FR Doc 02-30663

[Federal Register: December 3, 2002 (Volume 67, Number 232)]
[Proposed Rules]
[Page 71915-71925]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr03de02-38]

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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: rule-comments@sec.gov.
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)

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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.
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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.
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[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\
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\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).
---------------------------------------------------------------------------

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.
---------------------------------------------------------------------------

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