Investment Company Institute
January 15, 2003
Mr. Jonathan G. Katz
The Investment Company Institute1 appreciates the opportunity to comment on proposed Rule 3a-8 under the Investment Company Act of 1940, which would provide a safe harbor from the definition of "investment company" for certain companies engaged in research and development.2
Proposed Rule 3a-8 generally would be available to a company that uses its assets and income for research and development purposes.3 While the Institute supports the basic approach taken by the proposed rule, we have specific comments and recommendations on certain provisions of the rule, as set forth below. Our comments on these provisions are generally designed to ensure that the rule serves its purpose of providing a safe harbor only for those companies that are, in fact, bona fide research and development companies.
As a preliminary matter, we wish to underscore the vitally important public policy objectives served by the definitional provisions of the Investment Company Act and of the Commission's regulations. The crafters of the Investment Company Act paid careful attention to investment company status questions, as has the Commission itself in the intervening years, with the objective of assuring appropriately broad coverage for the Act and strong protection of investors. Over the years, numerous applicants, desiring to avoid the Act's requirements, have urged the Commission to relax, liberalize, and even dismantle these definitional provisions. In light of legitimate concerns about the unintended adverse consequences of such changes, the Commission has moved with appropriate prudence and caution in this area. We urge it to continue to do so.
While the Institute generally supports the codification of established exemptive orders because it frees up limited staff resources,4 we question whether, in the current economic environment, the need for this rulemaking is as urgent as some of its most vocal proponents suggest.5 In any event, we hope the Commission, with its limited resources and many other pressing regulatory priorities, will be no less attentive to the needs and concerns of the investment companies it does regulate, than the research and development companies it does not.
The Institute has several recommended revisions to the proposed rule, which are intended to ensure that the rule serves its purpose of providing a safe harbor only for those companies that are, in fact, bona fide research and development companies. In summary, our comments are as follows:
Each of these comments is discussed in greater detail below.
A. Research and Development Expenses as a "Substantial Percentage" of Total Expenses
In order for an issuer to qualify for the safe harbor, proposed Rule 3a-8 would require, among other things, that the issuer's research and development expenses for the last four fiscal quarters combined be a "substantial percentage" of its total expenses for the same period. The proposed rule does not specify what percentage of a company's total expenses would be considered "substantial." The Proposing Release states that the Commission has not proposed an objective standard in order to permit research and development companies to take into account fluctuations in the composition of their expenses over time. The Proposing Release also states, however, that if a company's research and development expenses are the majority of its expenses but for nonrecurring items or unusual fluctuations in recurring items, the research and development expenses would be "substantial" for purposes of this provision.
Given the broad range of percentages that may reasonably be viewed as "substantial," we are concerned that companies that are primarily engaged in the investment business might escape regulation under the Investment Company Act if the "substantial percentage" approach is adopted. We recommend that the Commission instead adopt an objective standard, such as a requirement that an issuer's research and development expenses be a majority of its total expenses over the relevant period. We believe that an objective standard would protect against misuse of the safe harbor. The need for flexibility could be addressed by permitting companies to exclude nonrecurring items or unusual fluctuations in recurring items from their calculations or by extending the time period over which the percentage calculation is made.6
B. Definition of "Capital Preservation Investments"
Another requirement that a company would need to satisfy in order to qualify for the safe harbor under proposed Rule 3a-8 would be that the company's investments in securities be "capital preservation investments" (with limited exceptions). The proposed rule defines capital preservation investments as "investments that are made to conserve capital and liquidity until the funds are used in the issuer's primary business or businesses." The Proposing Release states that, in general, capital preservation investments are liquid so that they can be readily sold to support the company's research and development activities as necessary, and present limited credit risk. The Proposing Release indicates that this requirement is intended to ensure that the investments are being used to support the company's research and development activities, rather than in a speculative manner that would be more characteristic of an investment company.
The proposed rule's broad definition of capital preservation investments encompasses a wide range of instruments, some of which may present risk.7 In our view, the additional guidance included in the Proposing Release would not be sufficient to prevent companies from classifying investments that are in fact speculative as "capital preservation investments." Many types of investments can reasonably be viewed as liquid, and the statement in the Proposing Release that investments should "present limited credit risk" is also less clear than guidance that the Commission has provided in the past. For example, in a 1993 investment company status exemptive order, the Commission actually specified certain inappropriate investments by stating that "[s]ignificant investments in equity or speculative debt would indicate that the company is acting as an investment company rather than preserving its capital for research and development."8
We believe, therefore, that the Commission should clarify the definition of capital preservation investments to prevent possible misuse of the safe harbor. We recommend that the Commission consider imposing on permissible capital preservation investments for research and development companies specific requirements relating to credit quality, maturity and liquidity.9 We also recommend that Rule 3a-8 require that the research and development company's board of directors adopt investment guidelines designed to assure that such investments are consistent with capital preservation and liquidity.
C. Limits on Other Investments
Under the proposed rule, in addition to "capital preservation investments," a company would be permitted to acquire "other investments," as defined in the rule, provided that immediately after such acquisition: (a) no more than 10 percent of the company's total assets consist of other investments; or (b) no more than 20 percent of its total assets consist of other investments and at least 75 percent of such other investments were made pursuant to collaborative research and development arrangements. The Proposing Release states that limits on "other investments" would be calculated only at the time such "other investments" are acquired. If a research and development company's "other investments" increase in value due to market fluctuations, it would not be required to sell any "other investments" it already owns, but it would not be able to continue to acquire "other investments." The Commission requests comment on whether this approach is appropriate and specifically requests comment on whether the rule should provide a limit, applicable at any time, on the percentage of a company's assets that may consist of "other investments."
Under the proposed rule, it would be possible for a company to continue to rely on the safe harbor even if an "other investment" dramatically increased in value and dwarfed the combined value of the company's capital preservation investments and its primary business. Investors in such a company would be subject to significant risk absent regulation under the Investment Company Act. To avoid this result, we recommend that the proposed Rule 3a-8 safe harbor specify that the value of a company's assets that may consist of "other investments" may at no time exceed a certain overall percentage limitation (e.g., 25%).
We recognize that various asset percentage requirements imposed on registered investment companies under the Investment Company generally apply only at the time of acquisition.10 We note, however, that the staff has consistently applied the asset percentage requirements relating to investment company status issues at any time, rather than at the time of acquisition.11 We believe that this is an appropriate distinction in the application of these requirements in view of the purpose of the requirements.
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The Institute appreciates your consideration of our views on this matter. If you have any questions regarding our comments or would like additional information, please contact the undersigned at (202) 326-5824 or Anu Dubey at (202) 326-5819.
cc: Paul F. Roye, Director