Life science companies that are already publicly traded may think they have little to learn from the U.S. Securities and Exchange Commission’s (“SEC”) recent rulemaking on Special Purpose Acquisition Companies (“SPACs”).[1] In the release, the SEC gave guidance on when a SPAC might be considered to be an investment company, which would trigger the application of a litany of rules and regulations under the federal securities laws. That guidance serves as a useful reminder that any company could conceivably trigger the definition of investment company under the Investment Company Act of 1940 (“the 1940 Act”), depending on factors that we describe below. Given the methods of financing and business trajectory of many pre-commercial stage life science companies, they may be particularly at risk for the application of these rules. The good news is that the risk, once identified, can usually be managed. If not identified and addressed, however, these “inadvertent investment companies” can attract unwelcome regulatory interest and possible private litigation.
The 1940 Act provides three definitions for what constitutes an “investment company” that is required to register as such under the 1940 Act.[2]The first two are triggered by companies that usually are purposefully intending to be investment companies as an integral part of their business. By contrast, the third definition can be triggered by a company that inadvertently or unintentionally qualifies under the definition. That definition essentially provides that any issuer of securities that “is engaged or proposed to engage in the business of investing, reinvesting, owning, holding, or trading” in securities and more than 40% of its assets (excluding Government securities and cash) are “investment securities”[3] is also an investment company.[4]
The consequences of triggering this definition can be severe. Registration under and compliance with the 1940 Act are cumbersome. A registered investment company has reporting obligations and limitations on its governance and capital structure. If a company that is deemed to be an investment company fails to register as such, the SEC can, and on occasion has, brought an enforcement action against the issuer. Contracts entered into in violation of the 1940 Act are “unenforceable.”[5] There is also risk of derivative and counter-party private litigation.
The risk of becoming an inadvertent investment company can occur at any point in the lifecycle of a company. A SPAC will have particular concern because it raises a large pool of capital, invests the proceeds, and then looks for a merger partner, for a period of up to two years, and sometimes longer. During those two years, the SPAC typically is not engaged in any business operations other than its search for a merger partner. Many investors redeem their shares in the SPAC before the merger occurs, suggesting they may see greater value in the SPAC’s pool of investments than in the acumen of the SPAC sponsors to find a desirable merger partner. At the other end of a company’s lifecycle, the SEC’s original guidance in this area arose in the context of a late-stage mining company – over time, it ceased operating mines and used its capital simply to invest in other mining companies.
Life science companies can face similar risks. They often raise early financing, which may be significant, to fund product development over a long and uncertain time period. Over that time, a company may divest itself of a successful product, leaving the remaining company with resources to seek another project but few or no ongoing operations. Or, the original product candidate may not succeed or obtain regulatory approval, but the company still continues in existence, with its primary activity focused on a search for a merger partner. In either event, if for some prolonged period of time the company is spending more of its time and energy managing its capital resources than in the actual operation of a business, it should ask itself whether it is still “primarily engaged” in a business other than investing in securities – and if it is not, whether there is a meaningful risk that it could be deemed to be an inadvertent investment company.
The SEC and courts have traditionally looked at five factors to determine whether a company is “primarily engaged” in an operating business.[6] Those five factors[7] are:
- Historical development of the company – has the company changed its focus over time;
- Representations of policy – how does the company hold itself out to the public and to shareholders;
- Activities of officers and directors – how do they spend the majority of their time;
- Nature of assets; and
- Sources of income.
Even if a company triggers the inadvertent investment company definition, it does not necessarily have to register as such. The 1940 Act and SEC rules provide a number of exceptions to the requirement to register.[8] The two most germane in this context are the exception for “transient investment companies”[9] and certain research and development companies.[10] If a company has a bona fide intent to engage primarily in an operating business “as soon as reasonably possible,” it will not be considered an investment company for up to one year. Likewise, if a research and development company satisfies certain income, expense, and investment thresholds, [11] as well as other tests,[12] it will not be considered an investment company. (There is also a mechanism to seek an exemption from the definition from the SEC.[13])
Many development stage life sciences companies have experienced setbacks, changes and reversals in their clinical paths over time, while also having accumulated meaningful amounts of investment securities. With some advance planning and analysis, these companies can avoid the inadvertent application of the 1940 Act, and the regulatory headaches that would accompany the application of the related rules.
If you have any questions concerning the material discussed in this client alert, please contact the members of our Securities and Capital Markets and Life Sciences practices.
[1] Special Purpose Acquisition Companies, Shell Companies, and Projections, Release No. 33-11265 (Jan. 24, 2024) (“the SPAC release”).
[2] Investment Company Act § 3(a)(1).
[3] “Investment securities” are defined as all securities except Government securities, securities issued by employees’ securities companies, and securities issued by majority-owned subsidiaries which are neither investment companies nor private, exempt investment companies.
[4] Investment Company Act § 3(a)(1)(C). An SEC rule exempts companies from this definition if no more than 45% of the value of its total assets and no more than 45% of its net income after taxes is derived from investment securities. 17 C.F.R. § 270.3a-1.
[5] Investment Company Act § 47(b).
[6] In the Matter of the Tonopah Mining Company of Nevada, 26 S.E.C. 426 (July 21, 1947); SEC v. National Presto Industries, Inc., 486 F.3d 305 (7th Cir. 2007).
[7] In the SPAC Release, the SEC seems to recast “historical development of the company” as “duration” (i.e., the length of time a company has operated without completing a de-SPAC transaction with a target company), collapses assets and income into one factor, and adds “merging with an investment company” as a new factor.
[8] Investment Company Act §§ 3(b), 3(c) & 6; 17 C.F.R. §§ 270.3a-1 to 3a-9.
[9] 17 C.F.R. § 270.3a-2.
[10] 17 C.F.R. § 270.3a-8.
[11] The thresholds look back over the prior four fiscal quarters - research and development expenses must be a “substantial percentage” of its total expenses; net income from securities investments cannot exceed twice its research and development expenses; and expenses for investment advisory and management activities, investment research and custody cannot exceed five percent of its total expenses.
[12] The company’s securities investments must be “capital preservation investments,” subject to other thresholds. The board of directors must adopt a written policy regarding its capital preservation investments and adopt a resolution stating that the company is primarily engaged in a business other than investing in securities. Finally, the company cannot hold itself out as being in the business of investing in securities, and must otherwise satisfy the Tonopoh factors, discussed above.
[13] Investment Company Act §§ 3(b)(2); 6(c); see also Commission Policy and Guidelines for Filing of Applications for Exemption, Release No. IC-14492 (Apr. 30, 1985).
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