CHAPTER 4. ISSUERS ENGAGED IN THE BUSINESS OF ISSUING FACE-AMOUNT CERTIFICATES OF THE INSTALLMENT TYPE SECTION 3(a)(1)(B) Contents

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1 CHAPTER 4 ISSUERS ENGAGED IN THE BUSINESS OF ISSUING FACE-AMOUNT CERTIFICATES OF THE INSTALLMENT TYPE SECTION 3(a)(1)(B) Contents 4.1 Introduction 4.2 Face-Amount Certificates of the Installment Type Section 2(a)(15) 1. In General 2. The Determinable Requirement 3. The Twenty-Four Month Requirement 4.3 Face-Amount Certificate Companies as Investment Companies Section 3(a)(1)(B) 1. In General 2. Engaging in the Business of Issuing Face-Amount Certificates of the Installment Type 3. Capital Structure 4.4 Overview of the Regulation of Face-Amount Certificate Companies 4.5 The Availability of 1940 Act Exceptions and Exemptions to Face-Amount Certificate Companies 4.6 Comparison to Companies Issuing Periodic Payment Plan Certificates

2 4.1 Introduction Section 3(a)(1)(B) of the 1940 Act 1, which, prior to the enactment of the National Securities Markets Improvement Act of 1996 was designated as Section 3(a)(2) 2, defines as an investment company any issuer which is engaged or proposes to engage in the business of issuing face amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding. In addition, Section 4(1) of the 1940 Act 3 classifies such an issuer as a face-amount certificate company. 4 Face-amount certificate companies today are quite rare. 5 Nonetheless, an issuer that offers certain types of debt or similar securities purchased on an installment basis may be deemed to be a face-amount certificate company and, thus, perhaps inadvertently, may become subject to the applicable provisions of the 1940 Act, regardless of whether it invests in or holds securities. Face-amount certificates of the installment type are not exempt from the 1933 Act and, thus, issuers of such certificates must register those certificates under the 1933 Act unless they otherwise are exempt from registration. Similarly, face-amount certificates of the installment type typically are not exempt from the 1934 Act, the Trust Indenture Act, or any of the other federal securities laws and, thus, issuers of such certificates, and broker-dealers selling such certificates, must comply with the applicable provisions of those laws. 4.2 Face-Amount Certificates of the Installment Type Section 2(A)(15) 1. In General Section 2(a)(15) of the 1940 Act 6 defines a face-amount certificate of the installment type as any certificate, investment contract, or other security which represents an obligation on the part of its issuer to pay a stated or determinable sum or sums at a fixed or determinable date or dates more than twenty-four months after the date of issuance, in consideration of the payment of periodic installments of a stated or determinable amount U.S.C. 80a-3(a)(1)(B) (LEXIS through 07/18/02). See Section 209(c) of the National Securities Markets Improvement Act of [QU: CITE TO PUB. L. NO.] The Act did not make any substantive changes to Section 3(a)(1)(B). 15 U.S.C. 80a-4(1) (LEXIS through 07/18/02). Also, as discussed infra in Chapter 39, Section 6(a)(4) of the 1940 Act, 15 U.S.C. 80a-6(a)(4), provides an exemption from the 1940 Act for certain issuers that continuously have been subsidiaries of registered face-amount certificate companies since at least March 14, See, e.g., ICOS Corp., Exchange Act Release No. 19,334, 58 Fed. Reg , n.1 (Mar. 22, 1993) (Order granting an exemption to a research and development company under Section 3(b)(2)) ( Only two face-amount certificate companies remain in existence. ); Safra Republic Holdings S.A., SEC No-Action Letter (Apr. 21, 1998) (noting that face-amount certificate companies are largely extinct ). 15 U.S.C. 80a-2(a)(15) (LEXIS through 07/18/02). Section 2(a)(5) also defines the term fully paid face-amount certificate as any security which represents a similar obligation on the part of a face-amount certificate company [that is, an obligation on the part of its issuer to pay a stated or determinable sum or sums at a fixed or determinable date or dates more than twenty-four months after the date of issuance of the security], the consideration for which is the payment of a single lump sum. The issuer of a fully paid face-amount certificate is not an investment company under Section 3(a)(1)(B). Cf. In the Matter of J. D. Gillespie, Trustee for Cleo George, 13 S.E.C. 470, 475 (June 23, 1943) ( Clearly the applicant is not a face-amount certificate company under the definition in Section 4(1), as its securities are not of the installment type. ).

3 Face-amount certificates of the installment type have been described as contracts between the corporation which [issues] them and the purchaser, whereby in consideration of the payment of certain specified installments the corporation agrees to pay to the purchaser at maturity a definite sum, the face amount of the certificate. 8 Such certificates are, in essence, debt instruments that often are unsecured and that are purchased on installment. 9 The courts, the Commission, and the Staff have held that a number of types of contracts or debt instruments are face-amount certificates of the installment type if they satisfy the statutory requirements. For example, both the courts and the Commission have held that certain debt securities purchased on installment and issued in connection with pre-need funeral service contracts are face-amount certificates of the installment type See Investment Trusts and Investment Companies: Hearing on S Before a Subcomm. of the Comm. on Banking and Currency, 76th Cong. 44 (1940) (statement of Robert E. Healy, Commissioner, SEC). See also S. REP. NO , at 3 (1940) ( The so-called face-amount certificates are in essence contracts between the corporation which issues them and the purchaser, whereby in consideration of the payment of certain specified installments the corporation agrees to pay to the purchaser at maturity a definite sum, the face amount of the certificate; or to pay prior to maturity a specified surrender value of the certificate. ); id. at 10 ( Face-amount installment certificates are, in essence, unsecured obligations to pay a specified amount to the holder at a specified future date provided the purchaser makes all the payments required by these contracts. ). See, e.g., The Travelers T-Mark Annuity, SEC No-Action Letter (May 13, 1993) (noting that a face-amount certificate company is an investment company although it offers debt securities ), withdrawn on other grounds, The Equitable Life Assurance Soc y of the United States, SEC No-Action Letter (Dec. 22, 1995). Cf. SEC v. Variable Annuity Life Ins. Co. of Am., 359 U.S. 65, 78 (1959) (J. Brennan, concurring) (noting that the 1940 Act covers face-amount certificate companies whose obligations are specified in fixed-dollar amounts ). The legislative history to the 1940 Act often referred to face-amount certificates of the installment type as unsecured obligations. See, e.g., SEC, REPORT ON INVESTMENT TRUSTS AND INVESTMENT COMPANIES: COMPANIES ISSUING FACE-AMOUNT INSTALLMENT CERTIFICATES, H.R. DOC. NO , at 1 2 (1940) (face-amount certificates of the installment type are in essence, simply unsecured obligations of the companies which issue them to pay a specified sum (called the face-amount or maturity value or amount) to the holder of a specified future date (called the maturity date) ) (footnote omitted); Investment Trusts and Investment Companies: Hearing on S Before a Subcomm. of the Comm. on Banking and Currency, 76th Cong. 301 (1940) (testimony of David Schenker, Chief Counsel to the Investment Trust Study) (face-amount certificate companies are companies which sell unsecured promissory notes on the installment plan ). See also In the Matter of The Variable Annuity Ins. Co. of Am., 39 S.E.C. 680, 690 (Feb. 25, 1960) (Section 28 of the 1940 Act contains a scheme of protective regulation for unsecured debentures (i.e., face amount certificates) which may be issued to the public by [face-amount certificate companies] ). Although it appears that Congress intent primarily was to regulate unsecured face-amount certificates of the installment type, the definition of a face-amount certificate of the installment type in Section 2(a)(15) appears to be broad enough to encompass secured obligations as well. See, e.g., SEC v. Mount Vernon Mem l Park, 664 F.2d 1358, (9th Cir.), cert. denied, 456 U.S. 961 (1982); In the Matter of Int l Funeral Servs. of California, Inc., Exchange Act Release No (Jan. 5, 1976) (Order denying exemptions), and Exchange Act Release No (Dec. 3, 1974) (Application and Order for hearing). Preneed funeral service contracts permit a contract holder to purchase funeral services in advance, on an installment basis. In the 1970s, in order to take advantage of a favorable provision in an applicable California statute, a number of California mortuaries began offering debt securities under their pre-need funeral service contracts, which were purchased on an installment basis. At the time of the contract holder s death, the principal of and interest on the debt securities could be applied to offset the then-applicable cost of the funeral services. As noted, both the courts and the Commission held that these debt securities were face-amount certificates of the installment type and that the mortuaries issuing them were face-amount certificate companies. Following the Commission s decision in In the Matter of International Funeral Services of California, the Commission granted several exemptive orders exempting other mortuaries from the provisions of the 1940 Act, even though those mortuaries also had issued such debt securities. The mortuaries that received these orders agreed to a number of conditions, including to cease issuing additional debt securities that constituted face-amount certificates of the installment type, offering to redeem any outstanding debt securities, and establishing a trust fund to reimburse the costs of funeral services incurred by any debt holder if the mortuary that issued those debt securities became unable to perform those services. See, e.g., In

4 Similarly, the Staff has taken the position that contracts permitting purchasers to prepay, on an installment basis, certain costs associated with their anticipated residence in a retirement home are face-amount certificates of the installment type. 11 The Staff also has taken the position that interests in a deferred compensation plan, pursuant to which employees receive a fixed sum at a determinable date in return for payments of periodic installments, may constitute a face-amount certificate of the installment type. 12 As discussed below, however, the Staff also has granted a number of no-action letters taking the position that interests in deferred compensation plans are not face-amount certificates of the installment type if the interests do not satisfy all of the requirements of Section 2(a)(15). 2. The Determinable Requirement Under Section 2(a)(15), in order for a security to be a face-amount certificate of the installment type, it must meet three tests: (1) the security must represent an obligation on the part of the issuer to pay a stated or determinable sum or sums; (2) the sum or sums must be paid on a fixed or determinable date or dates more than twenty-four months after the date of the issuance of the security; and (3) the purchaser of the security must pay periodic installments of a stated or determinable amount. Each of these three tests requires an amount or a date to be determinable. Although it is not entirely clear from the language of Section 2(a)(15), the legislative history leading to the adoption of the 1940 Act appears to have contemplated that such amounts or dates would be determinable at the time of the issuance of the faceamount certificate. 13 Thus, a security should not be deemed to be a face-amount certificate of the installment type if it provides for such an amount or date that is not determinable at the time of issuance but that subsequently is determinable, such as at the time of maturity of the security. 14 In this regard, it appears that the sum payable on a the Matter of Groman Mortuaries, Inc., Exchange Act Release No (Oct. 26, 1977) (Order), and Exchange Act Release No (Sept. 26, 1977) (Application); In the Matter of The Interment Ass n of California, Exchange Act Release No (Oct. 20, 1977) (Order), and Exchange Act Release No (Sept. 22, 1977) (Application). See, e.g., American Ret. Corp., SEC No-Action Letter (Sept. 2, 1977). The Staff stated that such contracts were face-amount certificates of the installment type even though the contract holders could surrender their contracts on thirty days notice and could suspend and subsequently resume installment payments. Id. See, e.g., Zenith Radio Corp., SEC No-Action Letter (Dec. 4, 1974). The issuer of such a deferred compensation plan for its employees might be deemed to be an employees securities company within the meaning of Section 2(a)(13) under the 1940 Act, 15 U.S.C. 80a-2(a)(13), and thus eligible to seek an exemptive order pursuant to Section 6(b) of the 1940 Act, 15 U.S.C. 80a-6(b). See Church of Jesus Christ of Latter-Day Saints, SEC No-Action Letter (June 19, 1975); Zenith Radio Corp., supra.. See also infra Chapter 41 (discussing employees securities companies). In addition, if an employer issuing a deferred compensation plan segregates and pools employee contributions for the purpose of funding the plan, the segregated pool may be deemed to be an issuer that independently satisfies the definition of investment company under Section 3(a)(1)(A) or Section 3(a)(1)(C). See Church of Jesus Christ of Latter-Day Saints, supra; Zenith Radio Corp., supra. See generally Foundation Cmty. Health Plan, SEC No-Action Letter (Feb. 22, 1975) (request letter discussing the relevant legislative history). Cf. In the Matter of The Trust Fund Sponsored by the Episcopal School Foundation College Award Program, Inc., Admin. Proc. File No (File No ), n.19 (Oct. 24, 1968) (an interest in a program, pursuant to which one or more investments in a savings account would be pooled with similar investments by others and the proceeds would be used to fund the future college expenses of designated students who remained eligible for the program following their freshman year of college, was not a face-amount certificate of the installment type because the amount to be paid to each eligible student was dependent upon the number of students who remained eligible and therefore was not a fixed sum). The Staff appeared to take a different position in a no-action letter entitled Amrep Corp., SEC No-Action Letter (June 19, 1975). See also Church of Jesus Christ of Latter-Day Saints, SEC No-Action Letter (June 19, 1975); Zenith Radio Corp., SEC No-Action Letter (Dec. 4, 1974). In Amrep, the Staff took the position that a contract

5 security is not determinable, and the security therefore is not a face-amount certificate of the installment type, if the value of that security depends upon the performance of one or more other securities. For example, the Staff has taken the position that an interest in a deferred compensation plan is not a face-amount certificate of the installment type when the value of that interest depends upon the performance of an investment vehicle, such as shares of a mutual fund or a variable annuity contract. 15 In a related vein, the Commission has held, and the courts have agreed, that an insurance contract whose value is based upon the performance of a pool of securities is a periodic payment plan certificate rather than a face-amount certificate of the installment type representing interests in a deferred compensation plan was a face-amount certificate of the installment type when the amount to be paid under that contract was not determinable at the time of the issuance of the contract but rather was to be calculated by reference to the performance of a specified variable annuity contract. The Staff stated that [w]e think it is sufficient for purposes of [Section 2(a)(15)] that the agreements specify the yardstick which will be used for measuring benefits that will be paid at retirement. The Staff also specifically rejected the argument that Section 2(a)(15) is limited to face-amount certificates whose value is determinable at the time of the purchase of the certificate. In a subsequent no-action letter entitled Foundation Cmty. Health Plan, SEC No-Action Letter (Feb. 22, 1975), however, the Staff apparently reversed its position in Amrep. The Foundation Community Health Plan no-action request letter specifically requested the Staff to reconsider its position in Amrep. The Foundation Community Health Plan no-action request letter presented a detailed analysis of the relevant legislative history of the 1940 Act and argued that Congress had intended, when it enacted Section 2(a)(15), that whether the amount to be paid under a security is determinable for purposes of that Section is to be measured at the time of the issuance of that security. In addition, that request letter argued that, under the Staff's position in Amrep, every periodic payment plan certificate also would be a face-amount certificate of the installment type. In this regard, the request letter stated, Congress clearly differentiated between a promise by the issuer to pay an investor at maturity a fixed dollar amount (a faceamount certificate ) and a promise to pay an investor the varying results of an investment by the issuer in securities it chooses or designates [such as a periodic payment plan certificate]. (The differences between face-amount certificates of the installment type and periodic payment plan certificates are discussed further infra in 4.6.) Accordingly, without necessarily agreeing with [the] analysis with respect to the applicability of Section [3(a)(1)(B)] of the [1940] Act, the Staff did not require the company at issue in Foundation Community Health Plan to register as an investment company, even though the company offered certain of its employees contracts representing interests in a deferred compensation plan that were substantially similar to the contracts offered in Amrep. In addition, as discussed below, following Foundation Community Health Plan, the Staff has continued to permit companies to issue such contracts without registering as investment companies. See, e.g., Phillips Petroleum Co., SEC No-Action Letter (Nov. 14, 1979); Foundation Cmty. Health Plan, SEC No- Action Letter (Feb. 22, 1975). In addition, as discussed infra in Chapter 35, the Staff has taken the position that, under appropriate circumstances, such a deferred compensation plan is not an investment company within the meaning of Sections 3(a)(1)(A) and 3(a)(1)(B) of the 1940 Act. For example, such a plan may be deemed not to be a separate issuer and, thus, not an investment company, when the participants in the plan have no legally cognizable interest in the investment vehicle that serves as the basis for determining the value of the interests in the plan. In such a case, the participants are general, unsecured creditors of the company, and the funding vehicle (to the extent it is owned by the company) is available to satisfy the claims of other creditors of the company. In this regard, the Staff has stated that this result would be the same whether or not [the company offering the deferred compensation plan] invests in interests in the investment vehicle whose value will serve as a basis for determining [the company s] obligations to Plan participants. See Phillips Petroleum Co., SEC No-Action Letter (Nov. 14, 1979). If the participants do receive an interest in a specified pool of securities or other assets, however, that pool might be deemed to be the issuer of the interests and might be subject to the provisions of the 1940 Act. See, e.g., Church of Jesus Christ of Latter-Day Saints, SEC No-Action Letter (June 19, 1975); Zenith Radio Corp., SEC No-Action Letter (Dec. 4, 1974). See, e.g., Prudential Ins. Co. of Am., 41 S.E.C. 335 (1963), aff d sub nom., Prudential Ins. Co. of Am. v. SEC, 326 F.2d 383 (3d Cir.), cert. denied, 377 U.S. 953 (1964).

6 In addition, the Staff takes the position that an amount or date specified in a security will not be determinable for purposes of Section 2(a)(15) and that such a security therefore is not a face-amount certificate of the installment type if, at the time of the purchase of the security, a contingency significantly could affect that amount or date. For example, the Staff has taken the position that employer-sponsored deferred compensation plans are not face-amount certificates of the installment type if either the amount payable to the employee or the time of payment is dependent upon or affected by the employment or nonemployment of the employee. 17 Thus, the Staff has taken the position that an employer-sponsored deferred compensation plan will not be a faceamount certificate of the installment type when the amount payable by the plan to a participating employee depends upon the employee s payments to the plan, which in turn depend upon the level of the employee s compensation and the length of the employee s continued employment. 18 Similarly, the Staff has taken the position that an employer-sponsored deferred compensation plan will not be a face-amount certificate of the installment type when the time of payment will commence when the employee reaches age fifty-five, dies, or terminates employment for any reason The Twenty-Four Month Requirement In order for a security to be a face-amount certificate of the installment type, it must be payable on a date or dates more than twenty-four months after the date of issuance of the certificate. Thus, the Staff has taken the position that a security is not a face-amount certificate of the installment type if it matures every six months, even if the security automatically rolls over for additional six-month periods if it is not presented for payment Face-Amount Certificate Companies as Investment Companies Section 3(a)(1)(B) 1. In General As previously discussed, Section 3(a)(1)(B) defines as an investment company any issuer which is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding, and Section 4(1) classifies such issuers as face-amount certificate companies. A face-amount certificate company therefore essentially is an issuer of debt securities that are sold on an installment basis. For example, in the Congressional hearings leading to the enactment of the 1940 Act, SEC Commissioner Robert E. Healy stated, In essence, the certificates sold by these companies are contracts between the corporation which issues them and the purchaser. In the contract, in consideration of the payment of certain specified installments, the corporation agrees to pay to the purchaser at maturity a definite specified sum, that is, a face-amount, and hence we get the name of See, e.g., Fleetwood Enters., Inc., SEC No-Action Letter (Apr. 25, 1983); The Milwaukee Co., SEC No-Action Letter (Apr. 5, 1982); Alco Standard Corp., SEC No-Action Letter (June 18, 1980); Coldwell, Banker & Co., SEC No-Action Letter (Jan. 27, 1980); Phillips Petroleum Co., SEC No-Action Letter (Nov. 14, 1979); Foundation Cmty. Health Plan, SEC No-Action Letter (Feb. 22, 1975). See also Monsanto Co., SEC No-Action Letter (Apr. 10, 1985) (permitting an employer to offer a supplemental savings plan to certain highly compensated employees without registering itself or the plan under the 1940 Act). See, e.g., The Milwaukee Co., SEC No-Action Letter (Apr. 5, 1982). See, e.g., id. See, e.g., H. & Val J. Rothschild, Inc., SEC No-Action Letter (Sept. 5, 1976).

7 face-amount securities or face-amount certificates. They also have a provision, at least most of them have it, that prior to maturity there is a specified surrender value. 21 Commissioner Healy also stated, This kind of contract, this so-called face-amount certificate it is just an evidence of indebtedness, I pay over some money to the corporation, and the corporation agrees that at a certain date it will pay back to me so much. 22 Unlike a Section 3(a)(1)(A) or 3(a)(1)(B) investment company, an issuer is not required to invest in or hold securities in order to be a face-amount certificate company. 23 Type 2. Engaging in the Business of Issuing Face-Amount Certificates of the Installment Under Section 3(a)(1)(B), an issuer must engage in, propose to engage in, or have engaged in the business of issuing face-amount certificates of the installment type. This business is not required to be the issuer s primary business. Indeed, the Court of Appeals for the Ninth Circuit has held that Section 3(a)(1)(B) defines a face-amount certificate company as one with any such certificates outstanding, whether or not the company is actively or presently engaged in selling certificates. 24 Similarly, the Staff has stated that [w]e believe that any company which issues face-amount certificates is engaged in that business. This conclusion is supported by the omission of the word primarily from Investment Trusts and Investment Companies: Hearings on H.R Before a Subcomm. of the Comm. on Interstate and Foreign Commerce, 76th Cong. 57 (June 13 and 14, 1940). See also H.R. REP. NO , at 6 (1940) ( Face-amount-certificate companies sell to the public face-amount certificates whereby in consideration of the payment of certain specified installments the corporation agrees to pay to the purchaser at maturity a definite sum, the face-amount of the certificate; or to pay, prior to maturity, a specified surrender value of the certificate. ). Similarly, in a 1966 report to Congress, the Commission defined face-amount certificate companies as those that issue certificates obligating the companies to pay at maturity fixed sums (the face amounts of the certificates) to purchasers who have made single payments or a series of installment payments. Rates of return on the certificates are almost entirely predetermined. See SEC, PUBLIC POLICY IMPLICATIONS OF INVESTMENT COMPANY GROWTH, REP. NO , at 7 (1966). In a 1969 report, the SEC defined face-amount certificates as debt securities which investors purchase either by means of periodic installment payments monthly, quarterly, semiannually, or annually or on a single payment basis. The issuer of a face-amount certificate agrees to pay the investor the sum of money stated in the certificate at a specific maturity date. That stated sum includes interest. See SEC, REPORT ON FACE-AMOUNT CERTIFICATE COMPANIES (1969), reprinted in Hearings Before the Subcomm. on Commerce and Fin. of the House Comm. on Interstate and Foreign Commerce, 91st Cong. 267, 275(on H.R , S. 2224, H.R , and H.R ) (1969) (footnote omitted). See also Jaretzki, The Investment Company Act of 1940, 26 WASH. U. L.Q. 303, 305 n.7 (1941) (describing face-amount certificate companies as companies which sell certificates on an installment payment basis, such certificates calling for payment of a fixed amount at a stated time ). Investment Trusts and Investment Companies: Hearings on H.R Before a Subcomm. of the Comm. on Interstate and Foreign Commerce, 76th Cong. 67 (June 13 14, 1940). See, e.g., SEC v. Mount Vernon Mem l Park, 644 F.2d 1358, 1363, (9th Cir.), cert. denied, 456 U.S. 961 (1982); The Milwaukee Co., SEC No-Action Letter (Apr. 5, 1982). As the Court stated in Mount Vernon Memorial Park, requiring a face-amount certificate company to be engaged primarily in reinvesting the proceeds of the sale of the face-amount certificates in other securities would render Section 3(a)(1)(B) superfluous as an independent basis for defining investment companies, a result disfavored in the law. An [(a)(1)(b)] issuer primarily in the business of reinvesting would be regulable under [(a)(1)(a)], and perhaps also [(a)(1)(c)]. 644 F.2d at Mount Vernon Mem l Park, 644 F.2d at 1363 (emphasis in original). The Court noted that [t]his distinction is significant because it logically implies that Congress did not intend to quantify the activity necessary for regulation under [Section 3(a)(1)(B)], as it did in [Sections 3(a)(1)(A) and 3(a)(1)(C)]. Id.

8 Section [3(a)(1)(B)] although it is used in Section [3(a)(1)(A)], and also by the last phrase of Section [3(a)(1)(B)], which states that an issuer is an investment company even if it is no longer engaged in the business of issuing face-amount certificates, as long as it has any such certificate outstanding. 25 In this regard, both the Ninth Circuit and the Commission have held that a mortuary that has issued preneed funeral contracts constituting face-amount certificates of the installment type is engaged in the business of issuing such certificates, even though its primary business is ministering to the needs of the dead Capital Structure Neither Section 2(a)(15), Section 3(a)(1)(B), nor Section 4(1) requires a face-amount certificate company to issue solely face-amount certificates of the installment type. Thus, an issuer that issues face-amount certificates of the installment type may be a face-amount certificate company, even though it also issues other debt or equity securities. 27 Other provisions of the 1940 Act, however, may restrict the other securities a face-amount certificate company can issue. For example, the Staff takes the position that a face-amount certificate company may not issue redeemable securities. In this regard, the Staff takes the position that a face-amount certificate company issuing redeemable securities would be an open-end company and, thus, subject to Section 18(f)(1) under the 1940 Act. 28 Section 18(f)(1) prohibits an open-end company from issuing senior securities, and the Staff takes the position that face-amount certificates representing unsecured indebtedness of the issuer are senior securities. 29 Similarly, requirements imposed by Section 28 of the 1940 Act, such as the reserve requirements applicable to face-amount certificate companies, may have the effect of limiting the ability of such a company to issue certain other types of securities. For example, a face-amount certificate company could not issue debt securities if those securities would encumber the reserves required to be maintained by the company Overview of the Regulation of Face-Amount Certificate Companies See Amrep Corp., SEC No-Action Letter (June 19, 1975). See also In the Matter of G. E. Employees Sec. Corp., Exchange Act Release No. 271 (Dec. 2, 1941) ( Any company selling or having outstanding face-amount certificates of the installment type is a face-amount certificate company. ). As previously discussed, the Staff apparently has reversed the position it took in Amrep concerning whether interests in certain deferred compensation plans were face-amount certificates of the installment type. However, the Staff has not suggested that it has reversed its position in Amrep concerning when an issuer is engaged in the business of issuing face-amount certificates of the installment type. See Mount Vernon Mem l Park, 644 F.2d at ; In the Matter of Int l Funeral Servs. of California, Inc., Exchange Act Release No (Jan. 5, 1976) (Order denying exemptions), and Exchange Act Release No (Dec. 3, 1974) (Application and Order for hearing). Huntoon, Paige & Co., Inc., SEC No-Action Letter (Aug. 13, 1973). 15 U.S.C. 80a-18(f)(1). Huntoon, Paige & Co., Inc., SEC No-Action Letter (Aug. 13, 1973). On the other hand, the Staff has taken the position that a face-amount certificate of the installment type may be nontransferable in order to comply with the Internal Revenue Code provisions applicable to certain tax-deferred employee benefit plans pursuant to which the certificates were issued. See First Home Inv. Corp. of Kansas, Inc.; Bush and Co., SEC No-Action Letter (Sept. 9, 1971). Huntoon, Paige & Co., Inc., SEC No-Action Letter (Aug. 13, 1973).

9 Among the SEC s reports to Congress leading to the enactment of the 1940 Act was an in-depth study of faceamount certificate companies. 31 That report found that face-amount certificates primarily were sold to persons of modest means with long-range objectives, such as saving for old age or for their children s educations. 32 Although the purchaser was entitled to receive her cash surrender value by turning in her certificates prior to maturity, in reality the cash value generally remained below the purchaser s aggregate payments until after the seventh year, reflecting the high sales charges skimmed off the initial installment payments. 33 In addition, although face-amount certificates of the installment type often were advertised as being safe investments, in fact this was not the case, in large measure because reserves often were insufficient in amount and illiquid in form. 34 In this regard, Congress stated, Many instances have been disclosed where this type of security [that is., a face-amount certificate of the installment type] has been sold on the basis of the comparison with savings bank deposits and insurance policies. Although savings banks and insurance companies are subject to strict regulation as to assets and reserves, the face-amount certificate companies have operated without any such uniform type of regulation with the result that, in some cases, assets have been carried at highly fictitious values and, in other cases, inadequate reserves have been maintained for the fixed obligations. 35 Accordingly, the Staff has stated that the 1940 Act s provisions dealing with face-amount certificate companies were intended to regulate unsecured debt securities sold to people who could afford only small monthly payments and who were therefore forced to buy on the installment plan; people who could least afford the penalties attached to defaults and low surrender values and who looked at these certificates as an alternative to a savings account, where they could get their money back. Such persons were in need of protection akin to that which state law had long given to those who placed their savings with banks, savings and loan associations, and insurance companies. 36 The 1940 Act principally regulates face-amount certificate companies in Section Section 28 imposes upon face-amount certificate companies minimum asset and reserve requirements and requires the reserves to be maintained in investments of the type in which life insurance companies may invest. Section 28 also imposes requirements concerning the custody of a face-amount certificate company s reserves and the surrender and other rights of certificate holders See SEC, REPORT ON INVESTMENT TRUSTS AND INVESTMENT COMPANIES: COMPANIES ISSUING FACE-AMOUNT INSTALLMENT CERTIFICATES, H.R. DOC. NO (1940). See id. at 17 18, 23, 32, 93. See id, at See id. at 14. [QU: TITLE, IF ANY, IN L/S CAPS]S. REP. NO , at 10 (1940). In the Matter of Int l Funeral Servs. of California, Inc., Exchange Act Release No (Jan. 5, 1976). 15 U.S.C. 80a-28 (LEXIS through 07/18/02). With respect to most provisions, the effective date of the 1940 Act was November 1, The effective date of the provisions of the 1940 Act as they relate to face-amount certificates and face-amount certificate companies, however, was January 1, See Section 53 of the 1940 Act, 15 U.S.C. 80a-52 (LEXIS through 07/18/02). According to the Commission,

10 In addition, the provisions of the 1940 Act that are applicable to investment companies in general (as opposed to those provisions that specifically are applicable only to open-end companies, closed-end companies, management companies, and/or unit investment trusts) are applicable to face-amount certificate companies. Also, Section 29 of the 1940 Act provides special rules governing the bankruptcy of face-amount certificate companies. A face-amount certificate company may register as an investment company on 1940 Act Form N-8B-4 and may register its securities on an appropriate form (such as Form S-1) under the 1933 Act The Availability of 1940 Act Exceptions and Exemptions to Face-Amount Certificate Companies Section 3(c) of the 1940 Act excepts a number of different types of issuers from the definition of investment company notwithstanding Section 3(a) of the 1940 Act. Accordingly, an issuer that otherwise would qualify and be subject to regulation as a face-amount certificate company will not be deemed to be an investment company if it qualifies for an exception under Section 3(c). For example, the Staff has taken the position that an insurance company could rely upon the Section 3(c)(3) exception from the definition of investment company, notwithstanding the fact that the insurance company also issued face-amount certificates of the installment type. 40 Similarly, the Commission has granted exemptive orders permitting face-amount certificate companies to deregister under Section 8(f) of the 1940 Act 41 when the face-amount certificate company was excepted from the definition of investment company under Section 3(c). Typically, such a company has ceased issuing face-amount certificates of the installment type and/or has transferred its face-amount certificate business to an affiliated entity that is registered as a face-amount certificate company. For example, the Commission has granted such orders to registered face-amount certificate companies that had ceased issuing face-amount certificates of the installment type and that were engaged primarily in the business of underwriting and distributing securities issued by other persons and acting as brokers within the meaning of Section 3(c)(2) of the 1940 Act, 42 that were engaged primarily in the insurance business and therefore were excepted from the definition of investment company by Sections 3(c)(3) and 3(c)(6) of the 1940 Act, 43 and that had ceased issuing face-amount certificates and were Section 28 of the Act requires that face-amount certificates at all times carry a cash surrender value of at least 80 percent of the amount the holder has paid in. Moreover, issuers of such certificates must maintain reserves sufficient to meet cash surrender and maturity obligations. These reserves may be kept in cash or in securities. If in securities, those securities must be of a type readily convertible into cash. The reserves must be held by an independent custodian. In the Matter of Int l Funeral Servs. of California, Inc., Exchange Act Release No (Jan. 5, 1976). See, e.g., Huntoon, Paige & Co., Inc., SEC No-Action Letter (Aug. 13, 1973). See, e.g., The Aetna Casualty & Surety Co., SEC No-Action Letter (June 20, 1975). 15 U.S.C. 80a-8(f) (LEXIS through 07/18/02). 15 U.S.C. 80a-3(c)(2) (LEXIS through 07/18/02). See In the Matter of Investors Diversified Servs., Inc., Exchange Act Release No (Feb. 20, 1969) (Order), and Exchange Act Release No (Jan. 27, 1969) (Application). 15 U.S.C. 80a-3(c)(3), (6). See, e.g., State Bond and Mortgage Co., Exchange Act Release No. 17,965 (Jan. 29, 1991), S.E.C. Dkt., Vol. 48, No. 2 (Feb. 13, 1991), at 120 (Order), and Exchange Act Release No. 17,826 (Oct. 29, 1990), 55 Fed. Reg (Nov. 2, 1990) (Application) (the company was primarily engaged in the insurance and banking businesses and was excepted by Sections 3(c)(3) and 3(c)(6); in connection with its application, the company transferred all of its face-amount certificates of the installment type to a wholly owned subsidiary, which registered under the 1940 Act as a face-amount certificate company). Similarly, in In the Matter of American Annuity Savings Association, American Annuity Life Insurance Company, Exchange Act Release No (Oct. 1, 1954) (Order), and Exchange Act Release No (Sept. 14, 1954) (Application), the Commission permitted a registered face-amount certificate company to deregister because the company was primarily engaged in the

11 engaged primarily in the business of purchasing or otherwise acquiring mortgages and other liens on or interests in real estate within the meaning of Section 3(c)(5)(C) of the 1940 Act. 44 In addition, a face-amount certificate company should not be subject to regulation under the 1940 Act if it qualifies for an exemption from all provisions of the 1940 Act by virtue of one of the exemptive provisions in Section 6(a) of the 1940 Act. The Commission also has granted an exemptive order under Section 6(b) of the 1940 Act permitting an employees security company that had face-amount certificates outstanding to not comply with the provisions of Section 28 of the 1940 Act. 45 On the other hand, the Court of Appeals for the Ninth Circuit has held that a face-amount certificate company cannot rely upon the exception from the definition of investment company provided by Section 3(b)(1) of the 1940 Act 46 for an issuer primarily engaged in a business or businesses other than investing, reinvesting, owning, holding, or trading in securities. 47 The court stated that Section 3(b)(1), by its terms, is applicable solely to issuers that are investment companies by virtue of Section 3(a)(1)(C) (which then was designated as Section 3(a)(3)). 48 There are at least two additional reasons that support this position. First, as previously discussed, under Section 3(a)(1)(B), any issuer that has outstanding face-amount certificates of the installment type is a face-amount certificate company, regardless of what other businesses the issuer also might conduct. Second, as also previously discussed, an issuer is not required to engage in the business of investing, reinvesting, owning, holding, or trading in securities in order to be a face-amount certificate company. Accordingly, Section 3(a)(1)(B) insurance business and, thus, was excepted by Section 3(c)(3). Previously, the company s parent, which was a registered face-amount certificate company that had ceased issuing face-amount certificates, had received an exemptive order permitting it to transfer all of its assets to the company. That order also exempted the company from certain of the requirements under the 1940 Act (including the registration requirements) because the company intended to engage in the insurance business. However, the Commission noted that the company was not then eligible for the Section 3(c)(3) exception because at the commencement of [the company s] business life its primary and predominant business activity [would] not be the writing of insurance but [would] be necessarily the servicing of its face-amount certificates. See In the Matter of American Annuity Sav. Ass n, American Annuity Life Ins. Co., Exchange Act Release No (June 2, 1954) (Opinion and Order), and Exchange Act Release No (May 18, 1954) (Application). 15 U.S.C. 80a-3(c)(5)(C). See In the Matter of Collateral Inv. Co., Exchange Act Release No. 306 (Jan. 31, 1942) (at the time, Section 3(c)(5) was designated as Section 3(c)(6)). Section 3(c)(5) is not available to any person who is engaged in the business of issuing face-amount certificates of the installment type. Nonetheless, in In the Matter of Collateral Investment Company, the Commission granted an order that in effect permitted a company with faceamount certificates outstanding to rely upon the Section 3(c)(5) exception so long as the company did not issue new face-amount certificates of the installment type. See In the Matter of G. E. Employees Sec. Corp., Exchange Act Release No. 271 (Dec. 2, 1941). 17 U.S.C. 80a-3(b)(1). See SEC v. Mount Vernon Mem l Park, 664 F.2d 1358, 1364 (9th Cir.), cert. denied, 456 U.S. 961 (1982). Id. Cf. In the Matter of U.S. Foil Co., Exchange Act Release No. 110 (Apr. 11, 1941) (noting that, if an applicant for an order under Section 3(b)(2) was an investment company under either Sections 3(a)(1)(A) or 3(a)(1)(B) (then Sections 3(a)(1) and 3(a)(2), respectively), then it would be necessary to dismiss the application. Under such circumstances, no purpose would be served by passing on the merits of the application since, whatever the determination, the applicant would still be an investment company subject to the [1940] Act ). It is worth noting, however, that, notwithstanding the express provision of Section 3(b)(1) limiting its applicability to Section 3(a)(1)(C) investment companies, the Commission has interpreted the Section 3(b)(1) exception as also being available to Section 3(a)(1)(A) investment companies. See infra 6.2. Nonetheless, the Commission has not extended the Section 3(b)(1) exception to apply to Section 3(a)(1)(B) investment companies and, for the reasons discussed below, probably is unlikely to do so.

12 apparently contemplates that an issuer should be regulated as a face-amount certificate company even if it is engaged primarily in a non-investment business within the meaning of Section 3(b)(1) Comparison to Companies Issuing Periodic Payment Plan Certificates Section 2(a)(27) of the 1940 Act 50 defines a periodic payment plan certificate as (A) any certificate, investment contract, or other security providing for a series of periodic payments by the holder, and representing an undivided interest in certain specified securities or in a unit or fund of securities purchased wholly or partly with the proceeds of such payments and (B) any security the issuer of which is also issuing securities of the character described in clause (A) and the holder of which has substantially the same rights and privileges as those which holders of securities of the character described in clause (A) have upon completing the periodic payments for which such securities provide. 51 The Commission has described a periodic payment plan certificate as essentially, a contract for purchasing investment company shares by installment. 52 On the other hand, and as previously discussed, a faceamount certificate of the installment type essentially is a debt security with a fixed or determinable face value that is sold on an installment basis. Periodic payment plan certificates and face-amount certificates of the installment type bear a certain resemblance because both types of certificates are sold on an installment basis. The fundamental difference between the two types of certificates, however, is that the holder of a periodic payment plan certificate principally bears an investment risk relating to the performance of an underlying security or group of securities, whereas a holder of a face-amount certificate of the installment type principally bears a credit risk relating to the ability of the issuer of such a certificate to meet the obligations under the certificate. The holder of a periodic payment plan certificate receives an interest in one or more securities, and the value of such a certificate is based upon the performance of the underlying securities. Thus, the holder of a periodic payment plan certificate bears the investment risk that the value of the underlying security or securities will decrease and is entitled to share in any investment gains produced by the underlying security or securities. As a result, the provisions of the 1940 Act (most notably Section 27) that govern periodic payment plan certificates primarily are concerned with assuring that a certificate holder has ready access to her money, presumably so that she promptly may get the benefit of any investment gains or forestall any further investment losses. For example, Section 27 requires a periodic payment plan certificate to be redeemable, imposes strict custody requirements, and limits the amount of money the issuer and others may deduct through sales loads and other charges. By contrast, the holder of a face-amount certificate of the installment type receives an instrument with a fixed or determinable value. The value of that certificate does not depend upon the performance of any other For these same reasons, a face-amount certificate company probably is ineligible to receive an exemptive order under Section 3(b)(2) of the 1940 Act, 15 U.S.C. 80a-3(b)(2). Such a company may receive an exemptive order under Section 6(c) of the 1940 Act, 15 U.S.C. 80a-6(c), however. 15 U.S.C. 80a-2(a)(27). Issuers of periodic payment plan certificates are subject to specific regulation under Section 27 of the 1940 Act, 15 U.S.C. 80a-27. See, e.g., Periodic Repurchases by Closed-End Management Investment Companies; Redemptions by Open-End Management Investment Companies and Registered Separate Accounts at Periodic Intervals or with Extended Payment, Exchange Act Release No. 18,869, [1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) 85,022, at 83,157, 83,181 n.132 (July 28, 1992). See also DIV. OF INV. MGMT., SEC. & EXCH. COMM N, PROTECTING INVESTORS: A HALF CENTURY OF INVESTMENT COMPANY REGULATION 375 (1992)

13 securities or other instruments. Rather, the issuer of the face-amount certificate bears the investment risk that the uses to which it puts the money it obtains from the sale of such certificates (which may be commercial or investment uses) will provide sufficient income to satisfy its repayment obligations under the certificates. The holder of a face-amount certificate of the installment type typically bears no investment risk. However, that holder does bear a credit risk, namely, the risk that the issuer of the certificate will default on its repayment obligations. 53 Accordingly, the provisions of the 1940 Act (most notably Section 28) that govern issuers of face-amount certificates of the installment type largely are concerned with minimizing the risk of issuer default. 54 For example, Section 28 imposes minimum asset requirements as well as stringent reserve and custody requirements. Section 28 also imposes various other consumer protection provisions that prevent overreaching by the issuer of the faceamount certificates. In the Congressional hearings concerning the 1940 Act, David Schenker, Chief Counsel to the Investment Trust Study that led to the enactment of the 1940 Act, put it more succinctly: In the periodic-payment plan there is no limitation upon the investments which the plan can make. They invest in common stocks which fluctuate up and down. They do not promise to pay you anything except the value of your certificates. In the face-amount certificate companies, they can only invest in those securities which insurance companies invest in. Therefore, they are not subject to the same fluctuations. They promise to pay you a fixed amount of maturity, or they promise to pay you a fixed surrender value, if you surrender before that maturity. 55 In practice, however, determining whether a particular instrument is a periodic payment plan certificate or a face-amount certificate of the installment type is not always easy. Indeed, immediately after Mr. Schenker explained the distinction between periodic payment plan certificates and face-amount certificates of the installment type, Congressman [QU: FIRST NAME]Boren asked Mr. Schenker whether the definitions in the 1940 Act of those two types of certificates were so clear that there can be no possible confusion. Mr. Schenker answered, again succinctly, No See, e.g., The Travelers T-Mark Annuity, SEC No-Action Letter (May 13, 1993) ( [A] face-amount certificate company is an issuer, although it offers debt securities, because investors rely upon the company s assets (and the earnings on those assets) to provide the principal and interest guarantees under the certificates. ), withdrawn on other grounds, The Equitable Life Assurance Soc y of the United States, SEC No-Action Letter (Dec. 22, 1995). Cf. In the Matter of The Variable Annuity Ins. Co. of Am., 39 S.E.C. 680, 690 (Feb. 25, 1960) (Section 28 of the 1940 Act contains a scheme of protective regulation for unsecured debentures (i.e., face amount certificates) which may be issued to the public by [face-amount certificate companies] ). Investment Trusts and Investment Companies: Hearings on H.R Before a Subcomm. of the Comm. on Interstate and Foreign Commerce, House of Representatives, 76th Cong. 136 (June 13 and 14, 1940). Id.