[Federal Register Volume 67, Number 232 (Tuesday, December 3, 2002)]
[Proposed Rules]
[Pages 71915-71925]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 02-30663]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-25835; File No. S7-47-02]
RIN 3235-AI57


Certain Research and Development Companies

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Commission is publishing for comment a new rule under the 
Investment Company Act of 1940 that would provide a nonexclusive safe 
harbor from the definition of investment company for certain bona fide 
research and development companies. The rule is intended to allow 
research and development companies greater flexibility to raise and 
invest capital pending its use in research, development and other 
operations and would also clarify the extent to which a company relying 
on the rule may make investments in other research and development 
companies pursuant to collaborative research and development 
arrangements.

DATES: Comments must be received on or before January 15, 2003.

ADDRESSES: To help us process and review your comments more 
efficiently, comments should be sent by one method only.
    Comments should be submitted in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, 
Washington, DC 20549-0609. Comments also may be submitted 
electronically at the following E-mail address: [email protected]. 
All comment letters should refer to File No. S7-47-02; this file number 
should be included on the subject line if E-mail is used. Comment 
letters will be available for public inspection and copying in the 
Commission's Public Reference Room, 450 Fifth Street, NW, Washington, 
DC 20549. Electronically submitted comment letters also will be posted 
on the Commission's Internet Web site (http://www.sec.gov).\1\
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    \1\ We do not edit personal identifying information, such as 
names or electronic mail addresses, from electronic submissions. You 
should submit only information that you wish to make available 
publicly.

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, 
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450 Fifth Street, NW, Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment 
on proposed rule 3a-8 [17 CFR 270.3a-8] under the Investment Company 
Act of 1940 [15 U.S.C. 80a] (the ``Act'').

I. Introduction and Summary

    The Commission is proposing for comment new rule 3a-8 under the Act

[[Page 71916]]

as a nonexclusive safe harbor from investment company status for 
certain bona fide research and development companies (``R&D 
companies''). The Commission previously proposed rule 3a-8 in 1993 
(``1993 Proposal'').\2\ The 1993 Proposal was intended to codify the 
terms of a Commission order under section 3(b)(2) of the Act issued to 
ICOS Corporation, a biotechnology company (``ICOS order'').\3\ In the 
ICOS order, the Commission addressed how the status of a company 
engaged largely in research and development activities should be 
determined under the Act. The Commission recently received a petition 
for rulemaking from the Biotechnology Industry Organization (``BIO'') 
asking the Commission to update and clarify Commission interpretations 
relating to the status of biotechnology companies under the Act.\4\
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    \2\ See Certain Research and Development Companies, Investment 
Company Act Release No. 19566 (July 9, 1993) [58 FR 38095 (July 15, 
1993)] (the ``1993 Proposal''). The Commission withdrew rule 3a-8 
from the Unified Agenda on April 1, 1996, because the Commission did 
not expect to consider the item within the next 12 months. 
Regulatory Flexibility Agenda, Investment Company Act Release No. 
21795 (Mar. 4, 1996) [61 FR 24066 (May 13, 1996)].
    \3\ ICOS Corp., Investment Company Act Release Nos. 19274 (Feb. 
18, 1993) [58 FR 1426 (Feb. 25, 1993)] (notice) and 19334 [53 S.E.C. 
Docket 2965] (Mar. 23, 1993) [58 FR 15392 (Mar. 22, 1993)] (order) 
(the ``ICOS Order'').
    \4\ 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'') (available at 
http://www.sec.gov/rules/petitions/petn4-457.htm). BIO represents 
more than 950 biotechnology companies in the United States and 33 
other countries. Its members are involved in the research and 
development of health care, agricultural, industrial, and 
environmental biotechnology products.
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    R&D companies often raise large amounts of capital, invest the 
proceeds and use the principal and return on these investments to fund 
research and development activities during their lengthy product 
development phase. An R&D company also may purchase a non-controlling 
equity stake in another R&D company as part of a strategic alliance 
with the other company to conduct research and develop products 
jointly. Either or both of these activities may cause an R&D company to 
fall within the definition of investment company and to fail to qualify 
for an exclusion from the definition when using the Commission's 
traditional analysis to determine a company's primary business for 
purposes of the Act.
    The Act defines an ``investment company'' rather broadly. Among 
other definitions, the Act provides that any company that owns or 
proposes to acquire certain types of securities having a value 
exceeding 40 percent of the value of the company's total assets on an 
unconsolidated basis (exclusive of U.S. government securities and cash 
items) is an investment company. The Act also provides certain 
exclusions from the definition of investment company for a company that 
is primarily engaged in a non-investment business. When the Commission 
determines whether a company is primarily engaged in a non-investment 
business, we principally look at the composition of the company's 
assets and the sources of its income. We also consider the company's 
historical development, its public representations, and the activities 
of its officers and directors.\5\
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    \5\ See infra note 14.
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    In the ICOS order, the Commission recognized that the traditional 
analysis emphasizing the composition of a company's assets and income 
might not appropriately reflect an R&D company's non-investment 
business activities. Accordingly, we modified the traditional analysis 
of a company's primary business to better fit the business realities of 
R&D companies.
    According to BIO, the analysis set forth in the ICOS order no 
longer provides some biotechnology companies sufficient flexibility or 
clarity to raise capital or enter into strategic alliances.\6\ The 
Commission believes that it may be appropriate for biotechnology and 
other R&D companies to have greater flexibility to raise capital and 
make strategic investments in other R&D companies. Therefore, we are 
proposing new rule 3a-8 to update and codify the analysis set forth in 
the ICOS order with respect to R&D companies. We believe that it is in 
the public interest to ensure that bona fide R&D companies do not 
inadvertently fall within the definition of investment company and are 
not unnecessarily hindered in their operations by the Act.\7\ We are 
equally concerned, however, that companies that are primarily engaged 
in the investment business not escape regulation under the Act and 
thereby deny their investors the protections afforded by the Act.
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    \6\ Id. at 1, 7.
    \7\ R&D companies increasingly are recognized as making an 
important contribution in many areas. For example, the U.S. Senate 
recently passed a resolution designating a ``National Biotechnology 
Week'' in recognition of the importance of biotechnology to the U.S. 
economy and to an improved quality of life overall. See Senate 
Resolution 243 Designating The Week Of April 21 Through April 28, 
2002, as ``National Biotechnology Week,'' 107th Cong., 2d Session, 
April 16, 2002. The resolution noted that the biotechnology industry 
is instrumental in the research and development of antibiotics and 
other drugs to treat and cure diseases and conditions such as 
cancer, diabetes, epilepsy, multiple sclerosis and Acquired Immune 
Deficiency Syndrome. It also develops products to improve 
agriculture, industrial processes, the environment, and national 
security. Id.
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    In order to accomplish these goals, the proposed rule generally 
would determine the primary business activity of a company based on how 
the company uses its assets and income. A company would be eligible to 
rely on the rule's nonexclusive 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 investment revenues 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.

II. Background

A. The Definition of Investment Company

    Section 3 of the Act determines when an issuer is an investment 
company subject to regulation under the Act. General provisions for 
determining investment company status are set forth in sub-sections 
3(a) and 3(b).
    Section 3(a) has two definitions of investment company that may be 
relevant to R&D companies.\8\ Section 3(a)(1)(A) 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.\9\ Section 3(a)(1)(C) defines as an investment company 
any issuer that is engaged or proposes to engage in the business of 
investing, reinvesting, owning, holding, or trading in securities and 
owns or proposes to acquire investment securities having a value 
exceeding 40 percent of the value of its total assets on an 
unconsolidated basis (exclusive of U.S. government securities and cash 
items).\10\ Section 3(a)(2)

[[Page 71917]]

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.\11\
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    \8\ 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.
    \9\ 15 U.S.C. 80a-3(a)(1)(A).
    \10\ 15 U.S.C. 80a-3(a)(1)(C).
    \11\ 15 U.S.C. 80a-3(a)(2). ``Government security'' is defined 
in section 2(a)(16) of the Act [15 U.S.C. 80a-2(a)(16)] and 
generally includes any security issued or guaranteed as to the 
principal or interest by the United States. ``Employees'' securities 
company'' is defined in section 2(a)(13) of the Act [15 U.S.C. 80a-
2(a)(13)] generally to mean an investment company owned by employees 
of a company. ``Majority-owned subsidiary'' of an issuer is defined 
in section 2(a)(24) of the Act [15 U.S.C. 80a-2(a)(24)] to mean a 
company 50 percent or more of the outstanding securities of which 
are owned by the issuer or by a majority-owned subsidiary of the 
issuer.
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    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). Section 
3(b)(1) provides that an issuer is not an investment company if it is 
primarily engaged, directly or through wholly-owned subsidiaries, in a 
business other than that of investing, reinvesting, owning, holding or 
trading in securities.\12\ Section 3(b)(2) provides that an issuer is 
not an investment company if the Commission by order finds and declares 
it to be primarily engaged (directly, through majority-owned 
subsidiaries or controlled companies \13\ conducting similar types of 
businesses) in a business other than that of investing, reinvesting, 
owning, holding or trading in securities.\14\
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    \12\ 15 U.S.C. 80a-3(b)(1).
    \13\ Section 2(a)(9) of the Act [15 U.S.C. 80a-2(a)(9)] defines 
``control'' as the power to exercise a controlling influence over 
the management or policies of a company. This section creates a 
rebuttable presumption that owners of 25 percent or more of a 
company's voting securities control the company, and that owners of 
less than 25 percent do not. Unless otherwise stated, ``control,'' 
when used in this release, refers to the section 2(a)(9) definition.
    \14\ 15 U.S.C. 80a-3(b)(2). Section 3(b)(2) allows issuers that 
are investment companies as defined by section 3(a)(1)(C) to apply 
to the Commission for an order. An exclusion pursuant to section 
3(b)(1), on the other hand, is ``automatic'' in that it is 
determined by the issuer itself. A determination under either 
section 3(b)(2) or section 3(b)(1) that an issuer is engaged 
primarily in a noninvestment business also means that it is not an 
investment company under section 3(a)(1)(A). See M.A. Hanna Co., 10 
S.E.C. 581 (1941).
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    To receive an order from the Commission under section 3(b)(2), an 
issuer initially must establish that it is engaged in some non-
investment business. If an identifiable non-investment business exists, 
the inquiry then shifts to whether that business is ``primary.'' In 
Tonopah Mining Co.,\15\ the Commission stated that its determination of 
an issuer's primary business under section 3(b)(2) would be based on 
five principal factors: (a) the issuer's historical development; (b) 
its public representations of policy; (c) the activities of its 
officers and directors; (d) the nature of its present assets; and (e) 
the sources of its present income (the ``Tonopah factors,'' also 
referred to as the ``Tonopah test''). The two most important factors 
are the composition of the issuer's assets and the sources of its 
income.\16\ The Tonopah factors also have been applied to determine 
whether an issuer satisfies the primary business standard under section 
3(b)(1).\17\ Rule 3a-1 under the Act, adopted in 1981, codified a 
series of Commission orders issued under section 3(b)(2).\18\
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    \15\ Tonopah Mining Co., 26 S.E.C. 426 (1947)(''Tonopah 
Order'').
    \16\ Id. at 427, 430-431.
    \17\ See Moses v. Black, Fed. Sec. L. Rep. (CCH) P 97,866 
(S.D.N.Y. 1981).
    \18\ 17 CFR 270.3a-1. The rule provides that a company that 
meets the definition of investment company in section 3(a)(1)(C) 
will not be deemed to be an investment company if it meets certain 
requirements. The rule essentially requires that the issuer derive 
no more than 45 percent of the value of its total assets, and no 
more than 45 percent of its net income for the last four fiscal 
quarters, from securities other than Government securities, 
securities issued by employees securities companies, securities 
issued by the issuer's majority-owned subsidiaries that are not 
investment companies, and securities issued by companies that are 
controlled primarily by the issuer through which the issuer engages 
in a non-investment business.
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B. Certain R&D Companies

    The Tonopah test, while well suited for most issuers, may not 
appropriately identify the primary business of certain R&D companies. 
For example, ``in the biotechnology industry, there is typically a 
significant time lag between research and development investments, and 
revenues produced by those investments.'' \19\ Accordingly, 
biotechnology companies must obtain financing many years \20\ before 
they offer their products for sale and invest the proceeds in liquid 
instruments \21\ so the funds are readily accessible for research and 
development activities.\22\ Some R&D companies also enter into 
strategic alliances with other R&D companies to conduct research and 
develop products jointly.\23\ These alliances may involve a strategic 
investment whereby one R&D company purchases a non-controlling equity 
stake in another R&D company.\24\
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    \19\ BIO Petition, supra note 3, at I.B. BIO states that it 
takes approximately 10 to 14 years and costs approximately $300 
million to $500 million to develop a new drug and obtain approval 
from the Food and Drug Administration (``FDA'') to market it. See 
also Ernst & Young, Convergence: The Biotechnology Industry Report, 
Millenium Edition (``Ernst & Young Report 2000'') at 6 (estimating 
that the average research and development cost of bringing a new 
drug to market is $400 million); Cynthia Robbins-Roth, Magic 
Bullets: The Breakthroughs, the Business and the People of 
Biotechnology, Forbes, May 31, 1999 at 42 (stating that new 
pharmaceutical products generally take more than 10 years from 
conception to approval by the FDA).
    \20\ Several cycles of equity offerings and depletions of the 
resulting investment pools can occur before an R&D company achieves 
profitable operations, if ever. See Financing the Biotech Industry: 
Can the Risks Be Reduced?, 4 B.U. J. SCI. & TECH. L. 1 (1998) 
(``Financing the Biotech Industry'') (noting that Chiron 
Corporation, a biotechnology company, ``came to market approximately 
six times * * * to get where it is today.''). See also Ernst & Young 
Report 2000, supra note 20 (indicating that at the end of 1999, 36 
percent of public biotechnology companies had less than one year's 
worth of cash on hand).
    \21\ Biotechnology companies, for example, are traditionally 
financially conservative because they need to preserve cash for high 
research and development expenses. See Biotech Firms Growing Up 
Fast, Standard & Poors, April 10, 2002.
    \22\ On an industry-wide basis, research and development 
accounts for approximately 45 percent of all expenses incurred by 
U.S. biotechnology companies. See Ernst & Young, Focus on 
Fundamentals, The Biotechnology Report (Executive Summary) (Oct. 
2001) (``Ernst & Young Report 2001'').
    \23\ In the biotechnology area, a very high risk business with 
few profitable companies, strategic alliances allow firms to share 
the risk and reduce fund-raising pressures. See Financing the 
Biotech Industry, supra note 20. Additionally, strategic alliances 
with pharmaceutical companies facilitate biotechnology companies' 
ability to raise additional funds in the market by providing 
confirmation of the company's prospects and tending to put a 
valuation on its products and technology. See Ernst & Young Report 
2000, supra note 19, at 48.
    \24\ In addition to equity interests, strategic partnerships can 
also take the form of licensing agreements and other contractual 
partnerships. See Hagedoorn, John, ``Inter-firm R&D Partnership--An 
Overview of Major Trends and Patterns Since 1960,'' Strategic 
Research Partnerships: Proceedings from an NSF Workshop, August, 
2001 (``Inter-Firm R&D Partnership'').
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    Many of the instruments in which R&D companies invest their capital 
and most investments made as part of a strategic alliance are 
investment securities counted toward the 40 percent threshold in 
section 3(a)(1)(C). Moreover, research and development expenses,\25\ 
including those associated with the development of ``intellectual 
capital,'' are not recognized as assets on balance sheets prepared in 
accordance

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with Generally Accepted Accounting Principles (``GAAP'').\26\ R&D 
companies therefore may have few assets other than investment 
securities. As a result, a bona fide R&D company may fall within 
section 3(a)(1)(C)'s definition of investment company and fail to meet 
the traditional assets and income factors for determining a company's 
primary non-investment business. Becoming subject to regulation under 
the Act, however, typically is incompatible with how operating 
companies, including R&D companies, conduct their business.\27\
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    \25\ Statement of Financial Accounting Standards No. 2 defines 
``research'' as planned search or critical investigation aimed at 
discovery of new knowledge with hope that such knowledge will be 
useful in developing a new product or service or a new process or 
technique or in bringing about a significant improvement to an 
existing product or process. ``Development'' is the translation of 
research findings or other knowledge into a plan or design for a new 
product or process or for a significant improvement to an existing 
product or process whether intended for sale or use. See Accounting 
for Research and Development Costs, Statement of Financial 
Accounting Standards No. 2 (Fin. Accounting Standards Bd. 1974) at P 
8 (``SFAS No. 2''). Research and development expenses generally 
include costs incurred for materials, equipment, facilities, 
personnel, intangibles, and indirect costs that are clearly related 
to research and development activities. Id. at 11.
    \26\ See id. at 12. Under GAAP, costs of self-developed 
intangible assets generally, and research and development expenses 
for ``intellectual assets,'' in particular, are charged to expense 
when incurred.
    \27\ Section 18 of the Act [15 U.S.C. 80a-18], for example, 
places limits on a registered investment company's capital 
structure, and would significantly reduce the ability of an R&D 
company to raise capital. Section 18's restrictions on the issuance 
of warrants, options, and other rights also would limit the 
company's ability to attract scientific talent.
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C. The ICOS Order

    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. The ICOS order stated that, ``Given the 
unique nature of [R&D] companies, the Commission believes that it is 
appropriate to expand the traditional Tonopah analysis. If a company 
demonstrates that it is engaged actively in bona fide research and 
development activities, the Commission would consider the use, rather 
than simply the composition, of the company's assets and income.'' \28\ 
Under the ICOS order, this consideration 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--then 
should be examined to determine whether the company is engaged 
primarily in a noninvestment business.\29\ Several months after issuing 
the ICOS order, the Commission proposed rule 3a-8 to codify the 
analysis that it set forth in the ICOS order. The rule was withdrawn 
from the Commission's rulemaking agenda in 1996.\30\
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    \28\ The ICOS Order, supra note 3, at section II. ICOS, a 
development stage biopharmaceutical company, had no drug products 
approved for commercial use and, as a result, no revenues from 
product sales. It had, however, raised $90 million in public and 
private stock offerings that it had invested in short-term U.S. 
government and commercial debt securities pending the use of the 
proceeds in its research and development programs and for capital 
expenditures. As a result, most of ICOS' revenues were derived from 
securities. On the other hand, a substantial percentage of ICOS' 
total expenses were for research and development, its research and 
development expenses exceeded its investment revenues, and its 
investment-related expenses were insignificant. ICOS' historical 
development, its public representations of policy, and the 
activities of its officers and directors also all indicated that it 
was not engaged primarily in the investment company business. ICOS 
thus applied for an order under section 3(b)(2) declaring it to be 
engaged primarily in a business other than investing, reinvesting, 
or trading in securities. In the ICOS order, the Commission stated 
that, ``The Commission believes that ICOS may rely on the automatic 
exclusion provided by section 3(b)(1) * * * The Commission, however, 
believes an order is appropriate here to modify the analysis for 
determining the primary business of bona fide [R&D] companies.'' Id.
    \29\ Id. at sections II.A--II.C.
    \30\ See supra note 2. It appears that the Commission's analysis 
set forth in the ICOS Order provided R&D companies and their counsel 
with sufficient guidance for determining their status under the Act.
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D. The BIO Petition

    The BIO Petition requests that the Commission adopt a rule to 
address what BIO perceives as weaknesses in the tests used to determine 
its members' status under the Act. BIO asserts that with respect to the 
biotechnology industry today, the ICOS test is arbitrary and unduly 
limiting. The BIO Petition states that competition for skilled 
personnel and technology has increased the need for strategic 
collaborations and, without greater certainty about their investment 
company status, biotechnology companies forego these investments, or 
invest liquid assets solely in government securities, rather than those 
that may provide a higher return. BIO also argues that the increased 
duration of the drug development cycle, the nature of the capital 
markets, and biotechnology companies' ability to receive financing 
early in the product development cycle may cause companies to forego 
funding opportunities that may result in its income exceeding research 
and development expenses during some periods. To address these issues, 
the BIO Petition requests that the Commission adopt a rule that 
modifies the ICOS analysis to permit biotechnology companies to own 
more strategic investments and capital preservation investments (the 
``BIO Proposal'').

III. Discussion

    Today we are proposing rule 3a-8 to update and codify the primary 
business test for R&D companies set forth in the ICOS order. The 
proposed rule would serve as a nonexclusive safe harbor from the 
definition of investment company in sections 3(a)(1)(A) and 3(a)(1)(C) 
of the Act. The analysis set forth in the proposed rule generally 
focuses on an R&D company's use of its capital and other indicia of the 
company's primary engagement in a non-investment business. Rule 3a-8, 
as proposed, differs from the BIO Proposal in certain respects, which 
are noted below. We generally request comment on these differences.

A. Use of Capital

    As the Commission has recognized, an R&D company would not be 
expected to maintain perpetually a portfolio of investment securities, 
and the amounts earned on the company's investments should bear some 
reasonable relationship to its actual research and development 
costs.\31\ A bona fide R&D company also would be expected to invest its 
capital in a manner designed to preserve it, rather than in a manner 
designed to produce speculative profits.\32\ Finally, we recognize that 
there are circumstances where an R&D company may want to make a 
strategic investment to gain access to another company's intellectual 
property or for other reasons related to the company's non-investment 
business.\33\ These strategic investments, however, should not be for 
speculative purposes and should not comprise an overly large portion of 
the company's assets (because, as non-controlling minority equity 
investments, they are not investments in companies through which the 
R&D company conducts its non-investment business).\34\
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    \31\ See the ICOS Order, supra note 3, at section II.A and the 
1993 Proposal, supra note 2, at section II.A.1.
    \32\ See the ICOS Order, supra note 3, at section II.C and the 
1993 Proposal, supra note 2, at section II.A.4.
    \33\ See the 1993 Proposal, supra note 2, at section II.A.4. See 
also Inter-Firm R&D Partnership, supra note 24. Strategic alliances 
enable R&D companies to cross-fertilize technological disciplines, 
achieve technology synergies and complements as well as R&D 
economies of scale and scope, share R&D costs, utilize a partner's 
R&D expertise, and jointly cope with R&D uncertainty. Id.
    \34\ Both the framers of the Act and the Commission in 
administering the Act have viewed non-controlling minority equity 
interests as a type of investment security, which, if it comprises a 
significant portion of a company's assets, suggests that the company 
may in fact be an investment company. See sections 3(a)(1)(C) and 
3(b)(2) of the Act; the Tonopah Order, supra note 14. The Act was an 
outgrowth of a Commission study of the investment company industry 
conducted between 1938 and 1940 pursuant to a Congressional mandate 
in the Public Utility Holding Company Act of 1935 [15 U.S.C. 79z-4]. 
When determining which companies to include in the study, the 
Commission distinguished between ``investment companies'' and 
``holding companies'' on the basis of whether the company held a 
controlling interest in other companies, or instead smaller blocks 
of securities. SEC, REPORT ON THE STUDY OF INVESTMENT TRUSTS AND 
INVESTMENT COMPANIES (1939-1942).

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[[Page 71919]]

    We view these factors as important to the distinction that must be 
drawn between bona fide R&D companies that should not be subject to the 
Act and investment companies that should be. The provisions of proposed 
rule 3a-8 described below are designed to limit the rule's safe harbor 
to bona fide R&D companies.
1. Substantial Research and Development Expenses
    Paragraph (a)(1) of proposed rule 3a-8 would require that research 
and development expenses \35\ for an R&D company's last four fiscal 
quarters combined be a substantial percentage of its total expenses for 
that period. The proposed rule leaves the determination of 
``substantial'' undefined in order to allow R&D companies to take into 
account fluctuations in the composition of their expenses over time. If 
an R&D company's research and development expenses are the majority of 
its expenses but for nonrecurring items or unusual fluctuations in 
recurring items, the research and development expenses certainly would 
be ``substantial'' for purposes of this provision. We request comment 
whether the rule should provide a more objective standard and if so, 
what that standard should be.
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    \35\ Research and development expenses are defined in paragraph 
(b)(5) by reference to SFAS No. 2, as currently in effect or as it 
may be subsequently revised.
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2. Revenues from Investments Compared to Research and
    Development Expenses
    Paragraph (a)(2) of proposed rule 3a-8 would require that the R&D 
company's revenues from investments in securities not exceed twice the 
amount of its research and development expenses.\36\ As defined in 
paragraph (b)(6), ``investments in securities'' would include all 
securities owned by the R&D company other than securities issued by 
majority-owned subsidiaries and companies controlled by the R&D company 
that conduct 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.\37\ Investment 
revenues, for purposes of the proposed rule, would include all 
investment returns, including amounts earned from dividends, interest 
on securities, and profits on securities (net of losses).
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    \36\ The Commission recognizes that bona fide R&D companies at 
times experience fluctuations in their research and development 
expenses and investment revenues. Consequently, the requirements in 
paragraphs (a)(1) and (a)(2) are calculated using the last four 
fiscal quarters combined.
    \37\ The BIO Proposal contains a similar requirement--that a 
company's investment income (excluding any income from strategic 
investments) be less than or equal to twice the amount the company 
spends on research and development. As proposed, paragraph (a)(2) 
would not exclude income from strategic investments. We request 
comment on our proposed approach. We ask commenters to discuss the 
types of income an R&D company receives from strategic investments 
and whether such income would be more properly viewed as indicative 
of research and development operations, rather than as investment 
income.
---------------------------------------------------------------------------

    The requirement set forth in paragraph (a)(2) is designed to allow 
an R&D company to raise a significant amount of capital during 
favorable market conditions while precluding a situation in which the 
company's primary focus is its revenues from investments rather than 
its research and development activities. We note that the proposed rule 
would permit R&D companies to raise and hold more capital than the ICOS 
order currently permits. Under the ICOS order, an R&D company was 
expected to spend more on research and development than its gross 
investment income. R&D companies are spending an increasing amount on 
research and development. For example, between 1997 and 2000, total 
funds for industrial research and development in the U.S. increased 
over 26 percent.\38\ Given these increased capital requirements and the 
lengthy product development phases faced by R&D companies, additional 
flexibility to raise and invest capital pending use in research and 
development would appear appropriate so long as the other requirements 
of the rule are met.
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    \38\ See National Science Foundation, Research and Development 
in Industry: 2000 (Early Release Tables), Table E-1 at http://www.nsf.gov/sbe/srs/srs02403/tables/e1.xls (last visited Nov. 26, 
2002). Since 1993, research and development expenses for 
biotechnology companies alone more than doubled, See Report on the 
State of the Industry, presentation by Carl B. Feldbaum, President 
of the Biotechnology Industry Organization to Covance Senior 
Management, Washington, D.C. (April 29, 2002)(''Feldbaum Speech'') 
available at http://www.bio.org/news/speeches/20020429.asp (last 
visited Nov. 26, 2002). From 1999 to 2000 alone, these expenses rose 
from $10.7 billion to $13.8 billion, a 29.2 percent increase. See 
Ernst & Young Report 2001, supra note 22.
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    In the 1993 Proposal, the Commission noted that, if an R&D company 
did not deplete its invested funds over time to fund its research and 
development, a question would arise as to whether it was maintaining 
the value of its reserves for use in its operations or was running a 
perpetual investment program.\39\
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    \39\ See 1993 Proposal, supra note at section II.A.1.
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    [sbull] We request comment on whether the rule as proposed today 
sufficiently protects against that possibility.
    [sbull] We also request comment on whether the rule should address 
an R&D company's other operational expenses as well.
    [sbull] Would a requirement that an R&D company spend more on 
research and development and other operational expenses than its gross 
investment income be more appropriate?
    [sbull] The Commission also requests comment on whether the rule 
should define ``investment revenues,'' and, if so, how that term should 
be defined.
    [sbull] We also request comment on whether the proposed test unduly 
limits the ability of R&D companies to raise capital during favorable 
market conditions. If so, what would be an appropriate alternative test 
for determining whether a company's investment program is consistent 
with a primary engagement in research and development and related non-
investment business activities?
    [sbull] We also request comment on whether the holding of 
investments by an R&D company should be subject to custody, bonding or 
other requirements, similar to those contained in the Act, relating to 
the safekeeping of liquid securities.\40\
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    \40\ Under the Act, securities and similar investments of a 
registered investment company must be placed in the custody of a 
bank, a member of a national securities exchange, or the company 
itself in accordance with Commission rules. 15 U.S.C. 80a-17(f); see 
also 17 CFR 270.17f-1 and 2. As authorized by the Act, the 
Commission requires registered management investment companies to 
provide and maintain a fidelity bond against larceny and 
embezzlement that covers officers and employees of the company who 
have access to its securities or funds. 15 U.S.C. 80a-17(g); see 
also 17 CFR 270.17g-1.
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3. Insignificant Investment-Related Expenses
    Paragraph (a)(3) of proposed rule 3a-8 would require that an R&D 
company 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.\41\ Under paragraph (a)(4), as 
discussed more fully below, most of an R&D company's investments would 
be made to conserve capital and liquidity pending use of the funds in 
its operations. Consequently, its excess funds generally would be 
invested in instruments presenting limited investment risk. 
Accordingly,

[[Page 71920]]

investment advisory, management, research, and similar expenses should 
be limited. In contrast, a high level of spending on these types of 
expenses may indicate that the company is more focused on its 
investment activities then its research and development activities, and 
should therefore be regulated as an investment company. We request 
comment on whether a different limitation on investment-related 
expenses would be more appropriate.
---------------------------------------------------------------------------

    \41\ See 17 CFR 210.6-07.2(a) (Regulation S-X).
---------------------------------------------------------------------------

4. Investments to Conserve Capital and Liquidity
    Paragraph (a)(4) of proposed rule 3a-8 would require that an R&D 
company's investments in securities be capital preservation 
investments, subject to two exceptions for ``other investments.'' The 
exceptions are designed to clarify the extent to which an R&D company 
may make investments that are not consistent with the preservation of 
capital and still remain within the safe harbor provided by the rule.
    a. Definition of Capital Preservation Investments. ``Capital 
preservation investments'' are defined in paragraph (b)(3) as 
investments made to conserve an R&D company's capital and liquidity 
until the funds are used in its primary business or businesses. In 
general, capital preservation investments are liquid so that they can 
be readily sold to support the issuer's research and development 
activities as necessary and present limited credit risk. This 
requirement is intended to ensure that the investments are being used 
to support the company's research and development activities, rather 
than in a speculative manner that would be more characteristic of an 
investment company.
    [sbull] We request comment on whether this definition provides 
sufficient guidance and, if more guidance would be appropriate, the 
types of issues any such guidance should address.
    [sbull] We also request comment on whether the rule should require 
the board of directors of the company to adopt investment guidelines 
designed to assure that the company's funds are invested consistent 
with the goals of capital preservation and liquidity.\42\
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    \42\ See the ICOS order, supra note 3, at section II.C.; see 
also BIO Petition, supra note 4, at 9.
---------------------------------------------------------------------------

    Finally, the proposed rule, like the ICOS order, does not impose a 
limit on capital preservation investments relative to the company's 
total assets because R&D companies tend to have few tangible assets and 
large amounts of capital are needed to conduct research and development 
activities. We request comment on this approach.
    b. Other Investments. In the 1993 Proposal, the Commission proposed 
a requirement that an R&D company's investment portfolio, viewed 
overall, present limited investment risk.\43\ The Commission also 
stated that it would not view the acquisition of a limited amount of 
equity securities of a noncontrolled company, pursuant to a 
collaborative arrangement or ``strategic business relationship,'' as 
necessarily placing the issuer outside of this requirement, depending 
upon the facts and circumstances of that investment.\44\ In recent 
years, companies are increasingly collaborating with other companies to 
conduct joint research and development.\45\ Further, these 
collaborative arrangements appear to enhance research and development 
efforts.\46\
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    \43\ See the 1993 Proposal, supra note 2, at section II.A.2.
    \44\ Id.
    \45\ See Inter-Firm R&D Partnership supra note 24. The trend 
among biotechnology companies over the last 9 years, for example, 
has been a substantial increase in the number of strategic 
partnerships, including a six-fold increase between biotechnology 
and pharmaceutical companies, and a twelve-fold increase in 
partnerships between biotechnology companies. See Feldbaum Speech, 
supra note 38. Although the most common alliance remains between 
biotechnology and pharmaceutical companies, partnering between 
biotechnology companies is growing as smaller companies with narrow 
areas of expertise require other biotechnology companies to generate 
product candidates. Id.
    \46\ See Audretsch, David B., Strategic Research Linkages and 
Small Firms, Strategic Research Partnerships: Proceedings from an 
NSF Workshop (Aug. 2001) (noting that it has been argued that 
linkages and partnerships among R&D companies has ``contributed to a 
superior innovative performance''). See also Ernst and Young Report 
2000, supra note 19, at 48 (noting that pharmaceutical companies 
rely on biotechnology companies to drive product development and to 
access cost-cutting technologies, which may increase the speed and 
efficiency of the drug discovery process).
---------------------------------------------------------------------------

    We believe that R&D companies should have some flexibility to 
obtain equity stakes that advance their strategic and business goals. 
The countervailing concern, however, remains that such investments, 
while being ``strategic,'' are nonetheless non-controlling minority 
equity interests which, if they constitute a significant portion of a 
company's assets, may indicate that the company's primary business is 
that of an investment company.\47\ We also note that it is unclear why 
some collaborative research and development arrangements include the 
purchase of a non-controlling equity interest, while others do not.\48\ 
We request comment on the specific reasons for including non-
controlling interests in securities as part of collaborative research 
and development arrangements.\49\
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    \47\ See the 1993 Proposal, supra note 2, at II.A.4.
    \48\ Although joint ventures and other equity partnerships 
previously dominated the alliances among R&D companies, recently R&D 
companies seem increasingly to prefer contractual partnerships. See 
Inter-Firm R&D Partnerships, supra note 24. See also Windhover's 
Pharmaceutical Strategic Alliances, Volume XIII (September 2002) 
(indicating that 98 of more than 650 strategic alliances signed 
between July 2001 and June 2002 included equity investments) 
(available at http://www.windhover.net/pubs/psa/psa.asp) (last 
visited Nov. 26, 2002).
    \49\ According to one commentator, the investing company may be 
motivated to make an investment more for strategic reasons than for 
the financial rewards. Mark A. Medearis & Michael W. Hall, Minority 
Equity Investments In Connection With Strategic Alliances, 1323 PLI/
Corp 117, 119 (July-August 2002). These strategic reasons may 
include investment: (a) to obtain influence or control over the 
investee and its business plans; (b) to serve as a prelude to an 
ultimate acquisition of the investee by the investing company; (c) 
to provide a mechanism through which the investing company may 
provide development funding without incurring an expense for 
accounting purposes; and (d) to serve as a ``goodwill'' gesture to 
the investee. Id. According to a recent article, however, technology 
corporations that invested in other technology companies for 
strategic reasons in the late 1990's are now selling those interests 
as their value has declined. Ann Grimes, Tech Companies Itch to Shed 
VC Portfolios in Tough Times, Wall Street Journal, September 26, 
2002. It is not clear that any of these motives are directly 
connected to the long, expensive research and development cycles 
experienced by R&D companies. We believe that understanding the 
reasons for structuring a strategic alliance to include an 
investment in a non-controlling interest in securities is important 
because, absent such an investment, a strategic alliance would not 
raise any issues under the Act.
---------------------------------------------------------------------------

    Paragraph (a)(4) of proposed rule 3a-8 is designed to balance these 
considerations by drawing a distinction between investments made 
pursuant to a collaborative research and development arrangement and 
other investments that are not made to preserve capital and liquidity. 
Paragraph (a)(4)(i) would permit an R&D company to acquire investments 
that are not capital preservation investments (``other investments,'' 
defined in paragraph (b)(7) of the proposed rule), provided that 
immediately after the acquisition no more than 10 percent of its total 
assets consist of other investments. Alternatively, paragraph 
(a)(4)(ii) would permit a larger 20 percent ``basket'' of investments 
that are not capital preservation investments so long as at least 75 
percent of those investments were made pursuant to collaborative 
research and development arrangements. These alternatives are designed 
both to ensure that an R&D company's investment portfolio, viewed 
overall, presents limited investment risk and to reflect the increased 
use of collaborative relationships to conduct research and development 
since the ICOS order was issued.
    [sbull] We request comment on whether the proposed limits on other

[[Page 71921]]

investments set forth in paragraph (a)(4) are too restrictive or 
whether they may be too broad.
    [sbull] We also request comment on whether other investments that 
were made pursuant to collaborative research and development 
arrangements should continue to be considered with respect the 75 
percent calculation, if the collaborations are no longer ongoing.\50\
---------------------------------------------------------------------------

    \50\ Under the BIO Proposal, an investment would not qualify as 
strategic if the subject of the collaborative activity or 
contractual right is not ongoing (i.e., once the collaboration or 
contractual right terminates, the investment would no longer be 
treated as a strategic investment.) See BIO Petition, supra note 4, 
at 8.
---------------------------------------------------------------------------

    Under the proposed approach, the limits on other investments would 
be calculated only at the time other investments are acquired. If an 
R&D company's other investments increase in value due to market 
fluctuations, it would not be required to sell any other investments it 
already owns, but it would not be able to continue to acquire other 
investments.
    [sbull] Is this approach appropriate?
    [sbull] Should the rule provide a limit, applicable at any time, on 
the percentage of an R&D company's assets, valued in accordance with 
section 2(a)(41) of the Act, that may consist of other investments?
    [sbull] Should the rule provide a period of time after a 
collaborative research and development arrangement ends during which 
securities obtained pursuant to it must be sold?
    We also encourage commenters to suggest alternative tests. We note 
that the BIO Proposal would not impose any asset-based limit on 
investments that meet its definition of strategic investments.\51\ The 
BIO Proposal would impose a cost-based limit on strategic investments, 
requiring that the cost of all strategic investments at any time be 
less than the total amount of the company's research and development 
expenses during the most recent four fiscal quarters.\52\
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    \51\ See id. The BIO Proposal would allow a company to hold 
strategic investments, provided they are owned to achieve goals that 
are directly related to its research and development activities. Id.
    \52\ Id. Unlike the proposed rule, the approach suggested in the 
BIO Proposal would not limit an R&D company's ability to continue to 
acquire other investments when non-controlling strategic 
investments, valued in accordance with section 2(a)(41) of the Act, 
are a large portion of the company's assets.
---------------------------------------------------------------------------

    [sbull] We request comment on the approach advocated by BIO.
    [sbull] We also request that commenters who propose tests 
alternative to that which we are proposing today address how their 
proposed test(s) would ensure that companies that should be regulated 
under the Act are not afforded the benefit of the rule's safe harbor.
    c. CollaborativeResearch and Development Arrangements. 
``Collaborative research and development arrangement'' is defined in 
paragraph (b)(4) 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. Together, 
paragraphs (a)(4) and (b)(4) recognize that certain investments, while 
not interests in controlled companies through which the issuer engages 
in a non-investment business, nonetheless may be sufficiently related 
to an R&D company's primary business that their holding should be 
permitted by the rule's safe harbor.
    [sbull] We request comment on the scope of the definition of 
collaborative research and development arrangement.\53\
---------------------------------------------------------------------------

    \53\ The BIO Proposal similarly would require that strategic 
investments be owned to achieve narrowly focused goals that are 
directly related to, and an integral part of, the issuer's research 
and development activities. Id.
---------------------------------------------------------------------------

    [sbull] Does the proposed definition appropriately distinguish a 
``strategic'' investment of an R&D company from one that primarily has 
an investment purpose?
    [sbull] Should other relationships, such as a licensor-licensee 
relationship with respect to a patent or other intellectual property 
rights, be included in the definition? \54\
---------------------------------------------------------------------------

    \54\ Under the BIO Proposal, an investment will qualify as 
``strategic'' if, among other things, the investing company made the 
investment in connection with a strategic agreement with another 
company under which (1) the parties collaboratively will conduct 
research, development, manufacturing, or commercialization 
activities, or (2) the investing company provides or receives a 
license of, or similar contractual right to use (or an option to 
provide or receive a license of, or similar contractual right to 
use) patents, know-how, or other proprietary intellectual property 
to use in research, development, manufacturing, or commercialization 
activities. Id.
---------------------------------------------------------------------------

    [sbull] Should activities other than research and development 
activities, such as manufacturing and joint marketing activities, be 
included? \55\ In this regard, we ask 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.
---------------------------------------------------------------------------

    \55\ The BIO Proposal also would permit an investment to qualify 
as strategic when the parties collaboratively conduct manufacturing 
or commercialization activities.
---------------------------------------------------------------------------

    We note that paragraph (b)(1) of the proposed rule provides that 
assets are to be valued for purposes of the rule in accordance with 
section 2(a)(41) of the Act.\56\ Section 2(a)(41)(B) 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. We request comment 
on whether some other basis (for example, cost) would be more 
appropriate for investments made pursuant to collaborative research 
arrangements, and if so, why.
---------------------------------------------------------------------------

    \56\ 15 U.S.C. 80a-2(a)(41)(B).
---------------------------------------------------------------------------

B. Conducting Business Through Primarily Controlled Companies

    The rule's safe harbor would be available to any R&D company that 
conducts business directly, through majority-owned subsidiaries, ``or 
through one or more companies which it controls primarily.'' Paragraph 
(b)(5) of the rule provides that ``controlled primarily'' means that 
the issuer has control over the company within the meaning of section 
2(a)(9) of the Act and that the degree of the issuer's control is 
greater than that of any other person. The ``controlled primarily'' 
standard, also found in rule 3a-1 under the Act, is designed to 
distinguish securities representing interests in operating companies 
through which an issuer engages in a non-investment business from mere 
investments in securities.\57\ The Commission traditionally has viewed 
the fact that an issuer's degree of control over a company is greater 
than that of any other person as strong evidence that the issuer is 
engaged in a business through the other company.\58\

[[Page 71922]]

We request comment on extending the rule's safe harbor to R&D companies 
that conduct their business in this manner.
---------------------------------------------------------------------------

    \57\ Rule 3a-1(a)(4) [17 CFR 270.3a-1(a)(4)]. See, e.g., 
Standard Shares, Inc., Investment Company Act Release Nos. 10200 
(Apr. 11, 1978) (notice) and 10234 (May 9, 1978) (order).
    \58\ See Health Communications Services Inc. (pub. avail. Apr. 
26, 1985). To demonstrate control over a company for purposes of 
section 2(a)(9) under the Act, an issuer must show not only the 
ability to exercise control, but also that it is exercising it. See 
id. (ownership of more than 25 percent of the outstanding stock of 
affiliates, if ``outstanding stock'' is comprised of voting 
securities, constituted control over those entities for purposes of 
the rebuttable presumption established by section 2(a)(9) of the 
Act). See also In the Matter of ENERSIS S.A., Investment Company Act 
Release Nos. 20925 (Feb. 27, 1995) (notice) and 20965 (Mar. 24, 
1995) (order); In the Matter of CITIC Pacific Limited, Investment 
Company Act Release Nos. 21282 (Aug. 15, 1995) (notice) and 21345 
(Sept. 12, 1995) (order); In the Matter of Safeguard Scientifics, 
Inc., Investment Company Act Release Nos. 24317 (Feb. 25, 2000) 
(notice) and 24345 (Mar. 22, 2000) (order).
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C. Holding Out as Primarily Engaged in a Non-investment Business

    Paragraph (a)(5) of the proposed rule would require that an R&D 
company not hold itself out as being engaged in the business of 
investing, reinvesting, or trading in securities. This requirement 
would ensure that any issuer that holds itself out as being an 
investment company could not rely on the rule. Paragraph (a)(5) further 
requires that the company not be a special situation investment 
company.\59\
---------------------------------------------------------------------------

    \59\ For a discussion of a special situation investment company, 
see e.g., Certain Prima Facie Investment Companies, Investment 
Company Act Release No. 10937 at nn. 19-20 & accompanying text (Nov. 
13, 1979).
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D. Other Tonopah Factors

    Paragraph (a)(6) of the proposed rule codifies the requirement in 
the ICOS order that the activities of an R&D company's officers, 
directors and employees,\60\ its public representations of policies, 
and its historical development demonstrate that it is primarily engaged 
in a business or businesses other than investing, reinvesting, owning, 
holding, or trading in securities. Paragraph (a)(6) also requires that 
the board of directors of a company seeking to rely on the safe harbor 
adopt an appropriate resolution evidencing that the company is 
primarily engaged in a non-investment business.\61\ We request comment 
on these provisions.
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    \60\ In the Tonopah Order, and subsequent Commission orders 
under section 3(b)(2) of the Act, the Commission considered the 
activities of a company's employees in determining a company's 
primary business. See Tonopah Order, supra note 14. See also, e.g., 
Yahoo! Inc., Investment Company Act Release Nos. 24459 (May 18, 
2000) (notice) and 24494 (June 13, 2000) (order); Airtouch 
Communications, Inc., Investment Company Act Release Nos. 24271 
(Jan. 28, 2000) (notice) and 24294 (Feb. 23, 2000) (order); Internet 
Capital Group, Inc. Investment Company Act Release Nos. 23923 (July 
28, 1999) (notice) and 23961 (Aug. 23, 1999) (order); and Extended 
Stay America, Inc., Investment Company Act Release Nos. 23167 (Apr. 
30, 1998) (notice) and 23210 (May 27, 1998) (order).
    \61\ This requirement is modeled on the requirement in rule 3a-2 
under the Act that provides a temporary exemption from the Act for 
transient investment companies. 17 CFR 270.3a-2.
---------------------------------------------------------------------------

E. Consolidation With Financial Statements of Wholly-Owned Subsidiaries

    Paragraph (b)(2) provides that, for purposes of the proposed rule, 
an R&D company's assets, expenses and revenues should be determined on 
an unconsolidated basis, except that the company shall consolidate its 
financial statements with the financial statements of any wholly-owned 
subsidiaries. This approach is consistent with rule 3a-1 under the 
Act.\62\ We note that, under GAAP, the assets, income and expenses of 
majority-owned subsidiaries of an issuer also are consolidated with the 
issuer's statement of operations.\63\ We request comment on whether it 
would be more appropriate for the proposed rule to require or permit 
consolidation of an R&D company's financial statements with those of 
its majority-owned subsidiaries.
---------------------------------------------------------------------------

    \62\ See rule 3a-1(c). Under section 3(a)(1)(C) of the Act, an 
issuer's status is determined by the composition of its assets on an 
unconsolidated basis.
    \63\ The consolidated statement reflects all income and expenses 
of these subsidiaries, whether the issuer/parent owns all or just a 
majority of the outstanding common stock of the subsidiary. The net 
income attributable to minority ownership of the subsidiaries is 
also deducted in arriving at consolidated net income on the 
consolidated income statement. 1993 Proposal, supra note , at n.31.
---------------------------------------------------------------------------

    An R&D company's investments in companies it controls primarily 
(but which are not majority-owned subsidiaries) may be accounted for 
using the equity method.\64\ Statements of operations prepared on the 
basis of the equity method of accounting reflect, in a single amount, 
the parent's share of the controlled company's net income, but not the 
parent's share of its investment revenues, investment-related expenses, 
or research and development expenses. We request comment on whether an 
R&D company should be allowed or required to combine its pro rata share 
of the relevant expenses and revenues of any companies it controls 
primarily with its own when determining whether it meets the 
requirements of paragraphs (a)(1) through (a)(3) of the proposed 
rule.\65\
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    \64\ See The Equity Method of Accounting, Accounting Principles 
Board Opinion No. 18 (American Institute of Certified Public 
Accountants 1971) (``APB No. 18''). APB No. 18 generally prescribes 
the equity method of accounting by investors for investments in 
investees when the investor owns more than 20 percent, but not more 
than 50 percent, of the investee's voting interests.
    \65\ This method of accounting, generally referred to as the pro 
rata consolidation method, currently is applied in certain 
industries in lieu of the equity method. See Simplification of 
Registration and Reporting Requirements for Foreign Companies; Safe 
Harbors for Public Announcements of Unregistered Offerings and 
Broker-Dealer Research Reports, Securities and Exchange Commission 
Release No. 34-33139 (Nov. 3, 1993) [58 FR 60307 (Nov. 3, 1993)].
---------------------------------------------------------------------------

IV. General Request for Comment

    The Commission requests comment on the rule proposed in this 
release, suggestions for other additions to the rule, and comment on 
other matters that might have an effect on the proposal contained in 
this release.

V. Cost-Benefit Analysis

    The Commission is proposing a rule that would serve as a 
nonexclusive safe harbor from investment company status for certain R&D 
companies. The rule is designed primarily to benefit R&D companies that 
currently are relying on the ICOS Order. The rule primarily would 
address two aspects of the analysis in the ICOS Order. First, it would 
allow R&D companies greater flexibility to raise and invest capital 
pending its use in research, development and other operations by 
modifying the requirement that an R&D company generally spend more on 
research and development that it earns on its investments. Second, the 
proposed rule would clarify the extent to which an R&D company may make 
investments in other R&D companies pursuant to collaborative research 
and development arrangements.
    The proposed rule generally would determine the primary business 
activity of a company based on how the company uses its assets and 
income. A company would be eligible to rely on the rule's nonexclusive 
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 investment 
revenues 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, in a noninvestment business, as 
evidenced by the activities of its officers, directors and employees, 
its public representations of policies, and its historical development.
    As the proposed rule is exemptive, rather than prescriptive, R&D 
companies are not required to rely on it. Therefore, we assume that R&D 
companies will only rely on the provisions of the proposed rule if the 
anticipated benefits from such actions would exceed the anticipated 
costs.

A. Benefits

    Proposed rule 3a-8 is intended to benefit R&D companies by reducing 
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 proposed rule is

[[Page 71923]]

designed to assist R&D companies in determining their status under the 
Act by clarifying the applicable test. Clarification of the test should 
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.
    In addition, the rule is designed to afford R&D companies greater 
flexibility to both raise and invest capital. R&D companies may be 
forgoing opportunities to access the markets or reducing the amounts 
raised when accessing the markets because of limits contained in the 
current test. The current limits also may discourage investment in 
higher yielding capital preservation instruments. The rule should allow 
R&D companies to raise larger amounts of capital in a more cost-
effective manner and to formulate more efficient asset allocations than 
would be permitted under the existing tests. Thus, the rule is expected 
to 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.

B. Costs

    In addition to the benefits of the rule, the Commission is 
sensitive to the costs that may be associated with it. The proposed 
rule would require a company's board of directors to adopt and record a 
resolution that the company is primarily engaged in a non-investment 
business. The Commission believes the cost of this requirement, which 
generally would need to be fulfilled once, to be minimal relative to 
its benefits. We estimate that to comply with this requirement, an 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. Based on our estimate that 500 companies would 
rely on the rule, one hour per company at a blended hourly rate results 
in a total cost of $103,750.\66\ The Commission requests comment on 
whether its estimates of 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 are appropriate. The Commission requests comment 
on the potential costs and benefits identified in the proposal and any 
other costs or benefits that may result from the proposal.
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    \66\ 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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VI. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, a rule is ``major'' if it results or is likely to result 
in an annual effect on the economy of $100 million or more; a major 
increase in costs or prices for consumers or individual industries; or 
significant adverse effects on competition, investment, or innovation. 
The Commission requests comment on the potential impact of the proposed 
rule on the U.S. economy on an annual basis. Commenters are requested 
to provide empirical data to support their views.

VII. 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 has considered rule 3a-8 in light of 
these standards and 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 proposed rule will promote efficiency 
and competition, and that the rule would not be unduly burdensome to 
those companies wishing to rely on it.
    The Commission requests comment on whether the proposed rule, if 
adopted, would promote efficiency, competition, and capital formation. 
Will the proposed rule materially affect both the number of R&D 
companies and their ability to raise capital for their business? 
Comments will be considered by the Commission in satisfying its 
responsibilities under section 2(c) of the Act. Commenters are 
requested to provide empirical data and other factual support for their 
views to the extent possible.

VIII. Paperwork Reduction Act

    R&D companies wishing to rely on the safe harbor provided by 
proposed rule 3a-8 must fulfill certain conditions set forth in the 
rule. One such condition requires 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 proposed 
rule would require that the resolution be recorded contemporaneously in 
the company's minute books or comparable documents. This requirement 
constitutes a ``collection of information'' within the meaning of the 
Paperwork Reduction Act of 1995 [44 U.S.C. 3501, et seq.], because 
adopting the resolution is necessary to meet the conditions of the 
rule. An agency may not conduct or sponsor, and a person is not 
required to respond to, a collection of information without display of 
a valid Office of Management and Budget (``OMB'') control number. 
Accordingly, the Commission has submitted the proposed rule to the 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.''
    The Commission has estimated the paperwork burden under the 
proposed rule. The total aggregate estimated annual reporting burden 
associated with the rule's requirements is 500 hours. The required 
board resolution would need to be adopted and recorded only once 
(unless relevant circumstances change). Thus, the Commission believes 
that the annual collection of information requirement will not be a 
significant burden.
    The Commission estimates 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.
    Persons wishing to submit comments on the collection of information 
requirements should direct them to the Office of Management and Budget, 
Attention: Desk Officer for the Securities and Exchange Commission, 
Office of Information and Regulatory Affairs, Room 3208, Washington, DC 
20503, and also should send a copy to Jonathan G. Katz, Secretary, 
Securities and Exchange Commission, 450 Fifth Street, NW., Washington, 
DC 20549-0609 with reference to File No. S7-47-02. OMB is required to 
make a decision concerning the collections of information between 30 
and 60 days after publication, so a comment to OMB

[[Page 71924]]

is best assured of having its full effect if OMB receives the comment 
within 30 days after publication of this release. Requests for 
materials submitted to OMB by the Commission with regard to these 
collections of information should be in writing, refer to File No. S7-
47-02, and be submitted to the Securities and Exchange Commission, 
Records Management, Office of Filings and Information Services, 450 
Fifth Street, NW., Washington, DC 20549.

IX. Summary of Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA'') in accordance with 5 U.S.C. 603 regarding proposed 
rule 3a-8 under the Act. The IRFA explains that the proposed rule would 
provide a 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 IRFA also explains that in order to be 
eligible for the nonexclusive safe harbor the proposal would create, an 
R&D company must have research and development expenses that are a 
substantial percentage of its total expenses, 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 IRFA states that proposed 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 would have no reporting requirements, but the 
board of directors of a company seeking to rely on the rule would need 
to adopt a board resolution and record that resolution 
contemporaneously in its minute books or comparable documents. The IRFA 
states that the only significant alternative to the proposed 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 proposal, although it could affect small 
entities, would be less burdensome than this alternative and, thus, 
would minimize any impact upon, or cost to, small businesses. Any 
company with net assets of $50 million would be a small entity for 
purposes of the proposed rule. The IRFA also states that the Commission 
believes that there are no duplicative, overlapping, or conflicting 
Federal rules with the proposed rule.
    The Commission encourages comment with respect to any aspect of the 
IRFA. The Commission specifically requests comment on the number of 
small entities that would be affected by the proposed rule, and the 
likely impact of the proposal on small entities. Commenters are asked 
to describe the nature of any impact and provide empirical data 
supporting the extent of the impact. These comments will be considered 
in connection with the adoption of the rule, and will be placed in the 
same public file as comments on the proposed rule itself. A copy of the 
IRFA may be obtained by contacting Karen L. Goldstein, Securities and 
Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0506.

X. Statutory Authority

    We are proposing rule 3a-8 pursuant to our authority set forth in 
sections 6(c) and 38(a) of the Investment Company Act of 1940 [15 
U.S.C. 80a-6(c) and 80a-37(a)].

List of Subjects in 17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

Text of Proposed Rule Amendments

    For the reasons set out in the preamble, Title 17, Chapter II of 
the Code of Federal Regulation is proposed to be amended as follows:

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

    1. The authority citation for part 270 continues to read, in part, 
as follows:

    Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39, 
unless otherwise noted;
* * * * *
    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 expenses 
for the same period;
    (2) Its revenues from investments in securities, for the last four 
fiscal quarters combined, do 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 the issuer may acquire other investments, 
provided that immediately after such acquisition:
    (i) No more than 10 percent of its total assets consist of other 
investments; or
    (ii) No more than 20 percent of its total assets consist of other 
investments and at least 75 percent of such other investments were made 
pursuant to collaborative research and development arrangements;
    (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; and
    (6) It is primarily engaged, directly, through majority-owned 
subsidiaries, or through one or more 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, or by an 
appropriate action of the person or persons performing similar 
functions for any issuer not having a board of directors, which 
resolution or action has been recorded contemporaneously in its minute 
books or comparable documents.
    (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) Capital preservation investments means investments that are 
made to conserve capital and liquidity until the funds are used in the 
issuer's primary business or businesses;
    (4) Collaborative research and development arrangement means 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;

[[Page 71925]]

and (iii)Is not entered into for the purpose of avoiding regulation 
under the Act;
    (5) Controlled primarily means the issuer has control over the 
company within the meaning of section 2(a)(9) of the Act (15 U.S.C. 
80a-2(a)(9)) and the degree of the issuer's control is greater than 
that of any other person;
    (6) 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;
    (7) Other investments means investments in securities that are not 
capital preservation investments; and
    (8) Research and development expenses means research and 
development expenses as defined in the Statement of Financial 
Accounting Standards No. 2, as currently in effect or as it may be 
subsequently revised.

    By the Commission.
    Dated: November 26, 2002.
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 02-30663 Filed 12-2-02; 8:45 am]
BILLING CODE 8010-01-P