Request for Rulemaking Concerning Definition of Investment Company
May 23, 2002
Jonathan G. Katz
Re: Petition for Investment Company Act of 1940 Rulemaking
Dear Mr. Katz:
We are writing on behalf of the Biotechnology Industry Organization ("BIO"). Pursuant to Rule 192 of the Securities and Exchange Commission's Rules of Practice, BIO hereby petitions the Commission to promulgate a new rule described below to address the unintended consequences for many BIO members caused by weaknesses in the basic tests used to determine investment company status under Section 3 of the Investment Company Act of 1940 (the "ICA").1
Basic changes in the nature of the United States economy call into question aging Commission interpretations in this area. The uncertainties about the proper application of these interpretations cause biotechnology companies to forego research and development and other collaborations, or forego investment return on liquid assets to avoid inadvertent investment company status, even though no member of the investing public would ever mistake these companies for investment companies. These constraints are preventing collaborations to develop potentially ground-breaking new drugs, and denying needed capital to young biotechnology companies.
In July 2001, we wrote the Commission's Division of Investment Management (the "Division") to describe these problems, and suggest several potential solutions. Based on an ensuing dialogue with the Division, we developed a proposed rule (the "Proposed Rule") that we believe will address the legitimate concerns of BIO members while protecting public investors. This letter describes the need for the Proposed Rule (Part I), outlines the Proposed Rule (Part II), and explains why the Proposed Rule is in the public interest (Part III).
I. The Need for the Proposed Rule
A. Traditional Tests
The traditional tests for determining investment company status heavily emphasize the composition of the issuer's assets and sources of income. Specifically, the tests compare the value of an issuer's "investment securities" and amount of income derived from "investment securities," to the value of the issuer's other assets and amount of income derived from other sources.
ICA Section 3(a)(1)(C) defines an investment company to include an issuer that owns or proposes to acquire "investment securities" having a value exceeding 40 percent of the issuer's total assets (exclusive of "Government securities" and "cash items") on an unconsolidated basis. ICA Section 3(a)(2) defines "investment securities" to include all securities other than Government securities and securities issued by majority-owned subsidiaries that are not investment companies.2 For purposes of Section 3, Section 2(a)(41) defines the "value" of assets that are not securities for which market quotations are readily available to mean the fair value at the end of the last preceding fiscal quarter, as determined in good faith by the board of directors.
ICA Section 3(b)(1) excludes from the Section 3(a)(1)(C) definition of an investment company any issuer primarily engaged, directly or through wholly-owned subsidiaries, in a business or businesses other than that of investing, reinvesting, owning, holding, or trading in securities. ICA Section 3(b)(2) excludes from Section 3(a)(1)(C) any issuer that the Commission finds, upon application, 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 through controlled companies conducting similar types of business." Since at least 1947, under the so-called Tonopah test, the Commission has focused primarily on the composition of the issuer's assets and sources of income when determining an issuer's primary business under Section 3(b).3 In doing so, the Commission has compared the value of the issuer's investment securities to the value of its other assets, and the amount of its income derived from investment securities to its other income.4
B. The Traditional Tests Underweight the Value of Intellectual Property
A large portion of the value of biotechnology companies consists of intellectual property. Biotechnology is one of the most research-intensive industries in the world. The U.S. biotechnology industry spent $26 billion in research and development in 1999.5 The top five biotechnology companies spent an average of $121,400 per employee on research and development during 1998. This compares with an average of $30,600 per employee for the top pharmaceutical companies. In addition, in the biotechnology industry, there is typically a significant time lag between research and development investments, and revenues produced by those investments. For example, it costs roughly $300 million to $500 million and takes roughly 10 to 14 years to develop a new drug and obtain FDA approval to market it.
For reasons entirely unrelated to the question of investment company status, the intellectual property created through these investments is not shown on these companies' balance sheets prepared in accordance with GAAP. As the Commission explained in 1993:
Unlike operating companies that generally invest in tangible assets, biotechnology companies use their capital to retain scientists and other professionals to produce "intellectual capital" and technology. Intellectual capital and technology, however, are not capitalized as assets on the companies' balance sheets, making it difficult for research and development companies to satisfy the asset test.6
Young biotechnology companies are particularly susceptible to this risk because, aside from the large pool of liquid assets they typically hold to fund research and development and the income generated by this pool, such companies are likely to have relatively few hard assets, and little current income, but extensive and valuable intellectual property.7
While this treatment of intellectual property on a company's financial statements may be entirely appropriate under GAAP, the treatment may discourage boards of directors from appropriately valuing these assets under the entirely different context of ICA Section 2(a)(41). In the absence of interpretive guidance from the Commission, boards of directors are reluctant to determine that intellectual property assets have a value greater than those assets have under generally accepted accounting principles.
C. The Traditional Tests Inappropriately Count Strategic Investments in Favor of Investment Company Status
Biotechnology companies increasingly rely on strategic investments to facilitate collaborations, reflecting a general trend among high technology companies.8 For example, according to one source, during all of the 1970s, U.S. companies formed only about 750 strategic alliances, but more than 20,000 new alliances between 1987 and 1992.9 Last year alone, companies announced over 10,000 new strategic alliances.10 Companies enter into strategic alliances for many reasons, including cost-sharing, risk sharing, to obtain or exploit technology, for joint research, to obtain financing or to obtain management assistance or marketing or distribution assistance, to compete more efficiently, to enter or access new materials, to effect synergies, or to use complementary business skills.11 Strategic alliances often include a strategic investment -- i.e., a large, well-funded corporation purchases a minority equity position in a smaller, start-up company. The investing company is "typically motivated more by strategic reasons, including influence or control over [the smaller company] and its business plans," than by the financial rewards from its equity investment.12 Similarly, a less well-funded company may acquire access to intellectual property by paying license fees, milestone payments, or other compensation using its stock instead of cash.
The biotechnology industry has been at the heart of this trend towards reliance on strategic alliances and investments.13 In many sectors of the biotechnology industry, the only way for companies to quickly access technology or skilled personnel that is in high demand is through strategic investments. For example, in the pharmaceutical sector, as a result of the completion of the mapping of the human genome, there has been an explosion in recent years in the demand for related technologies and skills. As a recent article in Time magazine explained, with the completion of the map of the human genome, "there will be many more potential avenues of research than the entire pharmaceutical industry could possibly hope to investigate over the next 20 years."14 The market for strategic alliances with the many small companies with these technologies and skills is thus highly competitive. These smaller capital-hungry companies are often unwilling to enter a strategic alliance with any company unwilling to make a strategic investment.
Among young biotechnology companies, strategic investments may be a significant portion of the assets valued on their balance sheets. Most strategic investments are not controlling interests, and are thus treated as investment securities that weigh in favor of investment company status. This, combined with the high valuations the market has given to some biotechnology start-up companies, exacerbates the problem.
D. The Traditional Tests Place Undue Emphasis on Liquid Assets Used to Fund Research and Development
In 1993, the Commission issued the ICOS order under Section 3(b)(2) and recognized the obsolescence of the traditional focus on assets and income as applied to biotechnology companies.15 ICOS was a biotechnology company that researched and developed medications. To fund its research and development, ICOS required substantial working capital. At the time of the exemptive order, ICOS did not have any drugs approved for commercial use. As a result, ICOS's income from non-investment sources was relatively small. Most companies in a similar position invested their liquid assets in government securities to avoid failing the 40 percent test. ICOS, however, wanted the ability to invest in high-quality debt instruments with a higher yield than government securities.
The Commission observed that while the income/asset test worked well for traditional bricks and mortar companies, the test was ill-suited for ICOS and similar companies. To remedy this problem, the Commission explained that if a company is actively engaged 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. Specifically, the Commission would deem a research and development focused company to be primarily engaged in a non-investing related business if:
E. Recent Developments Require Updating the ICOS Test
Since the Commission issued the ICOS order in 1993, the biotechnology industry has changed tremendously. Indeed, many have said that with the mapping of the humane genome, we are now entering the "golden age of biology." As a result, the need for strategic collaborations and investments among biotechnology companies is no longer a matter of choice -- in many cases, it is a matter of survival. Medium-sized biotechnology companies, for example, seeking to capitalize on the mapping of the human genome will cross the finish line on genetics-oriented drug research far too late, if at all, if they cannot quickly acquire skills and technology through strategic investments. More importantly, young biotechnology companies with promising, and potentially life-saving, research ideas, may wither on the vine without strategic investments to support that research.17
The rapid increase in the need for strategic investments in the biotechnology industry has had two principal consequences. First, as a result of strategic investments and the inability to value significant intellectual property, many BIO members are concerned about their status under the Section 3(a)(1)(C) and 3(b)(1) asset and income tests. Faced with the potential inability to access the capital markets absent a high degree of certainty about their investment company status, these BIO members threaten their success or even survival, by foregoing, missing, or altering strategic investments.
Second, the growth in strategic investments over last decade has limited the utility of the ICOS order. Despite the Commission's intent in the ICOS order to "clarify the status of virtually all such companies," today many biotechnology companies have trouble relying on ICOS because of their substantial strategic investments. In ICOS, the Commission required that substantially all of the issuer's non-controlling securities investments be secure investments designed to preserve capital. Although strategic investments are made to further a company's primary business objectives, they typically are not controlling interests and are not secure investments used to preserve capital. Accordingly, many BIO members are thus forced to forego strategic investments or invest their liquid assets in government securities, and forego the readily available higher return on other secure investments.
In addition to problems with fitting strategic investments under the ICOS test, young biotechnology companies are increasingly having trouble complying with the ICOS requirement that the company generally spend more on research and development than it earns in gross investment income. Increases in the gestation period of biotechnology products, the fickleness of the capital markets, and the ability of biotechnology companies to receive financing to fund future research and development of these products earlier in the product development cycle, may cause a biotechnology company's investment income to exceed research and development expenses during some periods.18
II. The Proposed Rule
To address these problems, BIO hereby petitions the Commission to promulgate, pursuant to its rulemaking authority under ICA Section 38(a), a new interpretive rule under ICA Section 3 defining the term "primarily engaged in a business" for purposes of ICA Section 3. Specifically, we propose that the Commission expand the ICOS test and implement it in this new rule as follows:
A. Elements of the Test. A biotechnology company will be deemed to be primarily engaged directly or through wholly-owned subsidiaries in a business or businesses other than investing, reinvesting, owning, holding, or trading in securities, if it meets all of the original requirements of the ICOS order except the following:
1. Subject to the cap described below, the company may own "strategic investments" (i.e., non-controlling securities positions) to achieve narrowly focused goals that are directly related to, and an integral part of, the investing company's research and development activities.
2. Cap on strategic investments.
a) The total cost of all strategic investments held at any time shall be less than the total amount of research and development expenses incurred during the most recent four fiscal quarters.
3. An investment will qualify as "strategic" for purposes of this interpretation only if and to the extent that:
a) 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;
b) the research, development, manufacturing, or commercialization activities that are the subject of the collaborative efforts or of the license or similar contractual right (or option on a license or similar contractual right) are the same as, or are a subset of, the investing company's regular business;
c) the investing company acquires the securities directly from the other party or its affiliate (i.e., open market purchases would not qualify) with the expectation that the collaboration or license or similar contractual right will be long-term;
d) the specified collaboration or license or similar contractual right is ongoing (i.e., once all collaboration, including any sharing of patents, know-how, or other intellectual property, joint marketing, or other rights or obligations completely terminates, the investment will no longer be treated as a strategic investment and will thus be treated like any other securities investment under the ICOS test).
4. The company may have investment income (excluding any income from strategic investments) less than or equal to twice the amount they spend on research and development.
5. The company's board of directors will adopt investment policies designed to ensure that the company makes its securities investments consistent with the requirements of ICOS.
III. Justification for the Proposed Rule
The Proposed Rule's treatment of strategic investments provides a more realistic assessment of biotechnology companies than the existing framework. As explained above, biotechnology companies make strategic investments primarily to support their biotechnology business, and not to engage in an investment business. Moreover, the Commission has concluded that strategic investments do not necessarily reflect an intent to engage in the business of owning or holding securities. In its proposal to exclude certain research and development companies from the Investment Company Act, the Commission explained:
Under [proposed] Rule 3a-8, determinations of whether a portfolio's holding is consistent with the requirement of investing to conserve capital and liquidity would be based on such investments "taken as a whole." Thus, the Commission 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 [inconsistent with conserving capital and liquidity], depending upon the facts and circumstances of that investment.19
The absence of such relief could lead one to the absurd conclusion that the primary business of a biotechnology company is investing simply because the company has strategic investments that have become valuable, even though the vast majority of the company's employees are scientists or engineers engaged in research and development.
The Proposed Rule's limited expansion of the ICOS limit on investment income would give biotechnology companies needed additional flexibility in deciding when and how to access capital markets. The test in ICOS that prohibits investment income from exceeding research and development costs, while an improvement over the Tonopah test, is arbitrary and has become potentially unduly limiting. In recent years, the duration of the drug development cycle has increased, and the capital markets have opened to biotechnology companies during brief windows. As a result, many biotechnology companies raise substantial amounts of money to fund anticipated future increases in research and development expenses in addition to current research and development expenses. Obtaining funding for future increases in research and development may, depending on the level of interest rates, cause a biotechnology company's investment income to exceed research and development expenses during some periods. The arbitrary limitation on investment income in ICOS, which provided ample flexibility in 1992, today may cause some biotechnology companies to forgo opportunities to raise additional capital, or to invest it in a way that is in the best interests of its shareholders, for fear that investment income may exceed research and development costs during some periods. This is precisely the outcome the Commission sought to avoid in ICOS.
The Proposed Rule has substantial safeguards to protect investors. The Proposed Rule would put reasonable limits on strategic investments and investment income based on readily available, publicly disclosed, and objective criteria. The Proposed Rule also carefully defines what investments qualify as strategic to limit the potential for abuse. Most importantly, under the Proposed Rule, shareholders of biotechnology companies would benefit because the additional collaborations allowed by the Proposed Rule would facilitated precisely the types of research activities from which investors in biotechnology companies seek to benefit.
From a broader public policy perspective, the Proposed Rule would permit investments that further important biotechnology research. Potentially ground-breaking drug research could result. These additional investments would create jobs and generate economic activity indirectly (e.g., through suppliers and service providers). The Proposed Rule would also help small biotechnology companies in need of funding, and improve the competitiveness of U.S. biotechnology companies versus foreign competitors.
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We appreciate your taking the time to consider these issues. If you have any questions, please call Matt Chambers at (202) 663-6591 or John Nagel at (202) 663-6134.
Matthew A. Chambers
John C. Nagel