The SEC recently proposed Rule 3a-8 under the Investment Company Act of 1940 (1940 Act), which would exempt certain bona fide research and development companies from investment company status under the 1940 Act. Proposed Rule 3a-8:

• Offers biotechnology and other research and development companies (R&D companies) greater flexibility to raise and invest capital pending its use in research, development and other operations. Rule 3a-8 would modify the current requirement that an R&D company generally spend more on research and development than it earns on investments.

• Clarifies the extent to which a company relying on the rule may make strategic investments in other R&D companies.

Context of Proposed Rule 3a-8

Section 3 of the 1940 Act sets out provisions for determining whether an issuer is an investment company subject to regulation under the 1940 Act. Two definitions in Section 3 may affect R&D companies.

Section 3(a)(1)(A) defines an investment company as any issuer that is or proposes to be primarily engaged in the business of investing, reinvesting or trading in securities.

Section 3(a)(1)(C) defines an investment company as any issuer that is or proposes to be engaged in the business of investing, reinvesting, owning, holding or trading in securities and owns or proposes to acquire "investment securities" having a value in excess of 40% of the value of its total assets (exclusive of U.S. government securities and cash) on an unconsolidated basis. "Investment securities" include all securities other than U.S. government securities and securities issued by majority-owned subsidiaries that are not investment companies. An issuer that meets the definition of investment company in Section 3(a)(1)(C) will not be deemed to be 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; or

• The SEC by order finds and declares it to be primarily engaged in a business other than that of investing, reinvesting, owning, holding or trading in securities.

Rule 3a-1 of the 1940 Act relaxes the definition under Section 3(a)(1)(C) by providing that a company will not be deemed an investment company if the company is not primarily engaged in the business of investing, reinvesting or trading in securities and no more than 45% of the value of its total assets, and no more than 45% of its net income for the last four fiscal quarters, derive from securities other than U.S. government securities, securities issued by employees' securities companies, securities issued by the company's majority-owned subsidiaries that are not investment companies and securities issued by controlled entities that are not investment companies. A company is presumed to control an entity if the company owns more than 25% of the voting interests in the entity.

Historically, the SEC has focused primarily on the composition of the issuer's assets and sources of income when determining an issuer's primary business under the preceding test. The SEC has compared the value of the issuer's investment securities to the value of its other assets, and the amount of its income derived from investment securities to its other income. The challenge for many biotechnology and other R&D companies is that their business goals do not fit the traditional income/asset test. R&D companies tend to have few tangible assets and often hold large amounts of capital in liquid instruments so that funds are readily accessible for research and development activities. Additionally, R&D companies often enter into strategic alliances that may include the purchase of a non-controlling equity stake in another R&D company. As a result of either or both of these activities, an R&D company may inadvertently be deemed an investment company. An R&D company that fails to register and report as an investment company may face significant penalties and damages under the 1940 Act, including being prohibited from engaging in interstate commerce.

In 1993, Perkins Coie obtained an SEC order on behalf of ICOS Corporation. In the ICOS Order, the SEC set out an alternative standard for determining the primary business of an R&D company. If a company demonstrates that it is engaged actively in bona fide research and development activities, the SEC will consider the use, rather than simply the composition, of the company's assets and income. Specifically, the SEC deems an R&D-focused company to be primarily engaged in non-investment activities if:

• The company generally spends more on research and development than it earns in gross investment income;

• The company spends a substantial portion of its gross expenses on research and development;
• The company's gross investment expenses are negligible when compared to gross expenses from all sources; and
• The company invests in securities in a manner that is consistent with the preservation of assets until funds are needed to finance operations. Significant investments in equity and debt may be disqualifying.

Proposed Rule 3a-8

Proposed Rule 3a-8 would update and codify the primary business test for R&D companies set forth in the ICOS Order. The new test is intended to address the increased use of strategic collaborations and investments among R&D companies to support joint research and development, the increased capital requirements of R&D companies, and the lengthy product development phases faced by R&D companies.

Rule 3a-8 would provide bona fide R&D companies a nonexclusive safe harbor from the definitions of investment company in Sections 3(a)(1)(A) and 3(a)(1)(C) of the 1940 Act. To qualify for the safe harbor, a company must satisfy the following criteria:

• The company's research and development expenses for its last four fiscal quarters combined must be a substantial percentage of the company's total expenses for that period. The proposed rule leaves the determination of "substantial" undefined in order to allow companies to take into account fluctuations in the composition of their expenses over time.

• The company's revenues from investments in securities must not exceed twice the amount of its research and development expenses. "Investments in securities" would include all securities owned by the company other than securities issued by majority-owned subsidiaries and companies controlled by the company that conduct similar types of businesses, through which the company is engaged primarily in a business other than that of investing, reinvesting, owning, holding or trading in securities. "Investment revenues" would include all investment returns, including amounts earned from dividends, interest on securities, and profits on securities (net of losses). This requirement would permit an R&D company to raise and hold more capital than is currently permitted under the ICOS Order. Under the ICOS Order, an R&D company is required to spend more on research and development than it earns on investments.
• The company must devote no more than 5% 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.
• The company's investments in securities must be capital preservation investments. "Capital preservation investments" are investments made to conserve the 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 and present limited credit risk. This requirement is subject to two exceptions:
  • A company could acquire "other investments" that are not capital preservation investments, provided that immediately after the acquisition no more than 10% of its total assets consist of "other investments."
  • A company would be permitted to acquire a larger 20% pool of "other investments" as long as at least 75% of those investments were made pursuant to collaborative research and development arrangements. A "collaborative research and development arrangement" is a business relationship that (i) is designed to achieve narrowly focused goals that are directly related to, and an integral part of, the company's research and development activities; (ii) calls for the company to conduct joint research and development activities with one or more other parties; and (iii) is not entered into for purposes of avoiding regulation under the 1940 Act.

Proposed Rule 3a-8 also would codify provisions in the ICOS Order requiring that the activities of an R&D company's officers, directors and employees, its public representations of policies and its historical development demonstrate that the company is primarily engaged in a business or businesses other than investing, reinvesting, owning, holding or trading in securities. The proposed rule would further require that the board of directors of a company seeking to rely on the safe harbor adopt a resolution evidencing that the company is primarily engaged in a non-investment business.

Text of Proposed Rule You will find the full text of proposed Rule 3a-8 at http://www.sec.gov/rules/proposed/ic-25835.htm. You can find discussion of other recent laws, regulations and rule proposals of interest to public companies on our website.