Editor

The Securities and Exchange Commission is mulling a rule change that would allow biotechnology firms more flexibility to invest, so they can better advance research and development - and in Washington, the industry push is on for a somewhat more extensive change.

"This law clearly can help small and mid-cap biotech companies," Peter Norman, manager of federal government relations for the Biotechnology Industry Organization, told BioWorld Financial Watch.

"It'll help them structure partnering deals that they couldn't before, joint ventures and equity agreements," he said.

Under scrutiny is the Investment Company Act (ICA) of 1940, the original aim of which was to keep people from raising cash for what they claimed was a company and then using most of it for investment returns instead. It does this by declaring what's an "investment company" in a very specific way - and for biotechnology firms, which don't operate like others, that's been a problem.

Proponents of the change as put forth by the SEC say it corrects a glitch in the longstanding original law. The problem is that R&D firms often have few tangible assets but plenty of capital in readily available funds, which they often use to enter strategic alliances that include buying noncontrolling securities in another R&D firm. As a result, they may find themselves in the category of "investment company" under the law's terms, and therefore be limited in their normal operations.

ICA defines an investment company as including any issuer that owns or proposes to acquire investment securities with a value of more than 40 percent of the issuer's total assets, excluding government securities and "cash items" on an unconsolidated basis.

By investment securities, ICA means all securities other than government securities and those issued by majority-owned subsidiaries that are not investment companies. Value of assets that are not securities means "fair value at the end of the last preceding fiscal quarter, as determined in good faith by the board of directors."

Now, by changing the law, the SEC may provide a "non-exclusive safe harbor" from the definition of investment company for some R&D firms, including those in biotechnology.

"If you go over the 40 percent, you're presumptively in the investment company category, and this rule would allow you to get out," explained Matthew Chambers, an attorney with Wilmer, Cutler & Pickering in Washington, which is representing BIO's concerns.

"There are other rules that can get you out if you use certain income and asset tests," he added, and these allow larger, profitable biotechnology firms and pharmaceutical companies to escape the category.

Chambers said the major difference between the old rule and the proposed change is that the old rule "would measure the amount of strategic investment by total assets, and we propose to measure it by an R&D budget" since, with the latter way, "you're proving the company is primarily engaged in R&D," he told BioWorld Financial Watch.

The idea is to give R&D companies more leeway to raise and invest capital pending its use in R&D and other operations. Also, the rule change would clarify the extent to which a company relying on it is allowed make investments in other R&D firms as part of collaborative programs.

Not only would smaller, start-up companies be helped by the rule change in evident ways, but it would help "the medium-sized firms that aren't profitable yet and don't have significant sales, because it gives them more certainty about their status," Chambers said.

He acknowledged that one company at the forefront of the effort to get the rule changed is Millennium Pharmaceuticals Inc. - a firm that is hardly regarded as a start-up but "they're certainly not profitable yet. And companies go in and out of profitability." Millennium referred phone calls to Chambers.

Under the guidelines of the SEC's proposed change, a company would qualify to escape that definition if it meets four criteria.

First, the company would have R&D costs that represent a "substantial percentage" of total expenses for the last four fiscal quarters combined, and that equals at least half of its investment revenues for the same period.

Second, the company would have investment-related expenses not more than 5 percent of total expenses for the period.

Third, it makes investments for the purpose of conserving capital and liquidity until it uses the funds in its main business. This criterion is subject to certain exceptions.

Fourth, the company is "mainly engaged" in non-investment work.

The SEC is taking comments on the proposal until Jan. 15 - and BIO, representing more than 950 companies, already has weighed in. BIO provided a copy of a letter to John Katz, drawn up by Chambers.

The letter says the rule as it exists makes some firms skip R&D deals or compromise investment returns "even though no member of the investing public would ever mistake these companies for investment companies. These constraints are preventing collaborations to develop potentially ground-breaking new drugs, and denying needed capital to young biotechnology companies."

The traditional tests for determining what's an investment company rely strongly on securities and the amount of income derived from them, as compared to the value of other assets and income derived from those. But many biotechnology firms base much of their value on intellectual property, which is often created through investments but isn't shown on balance sheets, nor are the companies required to come up with a number.

Also, BIO argues, it's not appropriate to count strategic investments in figuring investment-company status, as the rule currently demands.

"In many sectors of the biotechnology industry, the only way for companies to quickly access technology or skilled personnel that is in high demand is through strategic investments," says the letter to the SEC.

The investing firm usually isn't looking at immediate financial returns but at a business model whereby it can control the smaller company, the letter says, and "a less well-funded company may acquire access to intellectual property by paying license fees, milestone payments or other compensation using its stock instead of cash."

As long ago as 1993, the SEC issued a ruling on a case involving ICOS Corp., exempting the company, which had little income from non-investment sources and wanted to boost its investments even more.

The SEC decided that it would consider a firm in the "non-investing" category if the company generally spent more on R&D than it earned in gross investment income, although the latter could occasionally outstrip the former. A substantial portion of gross expenses had to go toward R&D, too, and investment expenses had to be negligible. Also, just about all of its investments had to be secure, rather than involving equity or speculative debt.

But in biotechnology especially, 1993 is ancient history, and a comprehensive, definite rule change would help many more firms, Norman said.

"Obviously, we applaud the SEC because of the positive impact this is going to have and we support the proposal, but we plan to request a higher ceiling," he said.

As for specific numbers, under the proposed change, biotechnology firms could invest up to 10 percent of their total assets and up to 20 percent of liquid assets, he said. In the latter category, BIO wants the limit raised to between 25 percent and 30 percent.

Chambers said he hadn't heard BIO's exact proposed numbers, and noted the comment period is not finished. A decision is expected in the spring. Norman called the outcome "really hard to tell," and declined to guess.

Meanwhile, BIO's lobbyists don't intend any action on Capitol Hill since, although the organization would like to see the SEC-proposed ceiling raised, taking any action on providing relief from the restrictive rule is a step in the right direction, Norman said.

"There's nothing we're going to do because we like this rule [overall]," he said. "We're not looking at that aspect of it."