United States: SEC Adopts Safe Harbor for Research and Development

The Securities and Exchange Commission (SEC) recently adopted a new rule under the Investment Company Act of 1940 (Act) to provide a nonexclusive safe harbor from the definition of investment company for certain research and development companies (R&D Companies). The effective date of new rule 3a-8 (Rule) is August 19, 2003.

R&D Companies often have few tangible assets and hold large amounts of capital in liquid investments. They often raise significant amounts of capital, investing the proceeds and using the principal and interest on these investments to fund future research and development (R&D) activities. In addition, R&D Companies often enter into strategic alliances or collaboration agreements with other companies that include an investment by the R&D Company in a non-controlling block of securities in the other company. Either of these activities may result in an R&D Company falling within the definition of an investment company under the Act.

The Act requires registration of, and regulates the activities and operations of, companies that fall within the definition of an investment company. Traditional tests to determine investment company status heavily emphasize the composition of a company’s assets and sources of income, without regard to their uses or even to the unique characteristics of an R&D Company. In the past, R&D Companies have had to rely on the exemption for companies "primarily engaged in a business other than that of investing in securities." Because of the uncertainty of how far this exemption extends, many companies, especially those whose holdings of investment securities exceeded 40% of their assets (and, therefore, fell within one of the Act’s definitions for deemed investment company status), sought the protection of an exemptive order from the SEC, with the attending conditions that may have been imposed.

In 1993, the SEC recognized that many R&D companies, especially biotechnology companies that raised large amounts of capital and invested those funds with a view toward using them to fund their operations, would under certain circumstances be deemed to be investment companies. The SEC issued an order to ICOS Corporation, a biotechnology company, that considered the use, rather than simply the composition, of the company’s assets and income. The ICOS order sets forth a test that looks at whether a company has substantial R&D expenses, invests its securities consistent with preservation of its assets until they were needed to fund its operations, and has insignificant investment-related expenses. This test did not provide a bright-line test and also continued to treat strategic investments as investment securities, which resulted in R&D companies that made substantial strategic investments continuing to deal with the uncertainty of whether they were inadvertent investment companies.

The Rule resulted from a petition for rule making delivered to the SEC by the Biotechnology Industry Organization (BIO) to update and codify the ICOS order. The Rule provides a new nonexclusive safe harbor from the definition of investment company upon which R&D Companies may now rely. Because the Rule is nonexclusive, it does not preclude R&D companies from using the test set forth in the ICOS order.

The Rule focuses on an R&D Company’s use of its capital and the factors indicating that the R&D Company is primarily engaged in a non-investment business. Generally, an R&D Company will be able to rely on the nonexclusive safe harbor of the Rule if it:

• Has research and development expenses that are a substantial percentage of its total expenses for its last four fiscal quarters combined and that equal at least half of its net income derived from investments in securities for that period;
• Has investment–related expenses that do not exceed 5% of its total expenses for its last four fiscal quarters combined;
• Makes investments to conserve capital and liquidity until it uses the funds in its primary business (subject to limited exceptions);
• Is primarily engaged, directly or through a company or companies that it controls primarily, in a non-investment business, as evidenced by the activities of its officers, directors and employees, its public representations of policies, its historical development and the resolutions and policies adopted by its board of directors; and
• Does not hold itself out as being engaged in the business of investing, reinvesting or trading in securities.

The Rule provides that to qualify under the safe harbor of the Rule, the R&D expenses for an R&D Company’s last four quarters combined must be a "substantial" percentage of its total expenses for that period. So that R&D Companies may take into account fluctuations in their expenses over time, the Rule does not define what constitutes a "substantial" percentage. The SEC in proposing the Rule indicated that if an R&D Company’s research and development expenses are the majority of its expenses (excluding for this purpose nonrecurring items or unusual fluctuations in recurring items), the R&D expenses would be considered "substantial," but the SEC did not offer further insight into what lower percentages also might qualify as "substantial." The SEC in adopting the Rule does not include any further clarification of what level of expenses would be deemed "substantial," but notes that the Rule aims to preserve necessary flexibility without jeopardizing investor protection.

Under the Rule, an R&D Company’s investments in securities must be capital preservation investments, subject to two exceptions for "other investments." The SEC has not used specific objective standards to define "capital preservation investments," but stated that, in general, capital preservation investments must be liquid so that they can be readily sold to support the R&D Company’s research and development activities as necessary and present limited credit risk. The SEC further stated that investments in equity or speculative debt would not qualify as capital preservation investments.

Companies increasingly are collaborating with other companies to conduct joint research and development, and it is not uncommon for an R&D Company to acquire a non-controlling interest in the securities of another company in connection with a collaboration arrangement to ensure that the companies have the flexibility to pursue these activities. The Rule provides that to qualify for the safe harbor either (i) not more than 10 percent of the company’s total assets may consist of non-capital preservation investments (Other Investments) or (ii) provided that at least 75 percent of such Other Investments are investments made pursuant to a collaborative research and development arrangement, not more than 25 percent of the company’s total assets may consist of Other Investments. In adopting the Rule, the SEC noted that a company seeking to rely on the Rule must comply with the limitation on Other Investments at all times it seeks to rely on the Rule, not only at the time the Other Investments are acquired.¹

Given that the Rule permits an R&D Company to hold up to 25 percent of its total assets in Other Investments, provided at least 75 percent of the Other Investments were made pursuant to collaborative R&D arrangements, the determination of what arrangements so qualify is of critical importance to companies that seek to rely on the safe harbor.

The Rule defines a "collaborative research and development arrangement" as a business relationship which (i) is designed to achieve narrowly focused goals that are directly related to, and an integral part of, the R&D Company’s R&D activities, (ii) calls for the R&D Company to conduct joint research and development activities with the investee or a company controlled primarily by, or which controls primarily, the investee and (iii) is not entered into for the purpose of avoiding regulation under the Act. In the release adopting the Rule, and in response to a concern raised that the term "joint" could require companies to be equally involved in the R&D throughout the entire R&D process, the SEC clarified that it would consider an arrangement involving R&D activities done sequentially or through a joint steering committee to be considered "joint" within the definition. The SEC further commented that a licensing or similar agreement, by itself, does not demonstrate a sufficient connection to the licensor’s primary business to justify treating an investment in the licensee any differently from any other speculative investment. In addition, the release notes that manufacturing and marketing agreements are treated similarly to licensing agreements under the Rule when determining whether they qualify as "collaborative research and development arrangements."

The Rule incorporates the use of specific guidelines for board action. To fall within the nonexclusive safe harbor of the Rule, the board of directors must adopt a written investment policy designed to assure that the company’s funds are invested consistent with the goals of capital preservation and liquidity and a separate resolution stating that the company is primarily engaged in a non-investment business.

Rule 3a-8 is particularly relevant for many biotechnology and other technology companies given it offers those companies qualifying as R&D Companies a new nonexclusive safe harbor from the regulatory requirements of the Act. Companies that raise significant amounts of capital, invest the proceeds and use the principal and interest on these investments to fund future R&D activities should review the Rule to determine whether they are eligible to rely on it. In addition, companies that enter into strategic alliances or collaboration agreements with other companies involving an investment in a non-controlling block of securities in the other company should consider the benefits afforded by safe harbor of the Rule. R&D Companies relying on the safe harbor should carefully monitor compliance with the provisions of the Rule and structure their strategic agreements so that they fall within the definition of a "collaboration agreement." The Board of Directors of these R&D Companies should adopt the resolutions required by the Rule and also adopt specific guidelines regarding capital preservation investments.