Investment Company Act of 1940 - Rule 3a-8
Cooley Godward & Kronish

July 12, 2007

Your letter dated July 12, 2007 requests that we concur with your view that, for purposes of rule 3a-8 under the Investment Company Act of 1940 (the "Act"), a company's research and development expenses constitute a substantial percentage of its total expenses, for the last four fiscal quarters combined, if the company's ratio of research and development expenses to total expenses, including cost of goods sold, for the company's last four fiscal quarters combined ("R&D Expense Ratio"), is at least twenty percent, and the company complies with all other requirements of rule 3a-8.

FACTS

You state that Cooley Godward Kronish LLP has clients that are research and development companies ("R&D companies").¹ You represent that each such R&D company complies with the requirements of rule 3a-8(a)(2) through (a)(7), such that:

1. the company's net income derived from investments in securities, for the last four fiscal quarters combined, does not exceed twice the amount of its research and development expenses for the same period;
    
2. the company's expenses for investment advisory and management activities, investment research and custody, for the last four fiscal quarters combined, do not exceed 5% of its total expenses for the same period;
    
3. the company's investments in securities are capital preservation investments, except as otherwise permitted by rule 3a-8;
    
4. the company does not hold itself out as being engaged in the business of investing, reinvesting or trading in securities, and it is not a special situation investment company;
    
5. the company is primarily engaged, directly or indirectly, in a business other than that of investing, reinvesting, owning, holding, or trading in securities, as evidenced by the activities of its officers, directors and employees, its public representations of policies, its historical development, and appropriate resolutions of its board of directors; and
    
6. the company's board of directors has adopted a written investment policy with respect to the company's capital preservation investments.

You request guidance concerning whether such a company would be deemed to have a substantial percentage of research and development expenses for purposes of rule 3a-8(a)(1) if the company has an R&D Expense Ratio of at least twenty percent.

ANALYSIS

Section 3(a)(1) of the Act includes two definitions of "investment company" that may be relevant to R&D companies such as Cooley's clients. Section 3(a)(1)(A) defines an investment company as any issuer that is, holds itself out as, or proposes to be engaged primarily in the business of investing, reinvesting, or trading in securities. Section 3(a)(1)(C) defines an investment company as any issuer that is engaged or proposes to engage 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 percent of the value of its total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Certain R&D companies can avoid meeting the definition of investment company in sections 3(a)(1)(A) and 3(a)(1)(C) of the Act by relying on the nonexclusive safe harbor that is provided by rule 3a-8 under the Act. Specifically, the rule provides that an R&D company would not be an investment company under sections 3(a)(1)(A) and 3(a)(1)(C) of the Act if the R&D company complies with certain conditions that are designed to demonstrate that it is engaged in a non-investment company business. As relevant here, paragraph (a)(1) of rule 3a-8 provides that an R&D company that relies on the rule must have research and development expenses, for the last four fiscal quarters combined, that comprise a substantial percentage of its total expenses for the same period. Paragraph (b)(9) of the rule defines the term "research and development expenses" to mean "research and development expenses as defined in FASB Statement of Financial Accounting Standards No. 2, Accounting for Research and Development Costs, as currently in effect or as it may be subsequently revised."

The term "substantial" is not defined in the rule. In the Proposing Release, the Commission proposed leaving the term undefined in order to allow research and development companies to take account of fluctuations in the composition of their expenses over time. The Commission adopted the provision as proposed, choosing not to adopt a more objective standard. In doing so, the Commission indicated that, while research and development expenses that constitute a majority of a company's total expenses certainly would be considered substantial, there are circumstances when research and development expenses that constitute less than a majority of the company's total expenses, notwithstanding nonrecurring items or unusual fluctuations in recurring items, also may be considered substantial.²

Subsequent to the adoption of rule 3a-8, the Commission issued an order to Applied Materials, Inc. ("Applied") under section 3(b)(2) of the Act declaring that it was primarily engaged in a business other than that of investing, reinvesting, owning, holding or trading in securities.³ The notice relating to the order states:

While Applied believes it could satisfy the other factors in the rule, Applied's research and development expenses have fluctuated from year to year due to the cyclical nature of the industry. During the 2000 through 2004 fiscal years, Applied's research and development expenses have varied, ranging from approximately 16% to 22% of its total expenses, including cost of goods sold. Applied's ratio of research and development expenses to total expenses thus may be deemed a "substantial percentage" in certain years, but not in others. Applied presently cannot rely on rule 3a-8 because its research and development expenses for the last four fiscal quarters ended on January 30, 2005 represented approximately 16% of its total expenses, including cost of goods sold.⁴

You request our concurrence that an R&D company complies with rule 3a-8(a)(1) if it has an R&D Expense Ratio of at least twenty percent, and complies with all other requirements of rule 3a-8. In support of your request, you assert that this interpretation is consistent with the plain meaning of "substantial": "Belonging to substance; actually existing; real; not seeming or imaginary; not illusive; solid; true; veritable. Something worthwhile as distinguished from something without value or merely nominal."⁵ In further support of this interpretation, you note that in certain instances under the federal securities laws, a twenty percent (or lower) threshold is used to define substantial.⁶ Finally, you argue that this interpretation is consistent with the Commission's Applied order.⁷

We agree that an R&D company complies with rule 3a-8(a)(1) if it has an R&D Expense Ratio of at least twenty percent and complies with all other requirements of rule 3a-8.⁸ Our position is based on all of the facts and representations in your letter. Any different facts and representations may require a different conclusion.

Endnotes

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¹ The Commission has described R&D companies as companies that often raise large amounts of capital, invest the proceeds and use the principal and return on these investments to fund their operations during their lengthy product development phase. The Commission also has noted that R&D companies may purchase a non-controlling equity stake in another R&D company as part of a strategic alliance with the other company to conduct research and develop products jointly. Certain Research and Development Companies, Investment Company Act Rel. No. 26077 (June 16, 2003) ("Adopting Release"); Certain Research and Development Companies, Investment Company Act Rel. No. 25835 (Nov. 26, 2002) ("Proposing Release").

² Adopting Release, supra note 1, at footnote 19.

³ Applied Materials, Inc., Investment Company Act Rel. No. 27114 (Oct. 12, 2005) (order).

⁴ Applied Materials, Inc., Investment Company Act Rel. No. 27064 (Sept. 13, 2005) (notice).

⁵ Black's Law Dictionary 1428 (6th ed. 1990).

⁶ See rule 3-16 of Regulation S-X (definition of "substantial portion of collateral" includes 20% threshold); rule 902 of Regulation S (definition of "substantial U.S. market interest" includes 20% threshold); Securities Exchange Act Release No. 39098 (Sept. 19, 1997) (approval of New York Stock Exchange proposal that cash sales of stock to a "substantial" security holder be exempt from its shareholder approval policy; a five percent threshold used in the definition of "substantial"); Stampede Int'l Resources Ltd, Northwest Ventures (pub. avail. Jan. 4, 1982) (for purposes of reorganizations relying on section 3(a)(10) of the Securities Act of 1933, "substantial" amount of securities considered to be greater than one percent).

⁷ See supra notes 3-4 and accompanying text.

⁸ We note that, under this position, an R&D company with an R&D Expense Ratio of twenty percent will have R&D expenses that are at a minimum four times larger than the company's expenses for investment advisory and management activities, which are capped at five percent by rule 3a-8(a)(3).

Incoming Letter

The Incoming Letter is in Acrobat format.

http://www.sec.gov/divisions/investment/noaction/2007/
cgk071207-3a-8.htm