On November 26, 2002, the SEC proposed for comment Rule 3a-8 (the "Proposed Rule") under the Investment Company Act of 1940 (the "1940 Act"). The Proposed Rule would provide a non-exclusive safe harbor from the definition of "investment company" for certain bona fide research and development companies ("R&D companies") so that such companies would not be deemed "inadvertent investment companies" required to register under the 1940 Act.

Background

The SEC initially proposed Rule 3a-8 in 1993 (the "1993 Proposal") to codify the terms of an SEC order under the 1940 Act issued to ICOS Corporation, a biotechnology company (the "ICOS order"). The ICOS order addressed how the status of certain R&D companies should be determined under the 1940 Act.

The SEC failed to adopt the 1993 Proposal, and R&D companies have continued to rely to some degree on interpretations of the ICOS order. Recently, in response to a petition for rulemaking by the Biotechnology Industry Organization, the SEC has once again undertaken to update and codify the analysis set forth in the ICOS order with respect to certain R&D companies.

Summary Of Proposed Rule 3a-8

The release defines "research" by reference to accounting SFAS No. 2, which defines it as planned search or critical investigation aimed at discovery of new knowledge with hope that such knowledge will be useful in: (i) developing a new product or service; (ii) developing a new process or technique; or (iii) bringing about a significant improvement to an existing product or process. "Development," also defined by reference to SFAS No. 2, is defined 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 for use.

Often R&D companies raise large sums of capital, invest the proceeds and use both the principal of and the return on these investments to help fund research and development activities. Certain R&D companies enter into strategic alliances with other R&D companies through the purchase of a non-controlling equity stake. As a result, an R&D company may inadvertently fall within the definition of "investment company".

The Proposed Rule would provide R&D companies with greater flexibility to raise and invest capital pending its use in research and development activities. It would also clarify the extent to which a company relying on the Proposed Rule may make investments in other R&D companies in connection with certain collaborative research and development arrangements. Generally, a company would be eligible to rely on the Proposed Rule's non-exclusive safe harbor if the company:

• has research and development expenses for the last four fiscal quarters that are a substantial percentage of its overall expenses for that period (although the term "substantial" is left undefined by the Proposed Rule, the SEC notes that if such expenses constitute a majority of the company's expenses, but for nonrecurring items or unusual fluctuations in recurring items, the expenses would be deemed "substantial" for purposes of the Proposed Rule);
• has investment-related revenues derived from investments in securities that do not exceed twice the amount of its research and development expenses;
• has devoted no more than five percent of its total expenses for its last four fiscal quarters combined to investment-related activities (e.g., investment advisory and management activities, investment research and selection and supervisory and custodial fees);
• makes its investments to conserve capital and liquidity until it uses the funds in its primary business subject to certain exceptions; and
• is primarily engaged, directly or through a company or companies that it controls primarily, in a non-investment business, as evidenced by the activities of its officers, directors and employees, its public representations of policies, and its historical development.

The SEC is currently inviting comments on the Proposed Rule.