Biotechnology Industry Organization
January 9, 2003
BY OVERNIGHT MAIL
Jonathan G. Katz
Re: Proposed Rule: Certain Research and Development Companies;
Dear Mr. Katz:
We are writing on behalf of the Biotechnology Industry Organization ("BIO")1 in response to the Securities and Exchange Commission's request for comment on proposed Rule 3a-8 under the Investment Company Act of 1940.2
BIO appreciates the Commission's responsiveness to the concerns expressed in the rulemaking petition submitted by BIO, and commends the Commission's proposal to adopt Rule 3a-8. BIO strongly supports the adoption of the proposed rule and is convinced that it would remove unnecessary constraints on investment in biotechnology research and development. Removal of these constraints would increase the flow of investment capital to research and development companies and thereby facilitate research into potentially ground-breaking new drugs and other technologies, and at the same time stimulate segments of the economy tied to biotechnology.
To fully realize these benefits, however, and accomplish the Commission's goal of ensuring "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," BIO respectfully submits that the Commission should make the changes to the proposed rule described below.3 Attached to this letter is a blackline version of the proposed rule showing specific language to effect these changes. BIO urges the Commission to take final action on the proposed rule as soon as possible after the close of the comment period.
I. Clarifying the Definition of "Collaborative Research and Development Arrangement"
Proposed Rule 3a-8(b)(4) would define a qualifying "collaborative research and development arrangement" as an arrangement that "[c]alls for the issuer to conduct joint research and development activities with one or more other parties." BIO is concerned that this proposed definition could be misread to require the collaborating companies to have equivalent roles throughout the research and development life cycle. For example, BIO is concerned that "joint research and development" could be read to connote scientists from each company working side-by-side in the laboratory throughout the research and development process. In many research and development collaborations, research and development is guided by a joint steering committee, with one company or the other primarily responsible for the hands-on research and development activities at different points in the process. BIO suggests that the Commission delete the word "joint" from this definition, and clarify in the adopting release that any bona fide research and development collaboration suffices, regardless of how the two companies divide responsibilities. Even with this change, the proposed rule would require involvement by both parties to the collaboration, because it would require that a qualifying arrangement be one that "[c]alls for the issuer to conduct research and development activities with one or more parties."4 Accordingly, we do not believe this change would open the door to potential abuse.
II. Additional Leeway on Proposed Threshold for Collaborative Investments
In BIO's rulemaking petition, BIO proposed limiting the total cost of collaborative investments to the total amount of research and development expenses incurred during the most recent four fiscal quarters. BIO proposed this approach because BIO views a biotechnology company's research and development expenses as a predictable and effective measure of the company's research and development activities. Proposed Rule 3a-8 takes a different approach and would limit qualifying collaborative investments to 20 percent of the company's total assets.5 Asset values tend to be much more volatile than research and development budgets, thus reducing the predictability of a company's ability to rely on the proposed rule. BIO is also concerned that in some cases, the proposed rule's asset-based approach may have the unintended consequence of discouraging additional investment in research and development. Additional investment in research and development may deplete a company's total assets, thus effectively lowering the company's cap on strategic investments. If the Commission decides to retain an asset-based test, BIO suggests that the Commission address these potential problems by increasing the proposed limit on collaborative investments from 20 percent to 30 percent of assets. This additional leeway should improve Rule 3a-8's effectiveness in protecting bona fide biotechnology companies from unnecessary restrictions on their activities.
III. Increased Consistency With GAAP
BIO submits that the Commission should maximize the extent to which companies seeking to rely on Rule 3a-8 can use generally accepted accounting principles ("GAAP") when performing the required calculations. Allowing reliance on GAAP would make possible the use of financial information in a company's audited financial statements, substantially reducing the burden of complying with the proposed rule. In contrast, requiring the use of financial information prepared inconsistently with GAAP subjects companies to the additional and potentially substantial burden of generating unaudited financial information solely for the purpose of determining Rule 3a-8 compliance. Allowing companies to rely on GAAP and thus on their audited financial statements also would enhance investor protection by basing the required calculations on information that has a high degree of reliability and is unlikely to be manipulated to achieve a particular result. Financial statements prepared in accordance with GAAP are rigorously scrutinized, audited by an independent public accounting firm, and disclosed to investors.
BIO suggests that the Commission make three changes to the proposed rule to allow additional reliance on GAAP.
Proposed Rule 3a-8(b)(2) requires calculations to be made on an unconsolidated basis, except that a company may consolidate its financial statements with any wholly-owned subsidiaries. Because GAAP has a different standard for consolidation, this requirement may impose a substantial burden on some companies, and indeed may render reliance on the rule impracticable. Preparing unconsolidated, unaudited financial statements can be quite time consuming and expensive, and the end product is not likely to be as reliable as audited financial statements. Accordingly, BIO submits that Proposed Rule 3a-8(b)(2) should be amended to permit issuers a choice of using either unconsolidated financial statements (as proposed Rule 3a-8 would require) or consolidated financial statements prepared in accordance with GAAP.
Proposed Rule 3a-8(b)(1) would require all assets to be valued in accordance with Investment Company Act § 2(a)(41). Section 2(a)(41) requires the board of directors to make a "good faith" determination of the "fair value" of any asset that is not a publicly traded security for which market quotations are readily available. While Section 2(a)(41) may work well for investment companies whose only assets typically are publicly-traded securities, Section 2(a)(41) may be impracticable for operating companies, and in particular biotechnology companies. Operating companies typically have numerous assets that are difficult to value, such as real estate, equipment, and, most significantly, intangible assets. If the proposed rule is adopted, biotechnology companies will likely own private securities that can be very difficult and costly to value. BIO suggests that the Commission amend Rule 3a-8(b)(1) to allow, but not require, companies to value their assets in accordance with GAAP.
In addition to valuation methodology, the timing of valuations that would be required by proposed Rule 3a-8 is problematic. Proposed Rule 3a-8 would, in effect, require a company seeking to rely on the rule to determine whether it complied with the asset-based limitations at the time it acquired each of its collaborative or other investments. Specifically, a qualifying company must meet the 20 percent test in proposed Rule 3a-8(a)(4) "immediately after [the] acquisition" of each collaborative or other investment. Depending on the age of a company and the number of its collaborative or other investments, this requirement could be quite burdensome and even impracticable, requiring the company to determine the total value of its assets at each of the times it acquired a collaborative or other investment.6 Moreover, this required look-back could render a company forever unable to rely on the rule based on investments made long before the company ever sought or needed to rely on the rule.7 BIO suggests that the Commission remedy this problem by relying on current asset values, rather than the value at the time of acquisition.
C. "Revenue From Investments"
Proposed Rule 3a-8(b)(2) would limit a company's "revenues from investments." The Proposing Release explains that revenues from investments "would include all investment returns, including amounts earned from dividends, interest on securities, and profits on securities (net of losses)." BIO is concerned that the proposed phrase "revenues from investments" is ambiguous, and might be read to include, for example, unrealized gains. BIO suggests using a more precise phrase such as "net income from investments" -- a phrase that would parallel the use of the phrase "net income" in Investment Company Act Rule 3a-1.8
* * *
BIO greatly appreciates the efforts of the Commission and its staff in proposing Rule 3a-8 and also appreciates the opportunity to offer these comments. 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
cc: Chairman Harvey L. Pitt
(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;
(ii) No more than
(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:
(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.
(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 and may consolidate its financial statements with the financial statements of any other subsidiary to the extent permitted or required by generally accepted accounting principles;
(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;
(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.