While all biotechnology and information technology companies fear hidden legal traps, only the truly paranoid have survived the snare of the Investment Company Act (ICA). That’s because their typical corporate profile fits-inadvertently-the ICA’s definition of an “investment company.” The troublesome attributes for such a company include relatively large liquid assets (especially following a public or private financing), intellectual property being carried on the balance sheet at a fraction of its true value, high R&D expenses, low operating income and collaborative arrangements that include strategic investments in other companies.
The following article summarizes proposed revisions that the SEC is expected to adopt soon to exclude qualifying R&D companies from becoming “inadvertent investment companies.”
First, a little background. The ICA was passed in 1940 as a way to regulate mutual funds and similar entities. However, it can apply to technology companies that no one would ever think should be regulated by it. Any public company with 40% of its assets in investment securities (that is, anything except those issued by the United States or by controlled subsidiaries) is an investment company for purposes of the ICA.
Registering as an investment company is not an option for an operating company. The ICA is meant for mutual funds and not for ordinary operating companies. Registering under the ICA places restrictions on capital structures and the issuance of options and warrants, and it prevents an operating company from raising sufficient funding and attracting qualified employees. Being an unregistered investment company is even worse. An unregistered investment company is prohibited from engaging in interstate commerce and from enforcing its contracts.
Past attempts by the Securities & Exchange Commission to exempt operating companies from the ICA are insufficient for today’s technology companies. In 1947, for instance, the SEC formulated a test that focused on sources of income and the nature of assets. It compared the value of investment securities to the value of other assets and the amount of income from investment securities to other income.
This test was not well suited for R&D companies. Their assets consist principally of liquid investments and intellectual property, and the intellectual property is not carried on the balance sheet because R&D costs are required to be expensed rather than capitalized. RT&D companies also raise funds in advance when capital markets permit and then invest the funds to earn income while they conduct R&D over an extended period.
Until R&D investments begin to produce revenues, their investment income exceeds operating income. R&D companies also frequently enter into strategic alliances in which they acquire non-controlling equity stakes in other companies. These stakes are investment securities on the books of the acquiring R&D company. With no other significant assets to offset the investment securities held as a result of parking funds and making strategic investments and with no income other than that produced by those securities, R&D companies often flunked the SEC’s test.
In 1993, the SEC determined that in the case of R&D companies it would “consider the use, rather than simply the composition, of the company’s assets and income.” Instead of focusing on the nature of the company’s assets and the sources of its income, the SEC instead began looking at whether a company used its securities and cash to finance its R&D activities, had substantial R&D expenses, had insignificant investment-related expenses and whether it invested in securities in a manner consistent with the preservation of its assets until they were needed to finance operations.
While an improvement, this new test had problems. It was vague and it continued to treat strategic investments as investment securities similar to, say, minority investments that a mutual fund might make in another company. Biotechnology companies in particular were worried that engaging in industry-standard activities (such as R&D collaborations that are coupled with strategic investments) might make them inadvertent investment companies. Strategic alliances in biotechnology have reportedly increased from 750 during the 1970s to 20,000 during 1987-1992 and 10,000 in 2001 alone.
With these concerns in mind, the Biotechnology Industry Organization (BIO), which represents more than 950 biotechnology companies in the United States and elsewhere, petitioned the SEC last year to adopt a bright-line rule that would provide a safe harbor from the definition of investment company for R&D companies. BIO’s position was that the SEC’s test was too vague and that R&D companies were being forced to forego funding and strategic investment opportunities for fear that they would be deemed investment companies.
In response, the SEC proposed new ICA Rule 3a-8. The rule is designed to be limited to bona fide R&D companies and focuses on the use of capital. It assumes that a bona fide R&D company will not maintain a portfolio of investment securities in perpetuity and that the amount earned on the company’s investments will bear some reasonable relationship to its actual R&D costs. It also assumes that a true R&D company will invest its capital in a manner designed to preserve it rather than to procure speculative profits. Finally, the rule acknowledges that a bona fide R&D company may wish to make a strategic investment to gain access to another company’s intellectual property, but it assumes that these investments would not be for speculative purposes and would not represent a disproportionate share of the company’s assets.
Among the proposed new rule’s requirements are the following:
* It would require that aggregate R&D expenses for the last four fiscal quarters be a “substantial percentage” of total expenses for that period. The rule does not define “substantial percentage,” but it states that a majority would “certainly” qualify.
* An R&D company’s income from investment securities may not exceed twice the amount of its R&D expenses. This provision would permit R&D companies to raise and hold twice as much capital as the current SEC test, which restricts investment income to 1x R&D expenses.
* No more than 5% of an R&D company’s total expenses for its last four fiscal quarters may be for investment advisory and management activities, investment research and selection and supervisory and custodial fees.
* All of an R&D company’s investment securities must be in “capital preservation investments,” except that (a) up to 10% of its total assets may consist of other investments or (b) up to 20% of its total assets may consist of other investments if 75% of those other investments are made pursuant to “collaborative research and development arrangements.”
Capital preservation investments are liquid so that they can be readily sold to fund R&D activities as necessary and present limited credit risk. The 20% exception is to provide flexibility to R&D companies to acquire equity stakes to advance their strategic and business goals.
A “collaborative research and development arrangement” is one that is designed to achieve narrow goals that are directly related to and an integral part of a company’s R&D activities. It also calls for the company to conduct joint research and development activities with one or more other parties and it is an arrangement that is not entered into for the purpose of avoiding regulation under the proposed act.
The SEC’s comment period on the proposed Rule 3a-8 ended in January. The comments were relatively modest and can be interpreted to signal widespread support. For instance, one comment recommended modifying the definition of “collaborative research and development arrangement” to make it clear that companies could have sole responsibility for R&D work at different points of the process as opposed to sharing duties throughout.
There was also a suggestion that measuring the 20% exception against historical R&D expenditures rather than assets would be better, given the volatility of asset valuations. Yet another suggestion was to add specificity to the “substantial percentage” that R&D expenses must represent of total expenses and to the definition of capital preservation investments.
While the SEC may make some revisions to the proposed rule before adopting it, we suspect that no substantial changes should be anticipated based upon the comment letters received. The proposal has been widely supported by commentators and should be adopted later this year. When it is so adopted, it will provide R&D companies with more objective rules for a safe harbor from being considered an investment company. Although peace of mind will never be truly assured, technology companies can be grateful for this guidance from the SEC.
Attorneys D. Roger Glenn and Albert L. Sokol are partners in the private equity and technology company practices of Edwards & Angell, LLP (www.ealaw.com), a 300-lawyer national law firm that focuses on financial services, private equity and technology.