[Federal Register: June 20, 2003 (Volume 68, Number 119)]
[Rules and Regulations]
[Page 37045-37053]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr20jn03-32]
[[Page 37045]]
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Part II
Securities and Exchange Commission
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17 CFR Part 270
Certain Research and Development Companies; Final Rule
[[Page 37046]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release No. IC-26077; File No. S7-47-02]
RIN 3235-AI57
Certain Research and Development Companies
AGENCY: Securities and Exchange Commission (``Commission'').
ACTION: Final rule.
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SUMMARY: The Commission is adopting a new rule under the Investment
Company Act of 1940 that provides a nonexclusive safe harbor from the
definition of investment company for certain bona fide research and
development companies.
EFFECTIVE DATE: The rule will become effective on August 19, 2003.
FOR FURTHER INFORMATION CONTACT: Karen L. Goldstein, Senior Counsel,
Janet M. Grossnickle, Branch Chief, or Nadya B. Roytblat, Assistant
Director, at (202) 942-0564, Office of Investment Company Regulation,
Division of Investment Management, Securities and Exchange Commission,
450 Fifth Street, NW., Washington, DC 20549-0506.
SUPPLEMENTARY INFORMATION: The Commission is adopting new rule 3a-8 [17
CFR 270.3a-8] under the Investment Company Act of 1940 [15 U.S.C. 80a]
(the ``Act'').\1\
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\1\ Unless otherwise noted, when we refer to rule 3a-8, or any
paragraph of the rule, we are referring to 17 CFR 270.3a-8 of the
Code of Federal Regulations in which the rule is published, as
adopted by this release.
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Executive Summary
Research and development companies (``R&D companies'') often raise
large amounts of capital, invest the proceeds and use the principal and
return on these investments to fund their operations during their
lengthy product development phase. An R&D company also may purchase a
non-controlling equity stake in another company as part of a strategic
alliance to conduct research and develop products jointly. Either of
these activities may cause an R&D company to fall within the definition
of an investment company under the Act. In 1993, a Commission order
issued to ICOS Corporation, a biotechnology company, addressed how to
determine the status of an R&D company under the Act (the ``ICOS
Order'').\2\
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\2\ ICOS Corp., Investment Company Act Release Nos. 19274 (Feb.
18, 1993) [58 FR 11426 (Feb. 25, 1993)] (notice) and 19334 (Mar. 16,
1993) [58 FR 15392 (Mar. 22, 1993)] (order).
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Late last year, the Commission issued a release proposing rule 3a-8
(``Proposing Release'') to update and codify the terms of the ICOS
Order.\3\ The proposed rule was designed to provide R&D companies with
greater flexibility to raise and invest capital pending its use in
research, development and other operations. The proposed rule also
sought to clarify the extent to which an R&D company relying on the
rule may make investments in other R&D companies pursuant to
collaborative research and development arrangements. The commenters on
the Proposing Release generally supported the proposed rule. Today the
Commission is adopting rule 3a-8 as a nonexclusive safe harbor from
investment company status for certain bona fide R&D companies.\4\
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\3\ See Certain Research and Development Companies, Investment
Company Act Release No. 25835 (Nov. 26, 2002) [67 FR 71915 (Dec. 3,
2002)]. The Commission initially proposed rule 3a-8 in 1993. See
Certain Research and Development Companies, Investment Company Act
Release No. 19566 (July 9, 1993) [58 FR 38095 (July 15, 1993)], but
later withdrew it from the Commission's agenda. Regulatory
Flexibility Agenda, Investment Company Act Release No. 21795 (Mar.
4, 1996) [61 FR 24066 (May 13, 1996)].
\4\ The Commission notes that any company that meets the
requirements of the rule we adopt today may rely on its nonexclusive
safe harbor, regardless of whether the company is primarily engaged
in research and development activities or in some other non-
investment business.
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I. Background
A. Definition of Investment Company
Section 3(a) of the Act has two definitions of investment company
that may be relevant to R&D companies.\5\ Section 3(a)(1)(A) of the Act
defines an investment company as any issuer that is, holds itself out
as, or proposes to be engaged primarily in the business of investing,
reinvesting, or trading in securities.\6\ Section 3(a)(1)(C) of the Act
defines an 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 that owns or proposes to acquire
investment securities having a value exceeding forty percent of the
value of the company's total assets on an unconsolidated basis
(exclusive of Government securities and cash items).\7\ An issuer that
meets the definition of investment company in section 3(a)(1)(C) of the
Act nevertheless may be deemed not to be an investment company under
two provisions in section 3(b) of the Act.
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\5\ A third definition, contained in section 3(a)(1)(B) of the
Act [15 U.S.C. 80a-3(a)(1)(B)], defines an investment company to
include companies that issue face-amount certificates of the
installment type and is not relevant for purposes of this release.
\6\ 15 U.S.C. 80a-3(a)(1)(A).
\7\ 15 U.S.C. 80a-3(a)(1)(C). Section 3(a)(2) of the Act
generally defines ``investment securities'' to include all
securities except Government securities, securities issued by
employees' securities companies, and securities issued by majority-
owned subsidiaries of the owner which are not investment companies.
15 U.S.C. 80a-3(a)(2).
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Section 3(b)(1) of the Act provides a self-executing exclusion from
the definition of investment company for a company primarily engaged,
directly or through wholly-owned subsidiaries, in a non-investment
business.\8\ Section 3(b)(2) of the Act allows a company that falls
within the definition of investment company in section 3(a)(1)(C) of
the Act to apply to the Commission for an order. Pursuant to section
3(b)(2), the Commission, upon application by the company, may find and
by order declare the company to be primarily engaged (directly, or
through majority-owned subsidiaries or through controlled companies
conducting similar types of businesses) in a business other than that
of investing, reinvesting, owning, holding or trading in securities.\9\
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\8\ 15 U.S.C. 80a-3(b)(1).
\9\ 15 U.S.C. 80a-3(b)(2). A determination under either section
3(b)(2) or section 3(b)(1) of the Act that an issuer is engaged
primarily in a non-investment business also means that it is not an
investment company under section 3(a)(1)(A) of the Act. See M.A.
Hanna Co., 10 S.E.C. 581 (1941).
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When the Commission determines whether a company is primarily
engaged in a non-investment business pursuant to section 3(b)(2), it
looks principally at the composition of the company's assets and the
sources of its income, and also considers the company's historical
development, its public representations and the activities of its
officers and directors.\10\ These factors also are used to determine
whether a company satisfies the primary business test under section
3(b)(1) of the Act.\11\
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\10\ See Tonopah Mining Co., 26 S.E.C. 426 (1947).
\11\ For a more detailed discussion of the relevant provisions
of the Act and Commission rules, see Proposing Release, supra note
3, at II.A.
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B. Research and Development Companies
When applied to R&D companies, the asset and income factors of the
traditional primary business test may not appropriately reflect these
companies' non-investment business. R&D companies, such as
biotechnology companies, frequently require large amounts of capital to
fund lengthy periods of research and development, the results of which
may not produce income for years. R&D companies also may enter into
strategic alliances for joint research and development that include the
purchase of non-controlling
[[Page 37047]]
investments in their partners. These non-controlling investments and
many of the instruments in which R&D companies invest their capital are
investment securities counted toward the forty percent asset test under
section 3(a)(1)(C) of the Act. Moreover, research and development
expenses and any resulting ``intellectual capital,'' are not recognized
as assets on balance sheets prepared in accordance with Generally
Accepted Accounting Principles (``GAAP''). Thus, R&D companies may have
few assets other than investment securities and little operating
income, which may cause them both to fall within the definition of
investment company and to be ineligible for an exclusion using the
traditional primary business test.\12\
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\12\ For a more detailed discussion of the nature of R&D
companies' activities, see Proposing Release, supra note 3, at II.B.
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The Commission recognized the unique nature of R&D companies when
it issued the ICOS Order in 1993. In the ICOS Order, the Commission set
forth an alternative test for determining the primary business of an
R&D company under sections 3(b)(1) and 3(b)(2) of the Act that was
based upon how the company uses its income and assets, instead of their
sources and composition. Under the ICOS Order, this status
determination focuses on three factors: (1) Whether the company uses
its securities and cash to finance its research and development
activities; (2) whether the company has substantial research and
development expenses and insignificant investment-related expenses; and
(3) whether the company invests in securities in a manner that is
consistent with the preservation of its assets until needed to finance
operations. If a company satisfies these factors, the remaining factors
of the traditional primary business test--the company's historical
development, its public representations of policy, and the activities
of its officers and directors--are examined.\13\
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\13\ See supra note 2. For a more detailed discussion of the
analysis set forth in the ICOS Order, see Proposing Release, supra
note 3, at II.C.
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C. The Proposing Release
On November 26, 2002, the Commission issued the Proposing Release
proposing rule 3a-8 to update and codify the analysis set forth in the
ICOS Order.\14\ Under the proposed rule, an R&D company would be deemed
not to be an investment company under sections 3(a)(1)(A) and
3(a)(1)(C) of the Act if it met certain requirements designed to
demonstrate the company's engagement in a non-investment business. The
proposal sought to ensure that bona fide R&D companies do not
inadvertently fall within the definition of investment company, while
also making sure that investors in companies that are primarily engaged
in the investment business receive the protections afforded them under
the Act.
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\14\ Rule 3a-8 was proposed, in part, in response to a petition
from the Biotechnology Industry Organization (``BIO'') to the
Commission for rulemaking to modernize and clarify the analysis set
forth in the ICOS Order. Petition for Investment Company Act of 1940
Rulemaking, submitted by Matthew A. Chambers and John C. Nagel,
Wilmer, Cutler & Pickering, on behalf of the Biotechnology Industry
Organization, File No. 4-457 (May 23, 2002) (``BIO Petition''). For
a more detailed discussion of the BIO Petition, see Proposing
Release, supra note 3, at II.D.
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Under rule 3a-8 as proposed, a company could rely on the rule's
nonexclusive safe harbor if it: (a) Had research and development
expenses that were a substantial percentage of its total expenses for
its last four fiscal quarters combined and that equaled at least half
of its investment revenues for that period; (b) had investment-related
expenses that did not exceed five percent of its total expenses for its
last four fiscal quarters combined; (c) made its investments to
conserve capital and liquidity until it used the funds in its primary
business; and (d) was primarily engaged, directly or through a company
or companies that it controls primarily, in a noninvestment business,
as evidenced by the activities of its officers, directors and
employees, its public representations of policies, and its historical
development.\15\
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\15\ See Proposing Release, supra note 3.
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The Commission received six comment letters on the Proposing
Release.\16\ The commenters generally supported the proposed rule, but
suggested certain changes to and clarifications of several of the
proposed rule's provisions. Today we are adopting rule 3a-8
substantially as proposed, with certain changes that respond to the
issues raised by the commenters.\17\
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\16\ The comment letters came from five commenters (one of the
commenters submitted an initial letter and a subsequent letter
discussing issues raised by another commenter). The comment letters
are available for public inspection and copying in the Commission's
Public Reference Room, 450 5th Street, NW., Washington, DC (File No.
S7-47-02).
\17\ We note that the adoption of rule 3a-8 is not intended to
preclude R&D companies from using the test set forth in the ICOS
Order under section 3(b)(1) of the Act. Any company that wishes to
determine its status under the Act in accordance with the ICOS Order
may continue to do so.
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II. Discussion
A. Substantial Research and Development Expenses
To qualify for the nonexclusive safe harbor from investment company
status, proposed rule 3a-8 required that a company's research and
development expenses, for the last four fiscal quarters combined,
constitute a substantial percentage of its total expenses for the same
period. In the Proposing Release, the Commission stated that it
proposed leaving the term ``substantial'' undefined in order to allow
R&D companies to take into account fluctuations in the composition of
their expenses over time, but requested comment on this approach.\18\
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\18\ See Proposing Release, supra note 3, at III.A.1.
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Two commenters agreed that leaving the term ``substantial''
undefined provides R&D companies the flexibility to accommodate
variations in expenses and fluctuations in research and development
budgets over time, and that an objective standard would be
unnecessarily restrictive. One commenter, however, stated that without
an objective standard, the rule potentially could allow companies
primarily engaged in the investment business to escape regulation under
the Act. This commenter suggested requiring a company's research and
development expenses to constitute a majority of its total expenses.
The Commission is sensitive to the concerns of excluding companies
from the Act that should be subject to its requirements, but notes that
the approach of the proposed rule is consistent with the ICOS Order.
That approach has been used by R&D companies for over ten years to
determine their status under the Act. In light of that fact and the
other safeguards contained in the rule, the Commission believes that
the approach of the proposed rule would provide the necessary
flexibility without jeopardizing investor protection.\19\ Therefore,
the Commission is adopting this provision as proposed.\20\
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\19\ While research and development expenses that constitute a
majority of a company's total expenses certainly would be considered
substantial, we note that there are circumstances when research and
development expenses that constitute less than a majority of the
company's total expenses, notwithstanding nonrecurring items or
unusual fluctuations in recurring items, also may be considered
substantial.
\20\ Rule 3a-8(a)(1).
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B. Net Income from Investments
Rule 3a-8 as proposed also required that an R&D company's
``revenues from investments in securities'' not exceed twice the amount
of its research and
[[Page 37048]]
development expenses.\21\ The Commission explained in the Proposing
Release that this requirement would allow R&D companies to meet their
increased capital needs by raising and holding more capital than
currently permitted under the ICOS Order, while ensuring that an R&D
company's primary focus remains funding its research and development
activities, rather than generating revenue from its investments.\22\
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\21\ Proposed rule 3a-8 defined ``investments in securities'' to
include all securities owned by the R&D company other than
securities issued by majority-owned subsidiaries and companies
controlled primarily by the R&D company that conducts similar types
of businesses, through which the R&D company is engaged primarily in
a business other than that of investing, reinvesting, owning,
holding, or trading in securities.
\22\ See Proposing Release, supra note 3, at III.A.2
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All of the commenters generally supported this provision. One
commenter suggested that the phrase ``revenues from investments'' is
ambiguous and that the phrase ``net income,'' which would parallel a
provision in rule 3a-1 under the Act, may be more clear and
appropriate.\23\ The Commission agrees. Rule 3a-8 as adopted today,
therefore, uses the term ``net income,'' and the Commission intends
that it be interpreted for purposes of this rule consistently with rule
3a-1 under the Act.\24\
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\23\ Rule 3a-1 under the Act, adopted in 1981 as a nonexclusive
safe harbor from investment company status, codified a series of
Commission orders issued under section 3(b)(2) of the Act. 17 CFR
270.3a-1
\24\ Rule 3a-8(a)(2).
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C. Insignificant Investment-Related Expenses
Rule 3a-8 as proposed required that an R&D company relying on the
nonexclusive safe harbor devote no more than five percent of its total
expenses for its last four fiscal quarters combined to investment
advisory and management activities, investment research and selection,
and supervisory and custodial fees.\25\ The commenters supported this
provision, and the Commission is adopting it as proposed.\26\
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\25\ See 17 CFR 210.6-07.2(a) (Regulation S-X). We note that the
investment-related expenses that are subject to the five percent
limit would include any investment advisory fees paid to an outside
adviser.
\26\ Rule 3a-8(a)(3).
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D. Investments in Securities
1. Capital Preservation Investments
i. Definition
To qualify for the nonexclusive safe harbor under rule 3a-8 as
proposed, an R&D company's investments in securities were required to
be capital preservation investments, subject to two exceptions for
``other investments,'' discussed below. The proposed rule defined
``capital preservation investments'' as investments made to conserve an
R&D company's capital and liquidity until the funds are used in its
primary business or businesses. The Proposing Release stated that, in
general, capital preservation investments are liquid so that they can
be readily sold to support the R&D company's research and development
activities as necessary and present limited credit risk.\27\
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\27\ Proposing Release, supra note 3, at III.A.4.a.
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One commenter suggested that the Commission provide additional
guidance concerning capital preservation investments to prevent
companies from considering speculative investments to be capital
preservation investments. We note that, in the ICOS Order, the
Commission stated that ``[s]ignificant investments in equity or
speculative debt would indicate that the company is acting as an
investment company rather than preserving its capital for research and
development.'' \28\ Similarly, under rule 3a-8 as proposed, investments
in equity or speculative debt would not meet the definition of capital
preservation investments, but would be considered ``other investments''
subject to the limits set forth in the rule.
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\28\ See the ICOS order, supra note 2, at II.C.
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One commenter suggested that capital preservation investments be
defined using specific objective standards for credit quality, maturity
and liquidity to minimize the risk that an R&D company would purchase
speculative investments. Another commenter opposed this recommendation
as unnecessary and one that would introduce undue complexity into the
rule.
We believe that attempting to specify such objective criteria would
render the rule unnecessarily complex and inflexible. Moreover, we
continue to believe that the approach we proposed is appropriate given
the variety of circumstances that an R&D company may face.\29\
Therefore, we are adopting the definition of capital preservation
investments as proposed.\30\ Our adopted definition is consistent with
the ICOS Order, which has been applied as a standard to determine the
status of R&D companies under the Act for over ten years.\31\
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\29\ For example, we would expect the portfolio of an R&D
company whose products require, on average, an additional eight
years to develop to differ from the portfolio of another R&D company
whose products are expected, on average, to be ready in two years,
even though both companies would be investing with the goal of
preserving capital and liquidity.
\30\ Rule 3a-8(b)(4).
\31\ One commenter requested clarification that the statement in
the Proposing Release that capital preservation investments
``present limited credit risk'' would be interpreted consistently
with the ICOS order. We did not intend a different meaning. We note,
however, that the ICOS order required an R&D company's portfolio,
taken as a whole, to present limited credit risk. Under rule 3a-8,
each investment is evaluated separately and categorized as either a
capital preservation investment or another investment; each capital
preservation investment must present limited credit risk.
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ii. Board-Approved Policy
The Proposing Release requested comment on whether rule 3a-8 should
require the board of directors of the R&D company to adopt investment
guidelines designed to assure that the company's funds are invested
consistent with the goals of capital preservation and liquidity.\32\
Two commenters addressed this issue, and both supported such a
requirement. Since rule 3a-8 would give R&D companies greater
flexibility to raise and invest capital, we believe that requiring the
boards of directors of R&D companies seeking to rely on the
nonexclusive safe harbor to focus on how their companies invest their
capital would enhance investor protection.\33\ Accordingly, the
Commission is adopting rule 3a-8 with this requirement.\34\
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\32\ Proposing Release, supra note 3, at III.A.4.a.
\33\ We also believe that this requirement may enhancd an R&D
company's ability to monitor its compliance with the requirements of
the rule that relate to its investments in securities.
\34\ Rule 3a-8(A)(7).
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2. ``Other Investments''
As discussed in greater detail in the Proposing Release, companies
increasingly are collaborating with other companies to conduct joint
research and development, and it is not uncommon for an R&D company to
seek to acquire a non-controlling interest in securities of another
company pursuant to such a collaborative arrangement (a ``strategic
investment'').\35\ Proposed rule 3a-8 sought both to clarify the extent
to which an R&D company relying on the nonexclusive safe harbor may
make investments other than capital preservation investments, and
specifically to reflect the increased use of collaborative
relationships to conduct research and development.
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\35\ See Proposing Release, supra note 3, at III.A.4.b.
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As proposed, rule 3a-8 allowed an R&D company to make investments
other than capital preservation investments (``other investments'') to
a limited extent. In setting the limits, the proposed rule
distinguished between investments made pursuant to a
[[Page 37049]]
collaborative research and development arrangement and other
investments that are not made to preserve capital and liquidity. As
proposed, rule 3a-8 permitted an R&D company to acquire investments
that are not capital preservation investments if, immediately after the
acquisition, no more than 10 percent of the company's total assets
consisted of other investments or no more than 20 percent of the
company's total assets consisted of other investmens so long as at
least 75 percent of those investments were made pursuant to
collaborative research and development arrangements. The Proposing
Release also explained that the Commission intended that the proposed
rule's limits on other investments would be calculated at the time
other investments are acquired.\36\
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\36\ See id.
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The Proposing Release requested comment on the proposed limits.\37\
We also requested comment on whether the percentage limits should be
applicable at any time, rather than being calculated only at the time
other investments are acquired.\38\ The commenters that addressed these
issues all suggested that we make the limits applicable at all times
and that we raise the applicable percentage limit when at least 75
percent of the R&D company's other investments were made pursuant to
collaborative research and development arrangements.
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\37\ See id.
\38\ See id.
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Specifically, two commenters expressed concern that the rule as
proposed could be interpreted to require the R&D company to determine
its compliance with the percentage limits at the time of every
acquisition it ever made, including acquisitions made years prior to
relying on the rule.\39\ These commenters also recommended raising the
20 percent limit to 30 percent. Another commenter suggested that
compliance with the percentage limits should be required at all times
to avoid the possibility that the value of an R&D company's other
investments could greatly exceed the value of its capital preservation
investments and its primary business. This commenter also suggested
increasing the 20 percent limit to 25 percent.
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\39\ One of these commenters responded to a request for
clarification from members of the Commission staff concerning its
comment on this issue made in its comment letter. These discussions
are summarized in a memorandum available in the public file. See
supra note 16.
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The Commission agrees that it would enhance investor protection if
the percentage limits were applicable at all times that an R&D company
seeks to rely on the rule. We also note that this approach is
consistent with the way both the Act and the Commission have formulated
asset tests for purposes of determining a company's status under the
Act.\40\ We also believe that it would be more appropriate to address
our concerns about market fluctuations in the value of investments made
pursuant to collaborative research and development arrangements by
raising the applicable percentage limit.
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\40\ See, e.g., 15 U.S.C. 80a-3(a); 17 CFR 270.3a-1; and the
ICOS Order, supra note 2.
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Although specifically requested in the Proposing Release,\41\ the
commenters that recommended raising the 20 percent limit 30 percent did
not provide any information or data to support their request and to
demonstrate the need for R&D companies to include a non-controlling
investment as a part of a collaborative research and development
arrangement. The Commission continues to be concerned that non-
controlling investments constituting a significant portion of a
company's assets, even if those investments potentially can be
characterized as ``strategic,'' may indicate that the company's primary
business is that of an investment company.\42\ We believe, however,
that raising the 20 percent limit to 25 percent would reflect an
appropriate balance between this concern and the needs for R&D
companies both to have greater flexibility to enter into strategic
alliances and to deal with fluctuations in the value of strategic
investments.\43\ Accordingly, the Commission is adopting a 25 percent
limit that would be applicable at all times that an R&D company seeks
to rely on the rule.\44\
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\41\ See Proposing Release, supra note 3, at III.A.4.b.
\42\ See id.
\43\ We note that the rule is designed to serve as a
nonexclusive safe harbor. We are willing to consider, on a case-by-
case basis, the status of R&D companies that cannot meet certain of
the requirements of the rule.
\44\ Rule 3a-8(a)(4)(i)-(ii).
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E. Collaborative Research and Development Arrangements
Rule 3a-8 as proposed defined a collaborative research and
development arrangement as a business relationship which (i) is
designed to achieve narrowly focused goals that are directly related
to, and an integral part of, the issuer's research and development
activities; (ii) calls for the issuer to conduct joint research and
development activities with one or more other parties, and (iii) is not
entered into for the purpose of avoiding regulation under the Act. For
the reasons discussed below, the Commission is adopting the definition
of a collaborative research and development arrangement substantially
as proposed. The Commission is making a technical clarification to the
definition to the effect that an investment in securities made pursuant
to a collaborative research and development arrangement must be an
investment in securities of a company (or of a company controlled
primarily by, or which controls primarily, the company) with which the
R&D company is engaged in the collaborative research and development
arrangement.\45\
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\45\ Rule 3a-8(b)(6). The Commission recognizes that a
collaborative research and development arrangement may involve
additional parties as well.
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1. ``Joint Research and Development''
Two commenters requested clarification of the term ``joint research
and development activities'' within the proposed definition. One
commenter was concerned that the term ``joint'' could be interpreted to
require the companies to be equally involved in the research and
development throughout the entire research and development process.
This commenter noted that research and development activities within
collaborative arrangements often are guided by a joint steering
committee with members from both companies, with one company or the
other primarily responsible for conducting research and development at
different stages. The Commission would consider an arrangement
involving research and development activities done sequentially or
through a joint steering committee to be ``joint'' within the meaning
of the definition.
2. Other Relationships
The Proposing Release requested comment on whether other
relationships, such as a licensor-licensee relationship with respect to
a patent or other intellectual property rights, should be included in
the definition of a collaborative research and development arrangement.
One commenter suggested that licensor-licensee and similar contractual
relationships should be included if they relate to product development
activities because such relationships are legitimate and common. While
we do not dispute the legitimacy or prevalence of licensing agreements,
we do not believe that a licensing or similar agreement, by itself,
demonstrates a sufficient nexus to the licensor's primary business to
justify treating an investment in the licensee differently from any
other speculative investment.
[[Page 37050]]
Such agreements may simply reflect a preference for securities over
cash considerations.\46\
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\46\ The Commission notes that licensor-licensee relationships
may not involve any collaboration between the parties, making it
unlikely that parties are engaged in ``joint'' research and
development activities within the meaning of the rule.
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The Commission also requested comment in the Proposing Release on
whether other activities, such as manufacturing and joint marketing
activities, should be included in the definition of a collaborative
research and development arrangement. In this regard, we specifically
asked commenters to address whether R&D companies face any unique
challenges that are not faced by other operating companies seeking to
produce and market their products. One commenter recommended that
manufacturing and marketing activities be included, but did not address
why R&D companies have a greater need than other operating companies to
make strategic investments to manufacture and market their products. We
thus are not including manufacturing and marketing activities in the
definition at this time.\47\
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\47\ The Commission and its staff are able to consider any
unique manufacturing or marketing circumstances faced by a
particular company on a case-by-case basis.
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F. Other Requirements
1. Valuation
As proposed, rule 3a-8 required a company to value its assets in
accordance with section 2(a)(41)(A) of the Act. Section 2(a)(41)(A)
provides, in relevant part, that for purposes of section 3 of the Act,
the term ``value'' means, (i) with respect to securities for which
market quotations are readily available, the market value of those
securities; and (ii) with respect to other securities and assets, fair
value as determined in good faith by the board of directors.\48\ Two
commenters opposed this requirement, arguing that an R&D company's
assets may be difficult to value. They recommended allowing R&D
companies to have the option of valuing their assets according to GAAP,
which provides for the valuation of some, but not all, assets at market
or fair value.
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\48\ 15 U.S.C. 80a-2(a)(41)(A).
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We note that Congress specifically mandated in section 2(a)(41)(A)
of the Act that companies use market or fair values for their assets
when determining their status under section 3 of the Act. The
Commission consistently has required the same when exempting operating
companies from the Act by order or rule, irrespective of any difficulty
that may be involved in valuing the assets. We therefore do not believe
that a departure from the valuation requirements under the Act in rule
3a-8 would be consistent with the protection of investors or the
purposes intended by the policy and provisions of the Act. We also note
that the increased percentage limit applicable when at least 75 percent
of an R&D company's ``other investments'' were made pursuant to
collaborative research and development arrangements under rule 3a-8 as
adopted should reduce any burdens associated with determining fair
values by giving R&D companies more flexibility to hold such
investments. Accordingly, the Commission is adopting the requirement to
comply with section 2(a)(41)(A) of the Act as proposed.\49\
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\49\ Rule 3a-8(b)(1).
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2. Consolidation
Proposed rule 3a-8 provided that the percentages relating to
assets, expenses and revenues set forth in the rule were to be
determined on an unconsolidated basis, except that an R&D company
should consolidate its financial statements with the financial
statements of any wholly-owned subsidiaries. This approach was
consistent with the method used in rule 3a-1 to determine a company's
status under the Act.\50\ We requested comment, however, on whether it
would be more appropriate for rule 3a-8 to require or permit
consolidation of an R&D company's financial statements with those of
its majority-owned subsidiaries, as is done under GAAP.\51\
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\50\ See supra note 23.
\51\ Proposing Release, supra note 3, at III.E.
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One commenter supported this alternative approach, arguing that the
use of a non-GAAP consolidated standard would impose a burden on some
R&D companies and possibly produce less reliable, unaudited numbers. We
note that all operating companies face similar burdens when determining
their status under section 3(a)(1)(C) of the Act or rule 3a-1 under the
Act. Moreover, an R&D company that sought to rely on rule 3a-8 already
would have determined that it met the definition contained in section
3(a)(1)(C) of the Act, which requires unconsolidated asset figures that
differ from GAAP. Accordingly, the Commission is adopting this
requirement as proposed.\52\
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\52\ Rule 3a-8(b)(2).
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III. Cost-Benefit Analysis
The Commission is sensitive to the costs and benefits of its rules.
New rule 3a-8 provides a nonexclusive safe harbor from the definition
of investment company for R&D companies. Under the rule, an R&D company
is eligible for the safe harbor if it: (a) Has research and development
expenses that are a substantial percentage of its total expenses for
its last four fiscal quarters combined and that equal at least half of
its net income derived from investments for that period; (b) has
investment-related expenses that do not exceed five percent of its
total expenses for its last four fiscal quarters combined; (c) makes
its investments to conserve capital and liquidity until it uses the
funds in its primary business, subject to certain exceptions; and (d)
is primarily engaged, directly or through a company or companies that
it controls primarily, in a noninvestment business, as evidenced by the
activities of its officers, directors and employees, its public
representations of policies, and its historical development.
New rule 3a-8 is designed largely to benefit R&D companies that
currently are relying on the ICOS Order by updating and codifying the
analysis in that order. The ICOS Order requires that an R&D company
generally spend more on research and development than it earns on its
investments. To allow R&D companies greater flexibility to raise and
invest capital pending its use in research, development and other
operations, the new rule modifies this requirement to require that an
R&D company's net income derived from investments not exceed twice the
amount of the company's research and development expenses.\53\ The new
rule also clarifies the extent to which R&D companies may make
investments in other companies pursuant to collaborative research and
development arrangements. Under the analysis in the ICOS Order, an R&D
company could make a limited amount of these investments so long as
``substantially all of its securities * * * present limited credit
risk.'' \54\ New rule 3a-8 specifies that an R&D company may make
investments that are not made to conserve capital and liquidity, so
long as these ``other investments'' do not exceed (a) 10 percent of the
R&D company's total assets, or (b) 25 percent of the R&D company's
total assets, so long as at least 75 percent of these other investments
are investments made pursuant to a collaborative research and
development arrangement.\55\
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\53\ Rule 3a-8(a)(2).
\54\ See the ICOS Order, supra note 2, at II.C.
\55\ Rule 3a-8(a)(4)(i) and (ii).
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The new rule also imposes two conditions on R&D companies relying
on the safe harbor that are not required
[[Page 37051]]
under the ICOS Order. Under the new rule, the board of directors of an
R&D company relying on the rule's safe harbor must adopt and record a
resolution that the company is primarily engaged in a non-investment
business \56\ and adopt a written investment policy.\57\
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\56\ Rule 3a-8(a)(6)(iv).
\57\ See Proposing Release, supra note 3, at III.A.4.b.
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Although we have identified certain costs and benefits that may
result from the new rule, rule 3a-8 is exemptive, rather than
prescriptive, and R&D companies are not required to rely on it.
Therefore, we assume that R&D companies will rely on the rule only if
the anticipated benefit from doing so exceeds the anticipated cost. In
the Proposing Release, we requested comment and specific data regarding
the costs and benefits of the proposed rule. We did not receive any
comments or data regarding the costs and benefits of the rule from
commenters.
A. Benefits
The Commission expects rule 3a-8 to benefit R&D companies in a
number of ways. As mentioned, the new rule affords R&D companies
greater flexibility to both raise and invest capital than currently
allowed. The requirement under the ICOS Order that an R&D company's
research and development expenses equal or exceed gross investment
revenues, in effect, imposed a ``burn rate,'' requiring the R&D company
to spend the income from and the principal amount of its investments in
its research and development business. As a result of these
limitations, R&D companies may have forgone opportunities to access the
markets or may have reduced the amounts raised when accessing the
markets. These limits also may have discouraged investment in higher
yielding capital preservation instruments. The rule allows R&D
companies to raise larger amounts of capital in a more cost-effective
manner and to formulate more efficient asset allocations than is
permitted under the existing tests. Thus, the rule should reduce any
costs that may be associated with a lack of flexibility (1) to access
fully the markets when conditions are favorable, and (2) to make
capital preservation investments.
Furthermore, by clarifying the extent to which R&D companies may
make investments in other companies pursuant to collaborative research
and development arrangements, rule 3a-8 will provide R&D companies
increased certainty as to the amount of these investments they may make
without becoming subject to regulation under the Act. The Commission
anticipates that this will reduce costs on an ongoing basis. When an
R&D company's status under the Act is uncertain, it may experience
higher costs when issuing securities or when borrowing. The Commission
expects clarification of the test to both reduce the costs that an R&D
company may need to incur to determine its status under the Act and
reduce any uncertainty in such determination, which may reduce costs
when issuing securities or borrowing.
B. Costs
R&D companies that choose to rely on the new rule's nonexclusive
safe harbor will incur certain costs in complying with the rule's
conditions that are not currently imposed under the ICOS Order. The
rule requires an R&D company's board of directors to adopt and record a
resolution that the company is primarily engaged in a non-investment
business and also to adopt a written investment policy concerning the
company's capital preservation investments. Because these requirements
need to be fulfilled only once, the Commission believes the cost of the
requirements to be minimal relative to the benefits provided by the
safe harbor. We estimate that to comply with the requirement that the
board of directors adopt and record a resolution, and R&D company would
need to have its in-house counsel spend 45 minutes preparing the
resolution, and its board of directors spend 15 minutes adopting the
resolution. We expect the board of directors to have based its decision
to adopt the resolution, in part, on investment guidelines the R&D
company has established to ensure its investment portfolio is in
compliance with the rule's requirements.\58\ We therefore believe that
no additional time will be required for the board of directors to
formally adopt a written investment policy, as required by the rule,
along with the resolution. Based on our estimate that 500 companies
will rely on the rule, one hour per company at a blended hourly rate
results in a total costs of $103,750.\59\ In the Proposing Release, the
Commission solicited comment on the number of companies that may rely
on the rule, the amount of time needed to adopt the required resolution
and the costs of such time. We did not receive any comments on our
estimates.
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\58\ We believe that many of the companies that will seek to
rely on the rule already have written investment guidelines.
\59\ The Commission's estimate concerning the weighted average
hourly wage rate is based on salary information for the securities
industry compiled by the Securities Industry Association. See
Securities Industry Association, Report on Management & Professional
Earnings in the Securities Industry--2001. The weighted average
hourly wage rate of $207.50 includes overhead costs and assumes that
75 percent of the time will be by in-house counsel at a rate of $110
per hour and 25 percent by the board of directors at a rate of $500
per hour.
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IV. Consideration of Promotion of Efficiency, Competition, and Capital
Formation
Section 2(c) of the Act provides that whenever the Commission is
engaged in rulemaking under the Act and is required to consider or
determine whether an action is consistent with the public interest, the
Commission also must consider, in addition to the protection of
investors, whether the action will promote efficiency, competition, and
capital formation. The Commission believes that, by clarifying the
status of certain R&D companies under the Act, and allowing R&D
companies greater flexibility to raise and invest capital, the rule is
consistent with the public interest and will positively affect capital
formation. The Commission also believes that the rule will promote
efficiency and competition, and that the rule will not be unduly
burdensome to those companies wishing to rely on it. In the Proposing
Release, the Commission solicited comments on this section, but did not
receive any.
V. Paperwork Reduction Act
New rule 3a-8 requires R&D companies wishing to rely on the safe
harbor provided under the rule to fulfill a number of conditions.
Certain of these conditions constitute ``collections of information''
within the meaning of the Paperwork Reduction Act of 1995 (``PRA'') [44
U.S.C. 3501 et seq.]. One condition is that the board of directors of
the company adopt an appropriate resolution evidencing that the company
is primarily engaged in a business other than that of investing,
reinvesting, owning, holding, or trading in securities. The rule
requires that the resolution be recorded contemporaneously in the
company's minute books or comparable documents. The Commission
submitted this collection of information to the Office of Management
and Budge (``OMB'') for review in accordance with 44 U.S.C. 3507(d) and
5 CFR 1320.11. The title for the collection of information is ``Rule
3a-8 under the Investment Company Act.'' OMB has approved the
collection of information for rule 3a-8; the OMB control number is
3235-0574 (expires March 31, 2006).
In the Proposing Release, the Commission estimated that the total
[[Page 37052]]
aggregate annual reporting burden associated with the proposed rule's
requirements is 500 hours. The Commission estimated that of the 500 R&D
companies that may take advantage of the proposed rule, the reporting
burden imposed by rule 3a-8 is one hour per company, for a total
aggregate reporting burden of 500 hours. No commenters addressed these
burden estimates for the collection of information requirements and we
continue to believe they are appropriate.
The rule we are adopting today contains an additional requirement
that is also a collection of information within the meaning of the PRA.
The board of directors of a company wishing to rely on the safe harbor
under rule 3a-8, must adopt a written policy with respect to the
company's capital preservation investments. We expect that the board of
directors will base its decision to adopt the resolution discussed
above, in part, on investment guidelines that the company will follow
to ensure its investment portfolio is in compliance with the rule's
requirements. We believe that many of the companies that will seek to
rely on the rule already have written investment guidelines. For those
that do not, we expect the board of directors to adopt the guidelines
simultaneously with the resolution. Furthermore, like the required
board resolution, the investment guidelines will generally need to be
adopted only once (unless relevant circumstances change). The
Commission therefore believes this additional collection of information
will not create additional time burdens, but can be accounted for in
the current burden hour estimate of 500 hours.
VI. Summary of Final Regulatory Flexibility Analysis
The Commission has prepared a Final Regulatory Flexibility Analysis
(``FRFA'') in accordance with 5 U.S.C. 604 regarding the adoption of
new rule 3a-8 under the Act. A summary of the Initial Regulatory
Flexibility Analysis (``IRFA''), which was prepared in accordance with
5 U.S.C. 603, was published in the Proposing Release. The Commission
received no comments on the IRFA. The following summarizes the FRFA.
The FRFA discusses the need for, and objectives of, the new rule.
The FRFA explains that the rule provides a nonexclusive safe harbor to
allow R&D companies more investment flexibility and the ability to hold
and invest more capital without becoming subject to the Act. The FRFA
also explains that in order to be eligible for the safe harbor provided
by the rule, an R&D company must have research and development expenses
that are a substantial percentage of its total expenses and that equal
at least half of its net income derived from investments for its last
four fiscal quarters combined, have relatively small investment-related
expenses, make its investments to conserve capital and liquidity until
it uses the funds in its primary business, subject to certain
exceptions, and be primarily engaged, directly or through a company or
companies that it controls primarily, in a noninvestment business.
The FRFA states that rule 3a-8 is designed to clarify, and provide
greater certainty concerning, the status of an R&D company under the
Act. Rule 3a-8 has no reporting requirements, but the board of
directors of a company seeking to rely on the rule would need to adopt
a board resolution, record that resolution contemporaneously in its
minute books or comparable documents and adopt written investment
guidelines related to its capital preservation investments. The FRFA
states that the only significant alternative to the rule would be for
an R&D company to engage in its own analysis and application of
existing statutory provisions, Commission orders and interpretations to
determine the R&D company's status under the Act. The Commission
therefore concluded that the rule, although it could affect small
entities, would be less burdensome than this alternative and, thus,
should minimize any impact upon, or cost to, small businesses. Any
company with net assets of $50 million or less would be a small entity
for purposes of the rule.
The FRFA is available for public inspection in File No. S7-47-02,
and a copy may be obtained by contacting Karen L. Goldstein, Office of
Investment Company Regulation, Securities and Exchange Commission, 450
5th Street, NW., Washington DC 20549-0506.
VII. Statutory Authority
We are adopting rule 3a-8 pursuant to our authority set forth in
section 6(c) and 38(a) of the Act [15 U.S.C. 80a-6(c) and 80a-38(a)].
List of Subjects in 17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Rule
0
For the reasons set out in the preamble, Title 17, Chapter II of the
Code of Federal Regulations is amended as follows:
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
0
1. The authority citation of part 270 continues to read, in part, as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted;
* * * * *
0
2. Section 270.3a-8 is added to read as follows:
Sec. 270.3a-8 Certain research and development companies.
(a) Notwithstanding sections 3(a)(1)(A) and 3(a)(1)(C) of the Act
(15 U.S.C. 80a-3(a)(1)(A) and 80a-3(a)(1)(C)), an issuer will be deemed
not to be an investment company if:
(1) Its research and development expenses, for the last four fiscal
quarters combined, are a substantial percentage of its total expense
for the same period;
(2) Its net income derived from investments in securities, for the
last four fiscal quarters combined, does not exceed twice the amount of
its research and development expenses for the same period;
(3) Its expenses for investment advisory and management activities,
investment research and custody, for the last four fiscal quarters,
combined, do not exceed five percent of its total expenses for the same
period;
(4) Its investments in securities are capital preservation
investments, except that:
(i) No more than 10 percent of the issuer's total assets may
consist of other investments, or
(ii) No more than 25 percent of the issuer's total assets may
consist of other investments, provided that at least 75 percent of such
other investments are investments made pursuant to a collaborative
research and development arrangement;
(5) It does not hold itself out as being engaged in the business of
investing, reinvesting or trading in securities, and it is not a
special situation investment company;
(6) It is primarily engaged, directly, through majority-owned
subsidiaries, or through companies which it controls primarily, in a
business or businesses other than that of investing, reinvesting,
owning, holding, or trading in securities, as evidenced by:
(i) The activities of its officers, directors and employees;
(ii) Its public representations of policies;
(iii) Its historical development; and
(iv) An appropriate resolution of its board of directors, which
resolution or action has been recorded
[[Page 37053]]
contemporaneously in its minute books or comparable documents; and
(7) Its board of directors has adopted a written investment policy
with respect to the issuer's capital preservation investments.
(b) For purposes of this section:
(1) All assets shall be valued in accordance with section
2(a)(41)(A) of the Act (15 U.S.C. 80a-2(a)(41)(A));
(2) The percentages described in this section are determined on an
unconsolidated basis, except that the issuer shall consolidate its
financial statements with the financial statements of any wholly-owned
subsidiaries;
(3) Board of directors means the issuer's board of directors or an
appropriate person or persons performing similar functions for any
issuer not having a board of directors;
(4) Capital preservation investment means an investment that is
made to conserve capital and liquidity until the funds are used in the
issuer's primary business or businesses;
(5) Controlled primarily means controlled within the meaning of
section 2(a)(9) of the Act (15 U.S.C. 80a-2(a)(9)) with a degree of
control that is greater than that of any other person;
(6) Investment made pursuant to a collaborative research and
development arrangement means an investment in an investee made
pursuant to a business relationship which:
(i) Is designed to achieve narrowly focused goals that are directly
related to, and an integral part of, the issue's research and
development activities;
(ii) Calls for the issuer to conduct joint research and development
activities with the investee or a company controlled primarily by, or
which controls primarily, the investee; and
(iii) Is not entered into for the purpose of avoiding regulation
under the Act;
(7) Investments in securities means all securities other than
securities issued by majority-owned subsidiaries and companies
controlled primarily by the issuer that conduct similar types of
businesses, through which the issuer is engaged primarily in a business
other than that of investing, reinvesting, owning, holding, or trading
in securities;
(8) Other investment means an investment in securities that is not
a capital preservation investment; and
(9) Research and development expenses means research and
development expenses as defined in FASB Statement of Financial
Accounting Standards No. 2, Accounting for Research and Development
Costs, as currently in effect or as it may be subsequently revised.
By the Commission.
Dated: June 16, 2003.
Jill M. Peterson,
Assistant Secretary.
[FR Doc. 03-15586 Filed 6-19-03; 8:45 am]
BILLING CODE 8010-01-P