under the laws of a country other than the United States, or a political subdivision of a country other than the United States, that is:

1. Regulated as such by that country's or subdivision's government or any agency thereof;
    
2. Engaged substantially in commercial banking activity; and
    
3. Not operated for the purpose of evading the provisions of the [1940] Act.
    

Rule 3a-6(b)(2) defines "engaged substantially in commercial banking activity" as:

engaged regularly in, and deriving a substantial portion of its business from, extending commercial and other types of credit, and accepting demand and other types of deposits, that are customary for commercial banks in the country in which the head office of the banking institution is located. [emphasis added].

Rule 3a-6 was designed to "put foreign banks selling securities in the United States on an equal footing under the [1940] Act with banks in like circumstances organized under the laws of the United States" ("U.S. Banks").⁴

You ask us to interpret "substantial" for purposes of determining whether a foreign bank may rely on rule 3a-6 because it derives "a substantial portion of its business from, extending commercial and other types of credit, and accepting demand deposits . . . ."⁵ You state that certain members of the securities bar currently interpret the "substantial portion" wording of rule 3a-6(b)(2) as applying to each of two banking functions, extending credit and accepting deposits individually, rather than collectively. You state further that those members of the securities bar generally have been comfortable opining that a 20% or greater activity level is sufficient for each prong. You are concerned that, under this interpretation, foreign banks, unlike U.S. Banks, could, for example be forced to maintain a higher level of deposits than would otherwise be economically warranted by the relative costs of deposits and alternative sources of funding. You contend that, as a result, these foreign banks would find themselves on unequal footing with U.S. Banks due to the need to comply with a rule that was intended to promote equality between U.S. and foreign banks.

In light of these concerns, you propose an alternative interpretation. You assert that a foreign bank should be deemed to derive "a substantial portion of its business from" commercial banking activity if the average of the separate percentages obtained by computing the entity's: (1) credit extension revenues as a percentage of the foreign bank's revenues; (2) receivables from credit activities as a percentage of the foreign bank's assets; and (3) aggregate deposits as a percentage of the foreign bank's liabilities, exceeds ten percent. You contend that the average of deposits and credit extension to the degree described in the ten percent test is consistent with the extent to which U.S. Banks must engage in those activities. Consequently, you argue that this interpretation of "substantial" will put foreign banks selling securities in the United States on an equal footing under the 1940 Act with U.S. Banks.⁶

You contend further that the ten percent test is consistent with the plain meaning of the word "substantial": "Belonging to substance; actually existing; real; not seeming or imaginary; not illusive; solid; true; veritable. Something worthwhile as distinguished from something without value or merely nominal."⁷ You also contend that foreign banks that meet the ten percent test view their deposit-taking and credit extension activities as substantial due in part to the resources that must be extended to engage in those activities. In addition, you assert that the relevant foreign financial authorities view these activities as substantial, as evidenced by their specific regulation of such activities.

In determining whether a foreign bank derives "a substantial portion of its business from … extending commercial and other types of credit, and accepting demand and other types of deposits," for purposes of rule 3a-6, we are not inclined to provide an interpretation based on particular minimum percentages of either the bank's liabilities (in the case of deposits) or assets or revenues (in the case of credit extensions). This conclusion is based, in part, on the fact that the Commission, when adopting this standard, chose not to define it by reference to minimum percentages. Although we are not willing to set forth such minimum percentages, we recognize that various percentages could demonstrate that a foreign bank derives a substantial portion of its business from extending commercial and other types of credit and accepting demand and other types of deposits.

We believe, however, that the banking activities in which a foreign bank engages clearly must be more than nominal to satisfy the "substantial" standard in the rule. In addition, in order to meet this standard, we generally would expect a foreign bank: (1) to be authorized to accept demand and other types of deposits and to extend commercial and other types of credit; (2) to hold itself out as engaging in, and to engage in, each of those activities on a continuous basis, including actively soliciting depositors and borrowers; (3) to engage in both deposit taking and credit extension at a level sufficient to require separate identification of each in publicly disseminated reports and regulatory filings describing the bank's activities; and (4) to engage in either deposit taking or credit extension as one of the bank's principal activities.

When the foregoing factors are present, we will view the foreign bank as deriving a substantial portion of its business from extending commercial and other types of credit and accepting demand and other types of deposits. We believe that this position is consistent with the purpose underlying rule 3a-6, which is to put foreign banks selling securities in the United States on an equal footing under the 1940 Act with U.S. Banks. We recognize that there may be other factors that would support a conclusion that a foreign bank derives a substantial portion of its business from extending commercial and other types of credit and accepting demand and other types of deposits, and that it may be possible for a foreign bank to satisfy this standard even when fewer than all of the foregoing factors are present.

Endnotes

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¹ Section 3(c)(3) of the 1940 Act excludes "banks" from the definition of investment company. The definition of "bank" in section 2(a)(5) of the 1940 Act addresses certain U.S. domestic banks, and only certain types of non-U.S. banks (those that are a branch or agency of a foreign bank as such terms are defined in section 1(b) of the International Banking Act of 1978). You state that your clients do not meet the definition of "bank" in section 2(a)(5).

² Section 7(d) of the 1940 Act states, in part:

No investment company, unless organized or otherwise created under the laws of the United States or of a State shall make use of the mails or any means or instrumentality of interstate commerce, directly or indirectly, to offer for sale, sell, or deliver after sale, in connection with a public offering, any security of which such company is the issuer.

³ Rule 3a-6(a) provides that "notwithstanding Section 3(a)(1)(A) or Section 3(a)(1)(C) of the [1940 Act], a foreign bank . . . shall not be considered an investment company for purposes of the [1940 Act]."

⁴ See Exemption from the Definition of Investment Company for Foreign Banks and Foreign Insurance Companies, Investment Company Act Release No. 18381 (Oct. 29, 1991) (adopting rule 3a-6). See also Safra Republic Holdings, S.A. (pub. avail. Apr. 21, 1998) ("Safra").

⁵ While rule 3a-6 does not define "substantial," that term requires something less than "primary." Rule 3a-6 is based on former rule 6c-9 under the 1940 Act, which codified prior exemptive orders that the Commission had issued to foreign banks. As originally proposed, rule 6c-9 would have required a foreign bank to be "primarily engaged in accepting demand deposits and making commercial loans." Exemption from the Investment Company Act of 1940 for the Offer or Sale of Debt Securities and Non-voting Preferred Stock by Foreign Banks or Foreign Bank Finance Subsidiaries, Investment Company Act Release No. 15314 (Sept. 17, 1986). In adopting rule 6c-9, the Commission revised the definition to impose "no requirements as to the primary activities engaged in by the entity seeking to the use the rule" in response to criticism by commentators that this definition was so restrictive as to render the rule inapplicable to many entities legitimately seeking exemption. Exemption from the Investment Company Act of 1940 for the Offer or Sale of Debt Securities and Non-voting Preferred Stock by Foreign Banks or Foreign Bank Finance Subsidiaries, Investment Company Act Release No. 16093 (Oct. 29, 1987).

In a prior letter, we concluded that certain foreign banks were "engaged substantially in commercial banking activity" for purposes of rule 3a 6, relying, in part, on the representation that time deposits were considered to be "other types of deposits" and interbank deposits were considered to be extensions of "commercial and other types of credit," both by the banking regulators in the countries in which the banks operate and under U.S. law. Safra, supra note 4. In the letter, we also cited to the fact that the banks' liabilities represented by deposits ranged from 90 to 96%, the banks' assets attributable to "interbank deposits" ranged from 59% to 84%, and the banks' assets attributable to conventional loans ranged from 12% to 2%. Id. You contend that this staff position does not represent the exclusive means by which a foreign bank can be substantially engaged in commercial banking activity. We agree.

⁶ In further support of this interpretation, you note that in certain instances in the securities laws, a ten percent or lower threshold is used to define substantial. See Securities Exchange Act Release No. 39098 (Sept. 19, 1997) (approval of New York Stock Exchange proposal that cash sales of stock to a "substantial" security holder be exempt from its shareholder approval policy; a five percent threshold used in the definition of "substantial"); Stampede Int'l Resources Ltd, Northwest Ventures (pub. avail. Jan. 4, 1982) (for purposes of reorganizations relying on section 3(a)(10) of the Securities Act of 1933, "substantial" amount of securities considered to be greater than one percent). But see rule 3-16 of Regulation S-X (definition of "substantial portion of collateral" includes 20% threshold); Rule 902 of Regulation S (definition of "substantial U.S. market interest" includes 20% threshold).

A ten percent threshold while not identified as "substantial" is of considerable importance in other areas of the securities laws. See, e.g., Regulation S-X (definitions of "principal holder of equity securities" and "significant subsidiary" include a ten percent threshold).

⁷ Black's Law Dictionary 1428 (6th ed. 1990).

Incoming Letter

The Incoming Letter is in Acrobat format.

http://www.sec.gov/divisions/investment/noaction/seward101205.htm