SEC Rule Provides Safe Harbor Under Investment Company Act for Research and Development Companies

Article by Gordon H. Hayes, Jr., Jocelyn M. Arel, Mitchell S. Bloom, Jeffrey M. Held

Safe Harbor Particularly Useful to Biotechnology Companies

Recently, the Securities and Exchange Commission (the "SEC") adopted Final Rule 3a-8 (the "Final Rule") under the Investment Company Act of 1940, as amended (the "40 Act"). The Final Rule provides a non-exclusive safe harbor from the definition of "investment company" for biotechnology and other companies engaged in long-term research and development ("R&D") that meet certain criteria relating, among other things, to the size of its R&D and investment-related expenses and compliance with restrictions on the investment of cash in securities pending use in its business. Under the Final Rule, biotechnology companies that meet the Final Rule’s requirements will have increased flexibility in investing their cash held to support R&D and to pursue investments and strategic alliances without concern of falling under the ambit of 40 Act regulation. The Final Rule becomes effective August 19, 2003. A copy of the Final Rule is available at http://www.sec.gov/rules/final/ic-26077.htm.

The 40 Act contains two definitions that potentially treat biotechnology companies as investment companies. Section 3(a)(1)(A) of the 40 Act defines an investment company as any issuer that is, holds itself out as, or proposes to engage primarily in the business of investing, reinvesting, or trading in securities. In addition, Section 3(a)(1)(C) of the 40 Act defines an investment company as any issuer which 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 the issuer’s total assets (exclusive of government securities and cash items) on an unconsolidated basis (the "Asset Test"). An investment company must either register with the SEC and be subject to significant regulatory requirements imposed by the 40 Act or find an exemption from registration.

Biotechnology companies have long struggled with inadvertent classification as investment companies under the Asset Test. The balance sheet of a typical biotechnology company usually includes large amounts of cash or investment securities to support R&D as well as strategic equity investments in partner companies to support collaborative research activity. Non-controlling equity interests in other companies are considered investment securities under the Asset Test. Consequently, many biotechnology companies, in order to avoid the burdensome regulatory requirements associated with classification as an investment company, have foregone potential strategic investments, limited the way they invest excess cash, or expended significant time and money seeking exemptions from registration under the 40 Act

In 1993, in recognition of the factors described above, the SEC issued an order to ICOS Corp. (the "ICOS Order"), a development stage biopharmaceutical company whose revenues were derived primarily from securities held to fund R&D efforts rather than for investment-related purposes. The ICOS Order exempted ICOS from the 40 Act based on a factual analysis of the company’s primary business activities. In the ICOS Order, the SEC recognized that the traditional analysis under the "Asset Test" did not appropriately reflect the non-investment business activities of some companies. Accordingly, the SEC set forth an alternative test for determining the primary business of a company for purposes of the 40 Act. Under the ICOS Order, three factors were emphasized: (1) whether the company used its securities and cash to finance its R&D activities; (2) whether the company had substantial R&D expenses and insignificant investment-related expenses; and (3) whether the company invested in securities in a manner consistent with the preservation of its assets until needed to finance operations. If these three initial requirements were met, then the SEC would examine additional factors including the company’s historical development, public representations of policy, and activities of officers and directors to determine whether the company would be exempt from the 40 Act requirements. Many biotechnology companies have since sought individual exemptions piggybacking on the ICOS Order.

Although the ICOS Order vastly improved a biotechnology company’s ability to avoid regulation under the 40 Act, the ICOS Order still left open certain questions: for example, the extent to which R&D companies can make investments in other companies not specifically made for capital preservation. The ICOS Order was also problematic because companies were expected to spend more on R&D than they earned in gross investment income. This ignored the fact that biotech companies would often raise capital whenever market conditions were favorable often resulting in investment income exceeding R&D expenses since R&D expenses would be spread out over many years. In addition, R&D companies concerned about their compliance with the 40 Act were required to expend significant time and money in seeking an individual exemption from the SEC. The Final Rule is intended to expand and codify the analysis contained in the ICOS Order and provide biotechnology and other R&D companies with a safe harbor from the definition of investment company.

The Final Rule provides a non-exclusive safe harbor from the definition of "investment company" for companies that raise large amounts of capital, invest capital proceeds in securities investments, and use the return from those investments to fund R&D activities. The Final Rule, which resulted, in part, from significant lobbying efforts by BIO and other industry organizations to codify the terms of the ICOS Order, benefits biotechnology and other R&D companies by reducing the costs and uncertainty associated with determining their status under the 40 Act and by affording them greater flexibility to raise and invest capital and enter into strategic relationships.

Under the Final Rule, a company must meet the following criteria to qualify under the non-exclusive safe harbor:

The company’s R&D expenses must represent a "substantial percentage" of total expenses for the last four fiscal quarters combined. The term "substantial" is left undefined in the Final Rule in order to provide flexibility to companies in accommodating for variations in expenses and fluctuations in R&D budgets over time. However, the SEC has indicated that (1) R&D expenses would certainly be "substantial" if they are at least a majority (>50%) of a company’s total expenses and (2) there are circumstances under which R&D expenses that constitute less than a majority of total expenses, notwithstanding "nonrecurring items or unusual fluctuations in recurring items," also may be considered "substantial."

The company’s net income derived from investments in securities, for the last four fiscal quarters combined, cannot exceed twice the amount of its R&D expenses for the same period.

The company’s expenses for investment advisory and management activities, investment research and custody, for the last four fiscal quarters combined, cannot exceed five percent of its total expenses for the same period.

Subject to certain limited exceptions discussed in the next bullet, the company must make all investments in securities (excluding – generally - investments in majority-owned entities or entities that are primarily controlled (i.e., at least 25%-owned, provided there is no other larger holder)) in "capital preservation investments." "Capital preservation investments" are investments made to conserve capital and liquidity until the funds are used in the company’s primary business. In considering which types of investments constitute capital preservation investments, companies should keep in mind the SEC’s position that each capital preservation investment must present limited credit risk.

Notwithstanding the above, reflecting the increased use of collaborative relationships to conduct R&D, the Final Rule permits a company to acquire "other investments" (i.e., investments in securities that are not capital preservation investments) if: (i) no more than 10% of the company’s total assets consist of other investments or (ii) no more than 25% of the company’s total assets consist of other investments, so long as at least 75% of those other investments were made pursuant to collaborative R&D arrangements. Collaborative R&D arrangements are defined as business relationships which: (i) are designed to achieve narrowly focused goals that are directly related to, and an integral part of, the issuer’s R&D activities; (ii) call for the issuer to conduct joint R&D activities with the party in which it is investing or one of its controlled entities, and (iii) are not entered into for the purpose of avoiding regulation under the 40 Act.

The company’s board of directors has adopted a written investment policy with respect to the issuer’s capital preservation investments.

Other Requirements

The company is primarily engaged, directly, through majority-owned subsidiaries, or through companies which it controls primarily, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities. The requirement in the preceding sentence must be evidenced by activities of officers, directors and employees; a company’s public representations of policies; its historical development; and an appropriate board resolution.

In addition, a company must not hold itself out as being engaged in an investment business.

Should a company not qualify for the safe harbor set forth in the Final Rule, or be uncertain as to whether it qualifies, the SEC has stated that the company may still determine its status vis-à-vis the 40 Act and seek an exemption based on the factors enumerated in the ICOS Order.

While the Final Rule still requires biotechnology and R&D companies to make certain judgments regarding the nature of their business in order to determine whether they may avail themselves of the safe harbor, it does provide companies with more certainty and comfort that they will not be inadvertently classified as an investment company under the 40 Act. We recommend that a company seeking to qualify under the Final Rule should evaluate its business in accordance with the above factors and adapt its budgeting to meet the threshold requirements necessary to qualify under the safe harbor. In addition, the board of directors should approve a resolution that the company is primarily engaged in a non-investment business, adopt investment guidelines designed to assure that the company uses its funds for investments consistent with the goals of capital preservation and liquidity and should take care to make sure public statements are consistent with such resolutions and policies.