January 29, 2003

Via e-mail - rule -

U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attention: Jonathan G. Katz, Secretary

Re: Certain Research and Development Companies; Proposed Rule 3a- 8
under the Investment Company Act of 1940; SEC File No. S7-47-02

Dear Ladies and Gentlemen:

This letter is submitted on behalf of the Committee on Federal Regulation of Securities of the American Bar Association's Section of Business Law (the "Committee")* in response to a request for comment by the Securities and Exchange Commission ("Commission") on a proposed new rule, Rule 3a-8, under the Investment Company Act of 1940, as amended ("1940 Act") ("Rule 3a-8" or the "Rule"). Proposed Rule 3a-8 would provide a non-exclusive safe harbor from the definitions of "investment company" in Section 3(a)(1)(A) and Section 3(a)(1)(C) of the 1940 Act for certain bona fide research and development companies. (See Release No. IC-25835 (Nov. 26, 2002), 67 F.R. 71915 (Dec. 3, 2002) ("Proposing Release")).

The comments expressed in this letter represent the views of the Committee only and have not been approved by the American Bar Association's House of Delegates or Board of Governors and therefore do not represent the official position of the Association.1 In addition, this letter does not represent the official position of the ABA Section of Business Law, nor does it necessarily reflect the views of all members of the Committee.

I. Introduction

The 1940 Act sets forth a comprehensive regulatory structure governing the organization and operation of investment companies. Section 3(a)(1)(A) defines the term "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 (the "Business Definition").2 Section 3(a)(1)(C) defines the term "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"3 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 Definition").4

Section 7(a) of the 1940 Act prohibits an investment company from offering to sell a security, purchasing a security, or otherwise engaging in business in interstate commerce in the absence of registering with the Commission as an investment company or relying on an exemption from registration. Due to the broad definition of "investment company," an operating company having no ability or intention to function as a registered investment company can inadvertently become an investment company because it falls within the Asset Definition. An operating company may not be required to register with the Commission, even if technically satisfying the definition of "investment company," in reliance on two provisions of Section 3(b) of the 1940 Act5 or other Commission exemption.

Section 3(b)(1) of the 1940 Act, a self-operative exclusion, provides that any issuer primarily engaged, directly or through a wholly-owned subsidiary or subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding or trading in securities, is not an investment company. Section 3(b)(2) of the 1940 Act authorizes the Commission to grant exemptive relief declaring that an issuer is primarily engaged in a business or businesses other than that of investing, reinvesting, owning, holding or trading in securities either directly or through majority-owned subsidiaries or controlled companies conducting similar types of non-investment company activities.

The Commission examines the non-investment company activities of companies in the context of Section 3(b)(2) on the basis of five factors derived from an early Commission order of 1947.6 These five factors, referred to in the Proposing Release as the "Tonopah factors," look to (i) the company's historical development; (ii) the company's public representations of policy; (iii) the activities of the company's officers and directors; (iv) the nature of the company's present assets; and (v) the sources of the company's present income. The Proposing Release notes that the two most important of the Tonopah factors are the composition of the company's assets and its sources of income.

II. Proposed New Rule 3a-8

The Commission has proposed for comment Rule 3a-8 under the 1940 Act, which, if adopted, would provide 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 research and development ("R&D") activities.7 The Proposing Release has referred to such companies as "R&D companies."

The Commission stated in the Proposing Release that the traditional analysis of the asset and income elements of the Tonopah factors may not appropriately reflect the operational aspects of an R&D company. Further, the nature of the capital raising efforts of R&D companies and their investment holdings can cause them to fall within the Asset Definition, thus requiring relief from investment company registration and regulation. In order to provide R&D companies relief from the application of the 1940 Act in the absence of a Commission order, the Commission proposed conditions and definitions under the Rule in an effort to address the operational realities of R&D companies.

  • Conditions and Definitions of Proposed Rule 3a-8

      R&D Expense Ratio

The proposed Rule requires that an R&D company's "research and development expenses," for the last four fiscal quarters combined, be a substantial percentage of its total expenses over the same four-quarter period. The Commission incorporates into its definition of "research and development expenses" key terms from the Statement of Financial Accounting Standards No. 2 (the "Statement") currently in effect or as modified in the future.8

Currently, the Statement defines "research" as planned search or critical investigation aimed at discovery of new knowledge with the 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. The Statement defines "development" as 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. According to the Statement, expenses for "research" and "development" include costs incurred for materials, equipment, facilities, personnel, intangibles, and indirect costs that are clearly related to R&D activities. The Commission does not define the term "substantial" for purposes of determining if R&D expenses account for most of an R&D company's total expenses. The Commission stated, though, that if R&D expenses were the majority of a company's expenses, the condition would be satisfied.

      Securities Investment Revenue Ratio

The proposed Rule requires that an R&D company's revenues from "investments in securities," for the last four fiscal quarters combined, not exceed twice the amount of its R&D expenses for the same four-quarter period. The Commission defines the term "investment in securities," as "all securities other than securities issued by majority-owned subsidiaries and companies controlled primarily 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." The 1940 Act defines the term "majority-owned subsidiary" in Section 2(a)(24) (e.g., 50 percent or more ownership of a subsidiary's voting securities). The Rule defines "control" by reference to Section 2(a)(9) of the 1940 Act.

The Commission's stated purpose for this condition of the Rule is to permit R&D companies to raise capital during favorable market conditions, while balancing against an R&D company focusing its business predominantly on securities investments in the character of an investment company.

      Investment Expense Ratio

The proposed Rule requires that an R&D company's expenses for investment advisory and management activities, investment research, and custody for the last four fiscal quarters combined, not exceed five percent of its total expenses for the same four-quarter period. The Commission premises this condition on the notion that a bona fide R&D company would make less risky investments in order to preserve capital and would invest in liquid securities for purposes of funding its R&D operations. That is, the more speculative the company's investment activities, the greater its investment-related costs are likely to be. High investment-related costs, in turn, provide evidence that a company may not be primarily engaged in bona fide R&D activities, but instead primarily engaged in owning, holding, investing, reinvesting, or trading in securities. Conversely, the more conservative the investment activities, the lower the investment-related costs are likely to be. Low investment-related costs, in turn, provide evidence that a company's primary business is something other than owning, holding, investing, reinvesting, or trading in securities.

      Nature of Investments

Subject to the revenue limits noted above, the proposed Rule requires the majority of an R&D company's investments to be in "capital preservation investments." The Rule does permit "other investments" on a limited basis, provided that, immediately after their acquisition, these investments account for (i) no more than 10 percent of the R&D company's total assets; or (ii) no more than 20 percent of the R&D company's total assets and at least 75 percent of these other investments are attributable to a "collaborative research and development arrangement."

The Commission defines the following terms for this condition of the Rule:

    (a). "Capital preservation investments" mean "investments that are made to conserve capital and liquidity until the funds are used in the [R&D company's] primary business or businesses."

    (b). "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 company's R&D activities; (ii) Calls for the company to conduct joint R&D activities with one or more parties; and (iii) Is not entered into for the purpose of avoiding regulation under the 1940 Act."

    (c). "Other investments" mean "investments in securities that are not capital preservation investments."

The Commission's stated purpose for this condition is to ensure that an R&D company's investments in securities and joint R&D efforts are consistent with funding its R&D operations, as opposed to speculating in the market in the manner of an investment company.

      Public Representations and Special Situation Investment Companies

The proposed Rule prohibits an R&D company from holding itself out to the public as being engaged in the business of investing, reinvesting, or trading in securities. This condition also prohibits reliance on the Rule by a special situation investment company.

      Codification of Certain Tonopah Factors

The proposed Rule codifies the Tonopah factors that look to an R&D company's (i) historical development; (ii) public representations of policy; (iii) activities of its officers, directors, and employees; and (iv) resolutions of its board as evidence of its non-investment company business. All of these Tonopah factors have traditionally guided an analysis of a company's investment company status.

  • Requests for Comment

The Commission requested comment on a number of technical aspects of the Rule's conditions and definitions, as well as generally whether the Rule advances the Commission's general purpose. Namely, the Rule is intended to strike a balance between permissible securities investments for purposes of funding bona fide R&D activities, in contrast to funding a securities investment business outside of the registration and regulatory obligations of the 1940 Act. The Commission also requested comment on whether alternative conditions or definitions may be more appropriate to achieve the Commission's purpose and to address practically the operations of R&D companies.

III. Committee Comments

The Committee supports the Commission's efforts to clarify the non-investment company status of certain types of operating companies under the 1940 Act. Proposed Rule 3a-8 is a valuable initial step in these efforts. The Committee has not addressed the more technical aspects of the Rule. Instead, the Committee's comments are limited to practical issues generally raised by the proposed Rule.

  • Scope of the Rule

Proposed Rule 3a-8 is narrowly tailored to benefit exclusively R&D companies that may inadvertently fall within the Business or Asset Definitions. A Commission rule in this area provides significant time and expense savings for R&D companies that might otherwise be incurred to obtain a Commission exemptive order or opinion of counsel. Therefore, the Rule provides a valuable benefit exclusively to one class of operating companies, R&D companies. As the Commission is aware, many other bona fide commercial and industrial companies confront similar difficult investment company status issues. These status issues appear to have become more prevalent as different business models and strategic alliances have developed to fund Internet or other start-up companies in the new economy, which do not otherwise intend to operate as investment companies. Under proposed Rule 3a-8, non-R&D companies will not have the advantage of relying on the certainty of a safe harbor as to their non-investment company status, even though they may fund their non-investment company activities in the same way as an R&D company. Inasmuch as non-R&D companies also have the preservation of capital as a significant component necessary to fund their future non-investment company activities, they should also benefit from the consideration of their legitimate investment efforts to preserve capital by relying on a rule that clarifies their non-investment company status.

Therefore, the Commission may wish to consider whether it is practical to extend the conditions of Rule 3a-8 or craft a separate safe harbor applicable to commercial and industrial companies under certain conditions. For instance, the Commission has received applications for exemptions under Section 3(b)(2) from operating companies that have successfully raised capital, but have not successfully transferred those assets into operating businesses or operating subsidiaries (for various reasons).9 In some cases, these companies have invested cash in high-quality debt securities, with returns at maturity structured over time to fund operations. Requests for exemption in this area argue that these operating companies do not operate as bond funds requiring registration and regulation under the 1940 Act, but as operating companies investing in capital preserving assets to fund their operating businesses. Thus, these applications could form the basis of a condition to proposed Rule 3a-8 or a new rule that would apply to non-R&D operating companies.

The Committee also recommends that the Commission, at a minimum, clarify that Rule 3a-8 is not strictly construed as the exclusive means of determining any operating company's non-investment company status. The Commission could make this point clear with a statement in the adopting release to Rule 3a-8 similar to clarifying statements in other contexts. For example, in the adopting release to Rule 151 under the Securities Act of 1933, as amended ("1933 Act"),10 the Commission stated:

Rule 151 is merely a `safe harbor,' not an all-inclusive definition purporting to encompass every annuity contract that falls within the Section 3(a)(8) exclusion. The rule, therefore, does not attempt to identify the outer limits of Section 3(a)(8) beyond which a contract, though denominated `insurance,' is a security subject to regulation. Rather, the rule simply defines a class of annuities that the Commission believes is clearly entitled to rely on the [Section 3(a)(8) exclusion]. While compliance with rule 151 will assure `non-security status,' failure to comply with the rule would not mandate `security status' for an annuity product.11

Courts have cited to this statement in analyzing the securities status of certain types of annuity contracts,12 and this statement has formed an integral part of opinions of counsel in this area. A similar statement would be beneficial to an analysis of the non-investment company status of operating companies that cannot rely on proposed Rule 3a-8 or of R&D companies that cannot satisfy all of the Rule's terms.

  • The Tonopah Factors

The necessity for a rule like proposed Rule 3a-8 perhaps proves that the income and asset factors of the five Tonopah factors have limited significance to the capital raising efforts of companies in the new economy. Indeed, commentators have noted that the focus on an operating company's present income and assets creates difficulties for new economy companies that inadvertently fall within the definition of investment company, but have no intention of acting as an investment company.13 Markets and the manner which operating companies fund their businesses have evolved significantly over the approximately six decades since the Commission enunciated the Tonopah factors. We suggest that the Commission consider whether strict reliance on the income and asset factors have continued relevance to the manner in which operating companies fund their future non-investment company activities, or whether a test focused around the first three elements of the Tonopah factors, as set forth below, are more relevant to an investment company analysis, not only of R&D companies, but other operating companies investing in securities or entering into strategic alliances to fund their operating company activities.

The other Tonopah factors addressing (i) a company's historical development; (ii) a company's public representations of policy; and (iii) activities of a company's officers and directors appear to have withstood the test of time and continue to provide useful guidance concerning a company's non-investment company status. Accordingly, the Committee has no strong objections with codifying those factors in proposed Rule 3a-8 or in any other rule addressing an operating company's non-investment company status.

  • Operating Through a Company "Controlled Primarily"

The Committee applauds the Commission's recognition of the fact that a company that operates its business through a company "controlled primarily," but that does not meet all of the other requirements of Rule 3a-1 under the 1940 Act, may still not be an investment company. The Committee believes that the difference between a business operated through a majority owned subsidiary and a company that is controlled primarily by the operating company is, in many cases, without substance. As various releases have shown, the distinction between ownership and management of 51% of the equity of a company and 25% of the equity of a company can be minimized when no other group is exercising more managerial authority over that company's business operations.14

These same business realities that cause an R&D company to engage in a business through a "primarily controlled company" apply to non R&D companies that cannot comply with Rule 3a-1. The Committee believes that the concept reflected in the proposal should be extended to these non R&D companies generally.

  • Non-Controlling Interests

The Committee supports the inclusion of non-controlling equity interests in related companies as permissible portfolio holdings for both R&D companies and other operating companies. The Committee believes that the unique transaction structures evolving in today's capital markets strongly suggest that the identification of a particular investment position as relevant to the company's operations is based on the facts and circumstances of a transaction, and does not always depend on the "control" aspect of the equity position. Some companies take small stakes in other companies with a view toward a majority or complete acquisition at a later date. Other companies may use multiple small equity arrangements to ensure access to component technology and technology support, while keeping options for future growth of the primary operating business as wide open as possible. Finally, many equity relationships are structured to increase over time either automatically through rights or option features, or through subsequent additional purchases including follow-on investments, co-investments and other joint equity investment opportunities. As such, a meaningful relationship can exist with a company although the equity position does not rise to a 25% "control" level.

  • Cure Provision

The Rule contains many technical, objective standards that are intended to measure the ratio of investment expenses and revenues to R&D expenses. Similar technical, objective standards also measure the permissible investments of an R&D company. The Committee does not believe that it is in the best position, or appropriate for it, to advocate whether these measures precisely account for an R&D company's business or operations. Technical measures of this nature can impose rigid operating standards that may be arbitrary and, in any event, difficult to administer.

To the extent that the Rule imposes technical, objective measures that might prove inflexible, the Commission may wish to consider balancing any unintended consequences of those measures with a cure period in the Rule. For example, an R&D company in reliance on the Rule invests in permissible securities investments during a market boom. Over four quarters, its returns exceed twice the amount of its R&D expenses because of an unexpected dormancy in its R&D activities. As a result, the R&D company presumably loses any certainty of its non-investment company status, which can impede ongoing operations or business activities.

The R&D company could rely on Rule 3a-2 under the 1940 Act for transient investment companies until it restores its compliance with Rule 3a-8. Of course, sub-paragraph (c) of Rule 3a-2 permits reliance only once during any three-year period. Thus, Rule 3a-2 may prove to be too limiting a cure provision.

The Commission may wish to incorporate a cure provision solely for purposes of applying proposed Rule 3a-8. This cure provision could give an R&D company 30 days following any four-quarter period to rebalance its asset holdings or modify its investment-related expenses to restore compliance with the Rule. An appropriate board resolution could evidence the R&D company's efforts to modify its holdings or investment expenses should it be necessary to restore compliance with Rule 3a-8.

  • Definitions

The Committee supports the Commission's efforts to maintain flexibility in the Rule, particularly in the definitions under the Rule. Some of the elements of these definitions will require Commission and staff interpretations. For instance the definition of "capital preservation investments" requires the R&D company to intend investments to be for purposes of conserving capital and liquidity. The definition is unclear as to the extent that an investment might conserve capital or liquidity, or just what those elements mean.

Similarly, the definition of "collaborative research and development arrangement" requires, among other things, that the arrangement be designed to achieve "narrowly focused goals." The definition is not clear what might constitute a narrowly focused goal.

The Commission may wish to consider generally interpreting these definitional elements in the adopting release, while ensuring that any particular situation be governed by the precise facts and circumstances. For instance, the Commission interpreted the meaning of "substantial" (i.e., 50% or more of expenses) in the Proposing Release, for purposes of the R&D expense ratio in sub-paragraph (a)(1) of the Rule. The Commission's no-action process may also be an important vehicle to give these definitional elements and the Rule greater meaning.

* * *

We hope these comments are helpful to the Commission and its staff. Members of the Committee's Subcommittee on Investment Companies and Investment Advisers would be happy to respond to any questions.

Respectfully submitted,


Stanley Keller
Chair, Committee on Federal
Regulation of Securities

Drafting Committee:
Alexandra Alberstadt
Diane E. Ambler
Jay Baris
Aviva Grossman
C. Dirk Peterson

cc: The Honorable Harvey L. Pitt
The Honorable Cynthia A. Glassman
The Honorable Harvey J. Goldschmid
The Honorable Paul S. Atkins
The Honorable Roel C. Campos
Paul F. Roye, Director, Division of Investment Management

* References to "we" and "our" refer to the Committee.
1 Not all the members of the Committee agreed with the views expressed in this comment letter.
2 Section 2(a)(36) of the 1940 Act broadly defines the term "security" to mean "any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or on any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a `security,' or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, warrant or right to subscribe to or purchase any of the foregoing."
3 Section 3(a)(2) of the 1940 Act defines the term "investment security" as all securities except Government securities, securities issued by employees securities companies, and securities issued by majority-owned subsidiaries of the owner which are not (i) investment companies and (ii) are not relying on exclusions from the definition of investment company in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act.
4 Section 3(a)(1)(B) of the 1940 Act also defines the term "investment company" to include certain face-amount certificate companies. Proposed Rule 3a-8 omits face amount certificate companies from its safe harbor.
5 Section 3(b) of the 1940 Act by its terms provides an exclusion only to companies that fall within the Asset Definition. Nevertheless, the Commission in the Proposing Release has interpreted Section 3(b) as applying to a determination of a company's business for purposes of the Business Definition. See Proposing Release, n. 14, citing, M.A. Hanna Co., 10 S.E.C. 581 (1941).

In other limited circumstances issuers have relied on exemptive relief from the Commission under Section 6(c) of the 1940 Act for not registering as an investment company. See, e.g., In the Matter of General Cinema Corporation, Release Nos. IC-17967 (Feb. 17, 1991) (Notice), IC-18021 (Feb. 27, 1991) (Order), IC-18337 (Oct. 1, 1991) (Notice), and IC-18377 (Oct. 24, 1991) (Order).

6 See In the Matter of Tonopah Mining, 26 S.E.C. 426 (1947).
7 The Commission previously proposed Rule 3a-8 in 1993. Investment Company Act Release No. 19566 (July 9, 1993). This proposal set forth a basic three-part test determining the non-investment company status of a company on the basis of (i) the company holding its business out as something other than investing, reinvesting, and trading in securities; (ii) the company's financial statements showing that the company's total expenses are attributable to research and development expenses and those expenses equal or exceed expenses for investment activities and investment-related expenses do not exceed five percent of the Company's total expenses; and (iii) the Company's securities investments, taken as a whole, are for capital and liquidity conservation. The Commission withdrew the proposal in Investment Company Act Release No. 21795 (Mar. 4, 1996).

The proposal was intended to codify terms of an exemptive order under Section 3(b)(2) to ICOS Corporation ("ICOS"). Investment Company Act Release No. 19274 (Feb. 8, 1993) (notice); Investment Company Act Release No. 19334 (Mar. 16, 1993) (order). ICOS was a development-stage biopharmaceutical company. The Biotechnology Industry Organization has petitioned the Commission to revisit rulemaking in this context.

8 Accounting for Research and Development Costs, Statement of Financial Accounting Standards No. 2 (Fin. Accounting Standards Bd. 1974).
9 See, e.g., In the Matter of Allscripts, Inc., SEC File No. 812-11996 (Mar. 3, 2000); and In the Matter of i2 Technologies, Inc., SEC File No. 812-11970 (Feb. 9, 2000).
10 Securities Act Release No. 6645 (May 29, 1986). Rule 151 under the 1933 Act is a non-exclusive safe harbor for purposes of determining the status of certain annuity contracts under an exclusion from the definition of "security" in Section 3(a)(8) of the 1933 Act. Section 3(a)(8) of the 1933 Act excludes from the definition of security, in relevant part, an annuity contract or optional annuity contract issued by an insurance company.
11 Id. at Release 6645. The Commission made a similar statement in the proposing release to Rule 151. See Securities Act Release No. 6558 (Nov. 21, 1984).
12 See, e.g., Otto v. Variable Annuity Life Insurance Company, 814 F.2d 1127 (7th Cir. 1986), rev'd on rehearing, 814 F.2d 1140 (1987), modified (1987), cert. denied, 486 U.S. 1026 (1988).
13 See generally Bancroft, Margaret A. and Stoller, Lawrence B., Avoiding Classification as an Investment Company: Exemptions and Exclusions for Business Corporations, Vol. 65, Corporate Practices Series (BNA), March 2001.
14 See, e.g., Yahoo! Inc., Investment Company Act Release No. 24459 (May 18, 2000) (notice); Investment Company Act Release No. 24494 (June 13, 2000) (order).