---

On October 12, 2005, the SEC granted an order to Applied Materials, Inc. declaring that it is not an investment company under the Investment Company Act of 1940 (the "1940 Act").  The application process took more than three years. 

Applied Materials is a public company that is in the business of developing, manufacturing, marketing and servicing integrated circuit fabrication equipment.  Like many other technology-oriented companies, Applied Materials raised a substantial amount of capital for its current and future business operations.  The company sought to preserve its capital and maintain liquidity by investing in short-term investment grade and liquid fixed income and money market investments.  In pursuing this strategy, Applied Materials inadvertently found itself within the statutory definition of "investment company" and potentially subject to the regulatory regime of the 1940 Act.

Applied Materials, an Inadvertent Investment Company

Even if a company passively holds securities, as opposed to actively trading in them, it may be deemed an investment company.  Under Section 3(a)(1)(C) of the 1940 Act, an issuer is an investment company if it is engaged in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire "investment securities" having a value exceeding 40% of the value of the issuer’s total assets (exclusive of U.S. government securities and cash items) on an unconsolidated basis.  The 1940 Act defines "investment securities" broadly to include virtually all securities except U.S. government securities and securities issued by majority-owned subsidiaries that are not themselves regulated or exempt investment companies.

Applied Materials conceded that the value of its investment securities first exceeded 40% of its assets (exclusive of U.S. government securities and cash items) in the third quarter of its 2001 fiscal year.  At the time of its initial application in August 2002 and each subsequent year thereafter, Applied Materials’ investment securities constituted more than 40% of its assets.  Thus, Applied Materials fits within the definition of investment company under Section 3(a)(1)(C) of the 1940 Act. 

Exemptions from the Definition of Investment Company

An issuer that meets the statutory definition of an investment company nevertheless may be deemed not to be an investment company under certain provisions of the 1940 Act.  Under Section 3(b)(1) of the 1940 Act, an issuer is not an investment company if it is primarily engaged, directly or through wholly-owned subsidiaries, in a business other than that of investing, reinvesting, owning, holding or trading in securities.  This provision is self-operating in that an issuer may decide to rely on it without seeking an order by the SEC.  An incorrect conclusion, however, could risk an enforcement action by the SEC against the issuer.  In addition, law firms are typically reluctant to issue an opinion that a company is not an investment company in reliance on Section 3(b)(1) because of the factual analysis required.

Although Applied Materials stated that it believes that it is exempt from the 1940 Act under Section 3(b)(1), it requested an order from the SEC because it could not consistently rely on other exemptions available under the 1940 Act and it wanted to remove any uncertainty regarding its status.

Rule 3a-1 under the 1940 Act exempts an issuer if no more than 45% of its total assets consist of, and not more than 45% of its net income (for the last four fiscal quarters combined) is derived from, securities other than U.S. government securities, securities issued by employees’ securities companies, securities of majority-owned subsidiaries and primarily controlled companies.  Applied Materials could not rely on this exemption because its non-excepted securities constituted more than 45% of its total assets.  Applied Materials also conceded that it could not rely on this exemption because it experienced significant and unpredictable fluctuations in the ratio of income from non-excepted securities relative to its net operating income due to the nature of the semiconductor industry.

Rule 3a-8 under the 1940 Act exempts an issuer that qualifies as a research and development company.  The key requirements of the rule are that the issuer’s:

(i)      research and development expenses must be a "substantial percentage" of its total expenses;

(ii)     net income from investments in securities may not exceed twice the amount of its research and development expenses;

(iii)    expenses for investment advisory and management activities, investment research and custody may not exceed 5% of total expenses;

(iv)    investments in securities must be "capital preservation" investments, except that: (a) up to 10% of total assets may consist of other investments, or (b) up to 25% of total assets may consist of other investments, provided that at least 75% of such other investments are made pursuant to collaborative research and development arrangements;

(v)     public statements are such that it does not hold itself out as being engaged in the business of investing, reinvesting or trading in securities; and

(vi)    board of directors adopts a written investment policy with respect to capital preservation investments. 

From its fiscal year 2002 through 2004, Applied Materials’ research and development expenses ranged between approximately 16% to 22% of its total expenses, including cost of goods sold.  Applied Materials was not comfortable relying on the exemption under Rule 3a-8 because, in its view, its research and development cost may be deemed a "substantial percentage" in some years, but not others. 

Accordingly, Applied Materials sought relief under Section 3(b)(2) of the 1940 Act.  This Section authorizes the SEC, based on findings of facts applicable to an individual issuer, to grant an order declaring that the issuer is primarily engaged (directly or through majority-owned subsidiaries or controlled companies conducting similar types of businesses) in a business other than that of investing, reinvesting, owning, holding or trading in securities.

Fact-Finding by the SEC

In Tonopah Mining Co., the SEC set forth five principal factors that it considers in determining an issuer’s "primary business" under Section 3(b)(2).[1]  The five factors are: (a) the issuer’s historical development; (b) its public representations of policy; (c) the activities of its officers and directors; (d) the nature of its present assets; and (e) the sources of its present income.  As part of its review, the SEC scrutinizes the issuer’s capital expenditures in comparison to total expenses and considers whether these expenditures conform to the issuer’s explanation of its intended use of the funds. 

Applied Materials’ Facts and Conditions

Historical Development.  Applied Materials represented that it manufactures equipment used in the semiconductor integrated circuit fabrication process, and provides products and services that enhance manufacturing yields.  Since its inception in 1967, Applied Materials claims that it has become the largest supplier of products and services to the global semiconductor industry.  Applied Materials’ customers include semiconductor wafer manufacturers and semiconductor integrated circuit ("chip") manufacturers.

Public Representations of Policy.  Applied Materials stated that it has never represented itself to be involved in any other business other than developing, manufacturing, marketing and services integrated circuit fabrication equipment.  In its public reports and statements, Applied Materials styles itself as the largest supplier of products and services to the global semiconductor industry.  Applied Materials stated that it generally does not make public representations about its investment securities except as required to comply with federal securities laws, and that it emphasizes its operating results and not its investment income or the possibility of significant appreciation from its cash management investment strategies as a material factor to its business or its development.

Activities of Officers and Directors.  Applied Materials stated that its directors and officers spend substantially all of their time managing Applied Materials’ business.  The directors spent less than 1% of their time on investment-related matters.  Applied Materials’ chief financial officer spent less than 10% of her time monitoring cash balances and managing short-term investment securities in accordance with Applied Materials’ investment policies.  Other than the chief financial officer, only two out of 30 senior officers spent time monitoring cash balances and short-term investment securities.  The treasurer spent less than 30% of his time and the corporate controller spent less than 5% of her time on such activities.

Nature of Assets.  Applied Materials conceded that, as of January 30, 2005, its investment securities of $5.1 billion constituted approximately 48% of its total assets (excluding U.S. government securities and cash items), when consolidated with its wholly-owned subsidiaries.[2]  More than 99% of Applied Materials’ investment securities supported its capital preservation strategy.  The remaining investment securities consisted of investments in businesses with complementary products, services and/or technologies and in an interest in a limited partnership that invested in technology companies in their early-development stages.  Applied Materials anticipates that its investment securities other than those used for its capital preservation strategy will not exceed 10% of its total consolidated assets (excluding U.S. government securities and cash items) in the future.  Applied Materials further stated that a significant portion of its assets consisted of intangible assets such as internally developed intellectual property that was not included in the value of its total assets for the purpose of determining its status under the 1940 Act.

Sources of Income and Revenue.  For the four quarters ended January 30, 2005, Applied Materials’ operating activities produced 94% of its net income after taxes.  Its investment securities produced 6% of its net income.  In earlier periods, Applied Materials had operating losses while deriving net income from its investment securities.  Applied Materials argued that, because its net income does not always accurately reflect its operating activities, it believes that its revenues provide a more accurate view of its activities as an operating company.  For the four quarters ended January 30, 2005, Applied Materials’ revenue from operations constituted approximately 99% of its total revenues, and its revenue from investments represented approximately 1% of its total revenues.  Applied Materials stated that, in the future, it expects that its total revenues derived from operating activities will ordinarily be over 90% and its total revenues derived from investments will ordinarily be under 10%.

In obtaining the order, Applied Materials agreed to the following conditions: (1) it will continue to allocate and use its accumulated cash and investment securities for bona fide business purposes, and (2) it will refrain from investing or trading in securities for short-term speculative purposes. 

Summary

Section 3(b)(2) orders are relatively rare.  Applied Materials, in obtaining an order declaring that it is primarily engaged in a business other than that of investing, reinvesting, owning, holding or trading in securities, joins Yahoo! and Microsoft as one of few technology-oriented companies that have successfully obtained such an order.  Indeed, the SEC has been known to decline to issue orders by directing applicants to withdraw their applications.