SEC Division of Investment Management staff letter: Pengrowth Energy Trust

BillC'l'Ii}l};r .2 fa ) (2.l{ ) I Z. ('i.l.£t.2)j Cq ) (I) (C) IH..7J.,JIj 1Wt'YPT,IC I A~b:ryJ}.J1r.L1.:.f'J: 1 2.:7-/oD January 27, 2000 RESPONSE OF THE OFFICE OF cHffiFlXmNSEL'-~Our Ref. No. 00-6 DIVISION OF INVESTMENT MANAGEMENT Pengrowth Energy Trust By letter dated January 14, 2000, you request our assurance that we would not recommend that the Commission take any enforcement action under Section 7 ofthe 1 . Investment Company Act (the "1940 Act") ifPengrowth Energy Trust ("Energy Trust") treats its subsidiary, Pengrowth Corporation (the "Operating Company"), as a majority￾owned subsidiary for purposes of Section 3(a)(I)(C) under the 1940 Act and, therefore, does not register as an investment company. Facts The Pengrowth Group includes three Canadian entities: Pengrowth, an operating oil and gas company; Energy Trust, which finances the operating company; and a management company that provides managerial and administrative services (the "Management Company") to Pengrowth and Energy Trust. Energy Trust wishes to publicly offer its securities in the United States without registering as an investment company under the 1940 Act. ! Energy Trust finances the Operating Company by issuing and selling beneficial I interests ("Trust Units") and investing most ofthe proceeds in royalty units issued by the Operating Company. Each royalty unit represents the right to receive a pro-rata portion of99% of all royalty income, which is essentially the gross revenues ofthe Operating Company less costs, taxes and payments to a reserve. Energy Trust owns approximately 99.96% ofthe royalty units outstanding, and the royalty units constitute approximately 85% ofthe Energy Trust's assets. The Operating Company has issued 100 shares of common stock, all of which are owned by the Management Company. Pursuant to a Unanimous Shareholder Agreement dated December 2, 1988 (the "Voting Agreement"), however, the Management Company has transferred all ofits voting power with respect to the Operating Company to holders ofthe Trust Units and royalty units, except that the Management Company has retained the power to elect two ofthe Operating Company's five directors. In addition, the trustee ofEnergy Trust agreed in the Voting Agreement not to vote the royalty units that it holds. Each Trust Unit issued by Energy Trust carries one vote, and the Trust Unit holders have the power to elect three ofthe Operating Company's five directors, as well as to-decide all other matters regarding the Operating Company that are subject to shareholder votes. Telephone conversation between John K. Whelan ofCarter, Ledyard & Milburn and Martin Kimel ofthe staff on January 24, 2000. :":'~ ..'..".:' ,"" . .." .

2
" i
.'
"
Analysis
Section 3(a)(1)(C) ofthe 1940 Act defines an investment company as any issuer
that is engaged or proposes to engage in the business ofinvesting, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percent ofthe value ofsuch issuer's total assets. Section 3(a)(2) defines "investment securities" to include, in relevant part, all securities except·· those issued by majority-owned subsidiaries ofthe owner which (i) are not investment companies and (ii) are not relying on Section 3(c)(1) or Section 3(c)(7) ofthe 1940 Act.
Section 2(a)(24) defines "majority-owned subsidiary" of a person as a company 50
percent or more ofthe outstanding voting securities of which are owned by such person or by a company which is a majority-owned subsidiary ofsuch person, Section 2(a)(42) defines "voting security" to mean, in pertinent part, any security presently entitling the owner or holder thereofto vote for the election of directors of a company. In Farley, Inc. (pub. avail. Apr. 15, 1988), we stated that we would not recommend enforcement action to the Commission if a company treated its subsidiary, Fruit ofthe Loom, Inc., as a majority-owned subsidiary, and therefore did not register as an investment company. 2 The company represented that, even though it would own less than 50 percent ofthe voting power to elect directors ofFruit ofthe Loom, it would, through a voting agreement with another large shareholder of Fruit ofthe Loom, have voting control ofthe subsidiary. Based on Farley, you argue that if Energy Trust had the voting power to elect a majority ofthe bo.ard of directors ofthe Operating Company, then the Operating Company would be deemed a majority-owned subsidiary ofEnergy Trust under Section 2(a)(24). You further argue that, as a result, Energy Trust would not be an investment company within the meaning of Section 3(a)(I)(C) because approximately 85 percent of . its assets would not be investment securities. You contend that the same result would obtain if voting control ofthe Operating Company were held not by Energy Trust itself, but by its owners -- that is, by the owners ofthe Trust Units. You argue that Section 3(a)(1)(C) is designed to exclude from the definition of "investment company" operating companies in which the investors have the power to elect directors who will, on their behalf, direct the management ofthe enterprise. You suggest that, under the circumstances presented, investors in Energy Trust are essentially investing in the Operating Company, and that treating the Operating Company as a majority-owned subsidiary ofEnergy Trust, and not treating Energy Trust Farley relied on Section 3(a)(3), the precursor of Section 3(a)(1)(C). For purposes ofthis letter, there are no material differences between Section 3(a)(1)(C) and its precursor. 2

\
) as an investment company for purposes of Section 3(a)(1)(C), therefore would be consistent with the purpose ofthe provision. Without necessarily agreeing with your legal analysis, we would not recommend any enforcement action ifEnergy Trust treats the Operating Company as a majority￾owned subsidiary for purposes of calculating the 40 percent test in Section 3(a)(I)(C) of the 1940 Act. Please note that this position is based on the facts and representatiops set forth in your letter, particularly that: (1) Energy Trust owns at least 99% ofthe outstanding royalty units, with such royalty units constituting approximately 85% of Energy Trust's assets; (2) effectively all the voting authority with respect to all matters, except the authority to elect a minority ofthe directors ofthe Operating Company, resides with the owners ofthe Trust Units (that is, with the owners ofEnergy Trust); and (3) the owners ofEnergy Trust will hold such voting authority in proportion to their ownership interests in Energy Trust. Any different facts or representations may require a different conclusion. Further, this response expresses the Division's position on enforcement action only and does not purport to express any legal or interpretive conclusion on the questions presented. 3

CARTER, LEDYARD & MILBURN
Counsellors at Law
2 Wall Street
New York, NY 10005-2072
570 wington Avenue
New York, NY 10022
(212) 371·2720
Tel (2/2) 732-3200
Fax (212) 732-3232
1350 1Street, N. W.
Washingtoll, DC 20005
(202) 898-1515
1940 Act/2(a)(24), 2(a)42, 3(a)1, 3(a)(2)
January 14,2000
Douglas J. Scheidt, Esq.
ChiefCounsel
Division ofInvestment Management
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re: Pengrowth Energy Trust
Dear Mr. Scheidt:
We represent Pengrowth Energy Trust (the "TrUst"), an Alberta, Canada trust that is the financing arm of a Canadian operating oil and gas company. We hereby request on behalf ofthe Trust your advice that the staff ofthe Division of Investment Management (the "Staff') will not recommend that the Securities and Exchange Commission (the "Commission") take enforcement act!~n under the Investment Company Act of 1940, as amended (the "Act"), ifthe Trust were to conduct public offerings ofits securities in the United States without registering as an investment company under the Act. Facts Structure The Pengrowth group of entities, with an asset base in excess of $800 million CDN (approximately $553 million U.S.), includes an operating oil and gas company, the Trust (which finances the operating company), and a management company that provides advisory, management and administrative services to the other two entities. 924801·5

Pengrowth Corporation (the "Operating Company") is an Alberta corporation, incorporated in 1987. It is engaged in the business of acquiring, owning and managing working interests and royalty interests in petroleum and natural gas properties, including tangible facilities such as pipelines, plants and equipment associated with production. The Trust was created pursuant to a Trust Indenture dated December 2, 1988, as amended, between the Operating Company and Montreal Trust Company ofCanada. It finances the Operating Company by issuing and selling beneficial interests ("Trust Units") and investing most of the proceeds in royalty units ("Royalty Units") issued by the Operating Company. The Royalty Units are issued pursuant to a Royalty Indenture dated as ofDecember 2, 1988, as amended, between the Operating Company and Montreal Trust Company ofCanada. Each Royalty Unit represents the right to receive a pro-rata portion of 99% of aU "Royalty Income," which is essentially gross revenues ofthe Operating Company, less costs (including debt service), taxes and payments to a reserve. The Trust owns approximately 99.96% ofthe Royalty Units outstanding, and such Royalty Units constitute approximately 85% ofthe Trust's assets and revenues. In addition to Royalty Units, the Trust owns real property consisting of oil and gas processing facilities which were acquired from the Operating Company in 1998 in a sale and leaseback transaction. Such facilities were transferred from the Operating Company to the Trust to reduce the level of pennanent indebtedness associated with holding the facilities in the Operating Company and to capture additional tax deductions for Unitholders ofthe Trust in the fonn ofcapital cost allowance which would otherwise be held captive-in the Operating Company. These processing facilities constitute approximately 15% ofthe assets and revenues ofthe Trust. As with the assets and revenues ofany oil and gas enterprise, the relative percentage ofthe Trust's assets and revenues attributable to the Royalty Units and processing facilities will fluctuate depending on the current market prices for oil and gas. Under the Trust Indenture, the Trust may also acquire securities of issuers other than the Operating Company. The Board of Directors of the Operating Company has restricted these purehases to securities ofissuers whose oil and gas properties are attractive acquisition candidates. As of December 31, 1998, such securities of other issuers consisted of marketable secwities representing less than 0.4% ofthe Trust's total assets. - - Pengrowth Management Limited (the "Management Company" and, together with the Trust and the Operating Company, the "Pengrowth Group") is an Alberta corporation which, pursuant to the provisions of an agreement (the "Management Agreement") dated as ofApril 29, 1997, among it, the Operating Company and the Trust, provides advisory, management and administrative services exclusively to the Operating Company and the
Trust, advising them with respect to the acquisition, development, administration, operation and disposition ofoil and natural gas properties and other related assets. 924801-5 -2-

. j
Voting Rights
The Operating Company has issued and outstanding 100 common shares, all ofwhich are ov.ned by the Management Company. Mr. James Kirmear, a Director and the Chief Executive Officer ofthe Operating Company and the Management Company, is the beneficial owner of96% of the issued capital of the Management Company, the remaining 4% being owned by another Director ofthe Management Company. All voting rights with respect to the Operating Company are governed by the terms of a Unanimous Shareholder Agreement dated as ofDecember 2, 1988 (the "Voting Agreement"). Pursuant to the Voting Agreement: (a) holders of Trust Units and holders ofRoyalty Units are entitled to one vote per Trust Unit and Royalty Unit held by them on any matter put before the shareholders of the Operating Company; (b) the Trustee of the Trust agrees, however, that itshall have no voting rights in respect ofthe Royalty Units held by the Trust, and that all such rights shall be exercised solely by the holders of Trust Units; and (c) the Management Company agrees that it shall have no voting rights with respect to the Operating Company except, for so long as the Management Company is a party to the Management Agreement, the right to elect 2 out ofthe 5 directors ofthe Operating Company. As a result, voting power with respect to the Operating Company is vested solely in the holders ofTrust Units and Royalty Units, subject only to the right ofthe Management Company to elect 2 out ofthe total of 5 directors. As of October 29, 1999, there were outstanding '55,610,379 Trust Units (each representing an equal beneficial interest in the Trust) and 18,940 Royalty Units entitled to vote at the meetings ofshareholders ofthe Operating Company, so that effectively, holders ofTrust Units had 99.96% of the voting power of the Operating Company, subject only to the right of the Management Company to elect 2 out of5 directors.· The owners ofthe Trust hold voting authority in the Operating Company in proportion to their interests in the Trust. Tax Advantages The Pengrowth Group was organized to provide an efficient Canadian tax mechanism for the distribution of net oil and gas revenues to its investors in a way that could not be achieved by a direct investment in common shares of the Operating Company. Conventional oil and gas companies typically reinvest substantially all oftheir cash flow to fund continuing exploration and development activities. To the extent that these companies make dividend payments to Canadian resident investors, those dividend payments Will be taxable in the hands ofthe investors and are not deductible by the company. Income retained within these companies will be taxable but can be sheltered by offsetting the income against tax pools created through the acquisition of petroleum

• We acknowledge the possibility that the percentage of the voting power of the Trust
  Unitholders could be reduced by the issuance by the Operating Company to persons other than the Trust of additional Royalty Units. The Trust understands that this letter is predicated on the assumption that the Trust Unitholders will always have at least 99% ofthe voting power ofthe Operating Company. 924801·5 -3-

properties, through the conduct of development and exploration activities or through the existing resource allowance and other permitted deductions. The structUre ofthe Pengrowth Group effectively moves certain tax pools from the Operating Company to the Trust, where they are offset against distributions made to holders ofTrust Units. The tax sheltered portion ofthe distributions is considered to be a return of capital. The sheltered (or reduced capital loss) distributions are not currently taxable but are recaptured in the form of additional capital gains on the ultimate sale by the investor ofthe Trust Units. The return ofcapital treatment on a portion of the distributions to Trust Unitholders and the deductibility of Royalty payments by the Operating Company are features which could not be accomplished through the direct payment ofdividends by the Operating Company. Obiectives Value creation for investors in the Pengrowth Group has been accomplished through active management ofapproximately 40 separate asset acquisitions over the past ten years and the conduct ofefficient operations on an increasingly high percentage ofproperties. Management believes that there are and will continue to be attractive opportunities for the Pengrowth Group to acquire additional significant oil and gas assets. Acquisitions will require funding generated by the sale of additional Trust Units, and Management is seeking the ability to access the United States capital markets by way of a public offering for that purpose. If, however, the Trust were deemed to be an "investment company" under the Act, it would be effectively prohibited by Section 7(d) ofthe Act from making a public offering ofTrust Units in the United States. Legal Analysis The Trust is not an investment company within the intendment ofSection 3(a)(l)(A) ofthe Act. However, Royalty Units issued by the Operating Company constitute more than 40% in value ofthe Trust'stotal assets and, ifthey were "investment securities" as defined in Section 3(a)(2), the Trust would be an investment company within the meaning ofSection 3(a)(1)(C). Section 3(a)(2) excludes from the definition of "investment securities" securities ofmajority-owned subsidiaries that are operating companies, and the Operatirig Company should be deemed to be a majority-owned subsidiary ofthe Trust. Hence, since the Trust does not own or propose to acquire investment securities exceeding 40% ofthe value ofits total assets, it is not an investment company. Discussion
Section 3(a)(1)(C) of the Act defines investment company to include any issuer which is
engaged or proposes to engage in the business ofinvesting, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum ofthe value ofsuch issuer'stotal assets (exclusive ofGovernment securities and cash items) 924801-5 -4-

., "" , on an Wlconsolidated basis. Section 3(a)(2) defines "investment securities" to include, among other things, all securities except securities issued by majority-owned subsidiaries ofthe owner which (i) are not investment companies and (ii) are not relying on the exception from the definition of investment company in Section 3(c)(l) or 3(c)(7) ofthe Act. Section 2(a)(24) defines "majority￾owned subsidiary" of a person as a company 50 per centum or more of the outstanding voting securities ofwhich are owned by such person or by a company which is a majority-owned subsidiary ofsuch person. Section 2(a)(42) defines "votingsecurity" to mean, in pertinent part, any security presently entitling the owner or holder thereofto vote for the election ofdirectors ofa company. It is clear, reading Sections 2(a)(24) and 2(a)(42) together, that a majority-owned subsidiary is defined with reference to the ability to elect a majority of its board of directors. This voting control need not be held by reason ofthe ownership ofsecurities; rather it may arise under a voting agreement. In Farley, Inc., 1988 WL 234210 (S.E.C.), a holding company proposed to transfer securities ofits majority-owned operating subsidiary to the controlling shareholder ofthe holding company, so that following the transfer the holding company would own less than 50% ofthe voting securities ofthe operating subsidiary. The holding company and its controlling shareholder executed a voting agreement which provided that so long as the controlling shareholder owned any voting securities ofthe operating subsidiary such securities would be voted by the holding company. In the incoming letter counsel pointed out that the Section 2(a)(24) definition ofmajority-owned subsidiary clearly permits upward aggregation (Le., ownership by a majority-owned subsidiary is attributed to its parent) and asserted that downward aggregation (ownership by the parent being attributed to its majority-owned subsidiary) should also be permitted. The Staff took a no-action position, agreeing that based on these facts, the operating subsidiary may be treated as a majority-owned subsidiary ofthe holding company for purposes ofSection 3(a)(l)(C) ofthe Act. Based on the foregoing, it is clear that, in the case ofthe Pengrowth Group, ifthe Trust had the voting power to elect a majority of the board of directors of ,the Operating Company, the Operating Company would be a majority-owned subsidiary ofthe Trust, the Royalty Units ofthe Operating Company owned by the Trust would not be investment securities and, therefore, the Trust would not be an investment company within the meaning of Section 3(a)(l)(C) ofthe Act We believe that the fact that the holders ofTrust Units rather than the Trust itselfhave the power to elect a majority ofthe board of directors ofthe Operating Company should not change this result. If anything, having the voting power directly in the hands ofthe Trust Unitholders, rather than.in the Trustee, is
actually a clearer case ofoperational control by the Trust Unitholders as equity investors. It is perfectly consistent with the purpose and the spirit ofthe Act to permit downward aggregation, so that the voting rights ofthe Trust Unitholders Wlder the Voting Agreement are attributed to the Trust, with the result that the Operating Company is a majority-owned subsidiary ofthe Trust and its securities (Royalty Units) owned by the Trust are not investment securities. 924801-5 -5-

It is fundamentally sound to conclude that, under the definitional sections ofthe Act, the Operating Company is a majority-owned subsidiary ofthe Trust. Section 3(a)(1)(C) is designed to exclude from its coverage operating enterprises in which the investors have the power to elect the directors who will, on their behalf, direct the management ofthe business in which they have chosen to invest. This is precisely the situation with the Pengrowth Group. The fact that the form ofthe enterprise is not ofthe conventional corporate parent-subsidiary nature should not detract from its substance as an operating oil and gas enterprise that is structured to provide tax advantages for its investors and that is managed by a board ofdirectors whose majority is investor-elected. Conclusion Based on the foregoing, we respectfully request that the Staff confirm that it will not recommend that the Commission take any enforcement action under the Act ifthe Trust were to make public offerings in the United States without registering as an investment company under the Act. In accordance with Release No. IC-6330, seven additional copies ofthis letter are enclosed. Please call John K. Whelan at (212) 238-8810 or Steven A. Meetre at (212) 238-8673 ifwe may be of assistance to you in connection with this request. Very truly yours, ) JKW:ma Enclosures 924801-5 -6-

TO:
FROM:
DATE:
MEMORANDUM:
2 (a) (24) File
Stephan N. Packs
July 16, 1998
~::~o~·{iiU'7l:~:: RULE == ::
:~~~BILlTY zt!?};.;:rt:;1U~
SUBJECT: Majority Owned Subsidiary
Elizabeth Krentzman of Deloitte &Touche asked whether a 50% owned entity constitutes a majority owned subsidiary under Section 3 of the Investment Company Act of 1940.
Section 2(a) (24) of the Act says:
"Majority-owned subsidiary" of a person means a company 50 per centum or more of the outstanding voting securities of which are owned by such person, or by a company which, within the meaning of this paragraph, 1 is a majority-owned subsidiary of such person. I found no Commission or staff positions on point. On June 11, I told Krentzman that we agreed that, at least for purposes of Section 3, a 50% owned entity could be considtred to be a majority owned subsidiary under Section 2(a) (24). 1 This definition is the same as in the original Act. 2 It should be noted that this interpretation of majority￾owned subsidiary is not consistent with various accounting rules and principles. For example, the definition of majority-owned subsidiary in Regulation S-X requires ownership of more than 50% of the outstanding voting shares. See Reg. § 210.1-02(n). Additionally, it conflicts with Statement of Financial Accounting Standards No. 94 regarding consolidation of financial statements of majority-owned subsidiaries, which is required when there is ownership of over 50% of the outstanding shares of another company. See November 7, 1997 Investment Management letter to Chief Financial Officers.