[Federal Register Volume 68, Number 119 (Friday, June 20, 2003)]
[Rules and Regulations]
[Pages 37046-37053]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-15586]



[[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

  Federal Register / Vol. 68, No. 119 / Friday, June 20, 2003 / Rules 
and Regulations  

[[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.
---------------------------------------------------------------------------

    \48\ 15 U.S.C. 80a-2(a)(41)(A).
---------------------------------------------------------------------------

    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