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Say, Aren't You a Mutual Fund?

If so, you might have to get shareholder permission to raise capital and stop offering stock options to employees.
Emily S. Plishner, CFO Magazine
November 1, 2000

Ever wonder why the Securities and Exchange Commission doesn't treat Internet incubators like mutual funds? After all, most of their assets consist of securities in other companies. And under the Investment Company Act of 1940, companies with more than 40 percent of their assets in companies they don't control are supposed to be regulated as investment companies--such as mutual funds--rather than as operating companies. In fact, any company with more than 40 percent of its assets in cash, cash equivalents, or marketable securities is subject to such regulation. Those that should register as mutual funds with the SEC but don't can wake up to find all their contracts in legal limbo.

In fact, one of the biggest Internet incubators, CMGI Inc., of Andover, Massachusetts, recently found it necessary to take evasive action in order to escape classification as a mutual fund. It did so by increasing its interest in Internet search engine AltaVista from minority status to controlling, converting enough investment assets to operating assets to keep itself under the 40 percent threshold, at least for the time being.

Thanks to the bull market, many other companies were well over the limit at the end of their most recent fiscal year, according to a survey for CFO by the data-retrieval firm Standard & Poor's Compustat. As a result, they may have to do what CMGI did, acquiring more than 50 percent of those companies and then consolidating their financial results in their own. They do have other alternatives, though none may be any more attractive. They could, for instance, put cash into Treasury securities, spend like mad on R&D, or convince the SEC they control some companies in which their interest is little more than 25 percent. In any case, the SEC provides a one-year grace period in which companies can take steps to shift their assets to comply with the 40 percent limit.

The distinction between an operating company and an investment company is more than a legal technicality. The Investment Company Act requires the SEC to regulate investment companies more closely than operating companies. For instance, investment companies usually can't offer stock to employees, or raise capital, without getting shareholder approval.

The restrictions arose in the wake of the 1929 stock market crash, after congressional hearings determined that investors' interests were often compromised when public companies supplied capital to other companies without acquiring them outright. If the investing company strongly influenced another's finances, the thinking went, it could easily convince that company to transfer assets or operating profits to a third company. Thus, it could reward one set of shareholders at the expense of another.

A regulatory relic? Perhaps. But CMGI's stated objective of finding "synergies" among the companies it finances has raised concerns over that very issue.

The T-Bill Solution
The escape routes for companies trying to avoid such SEC restrictions can consume time and money. Investing in Treasuries gets companies off the hook simply because those securities are excluded from the calculation of the 40 percent threshold. That explains why some companies in S&P's Compustat study, including Microtune Inc., eSpeed, and Freemarkets, have most of their assets in T-bills and the like. "Everything we have is in Treasuries," says Buddy Rogers, CFO of Microtune, a Plano, Texas, company that recently went public.

But Treasuries certainly aren't an ideal solution, simply because their yields won't always satisfy investors used to higher returns in the stock market. Microtune, for example, will soon start seeking them through minority investments, according to CFO Rogers.

Small wonder, then, that the biotech industry approached the SEC in 1993 to discuss a regulatory safe harbor. It argued that the asset test wasn't relevant to start-up companies spending heavily on research and development, most of whose assets are intangible. The SEC clarified its position in an order to ICOS, a suburban-Seattle-based biotech company that had asked for such a move.

In the order, the SEC said that ICOS, and by extension other companies in a similar position, qualified as an operating company under another standard, 3(b)(1), the introductory paragraph of the Investment Company Act. This standard says that if a company's cash is slated for operating purposes, everything is copacetic.

Among the biotech companies that have sailed into this safe harbor is Cell Genesys, in Foster City, California. Cell Genesys ranked highest in assets held in cash, Treasuries, and other marketable securities according to the S&P's Compustat study. "If it hadn't been for that ruling in 1993, chances are [those assets] would all be sitting in Treasuries," says Cell Genesys CFO and vice president Matthew Pfeffer.

Although the safe harbor applies to biotech companies, other types of companies are now relying on this standard. But the standard isn't easy to meet, and many lawyers are concerned that their clients are on thin ice.

The SEC order to ICOS, to be sure, also specified that companies spending more than their investment income on R&D would qualify as operating companies. But while today's telecom, Internet, and other high-concept companies are big on intangibles, they may spend more on marketing to build brands than on researching to develop software, and marketing expenditures don't qualify as R&D.


Unconsolidated Control
After years of investing in Treasuries to avoid classification as an investment company, Yahoo won its own exemption under Section 3 (b)(2) of the Investment Company Act. This exemption is not always easy to obtain; in fact, as this issue went to press, Yahoo was the only company to get one so far this year.

According to published reports, former CFO Gary Valenzuela and the company's legal team went back and forth with the SEC for years before they felt confident enough of their legal strategy to formally apply for the exemption last February 11. The fact that Yahoo's 34 percent stake in a joint venture with Softbank of Japan was soaring in value at the time may also have influenced the company's decision.

In any case, it took the SEC a full four months to conclude that Yahoo had sufficient strategic control over the venture, Yahoo Japan, to avoid investment-company status.

One might think that Yahoo's interest in the venture should then be consolidated on its books. But it's possible to control a company under the Investment Company Act without having to consolidate for accounting purposes, as long as the equity stake is less than 50 percent. (An equity stake of anything less than 25 percent is presumed by the SEC to be noncontrolling.)

The catch is that it isn't easy to convince the SEC that you have effective control with less than 50 percent equity. Representation on the board of the company in question will help persuade the agency, as it did in Yahoo's case with its Japanese venture, but it won't guarantee quick action. No wonder relatively few companies have sought and obtained such relief (see table, page 129). Yet a growing number of Internet incubators are doing so, including Internet Capital Group and Idealab, which has been waiting for its safety blanket since January 28.

It may be only a matter of time before CMGI joins this list, if only to help itself raise capital. The company has cited the issue in the "risk factors" section of at least two recent registration statements. CMGI's disclaimers noted that limitations under this provision of the Investment Company Act could limit its flexibility to monetize investments at the most advantageous time.

Any Port in a Storm
This is not to suggest that the SEC regularly prosecutes companies for failing to register as mutual funds. And while it has done so on occasion, its recent activities have focused on companies that do little besides mount hostile takeovers. More often, an operating company discovers that it may be subject to the Investment Company Act in the process of going public, when it is expected to sign a document affirming that it is not an investment company as defined by the law.

Rather than satisfy itself that it is not, or apply for an exemption and thus delay its initial public offering, a company may be tempted to seek a "no action" letter from the SEC. But unlike an exemption, a no-action letter may not protect its recipient if the regulatory climate changes with a new Administration in Washington, D.C.

In that case, an impatient company may have no alternative but to reallocate its portfolio. In addition, unless those maneuvers qualify as strategic in the eyes of the SEC, the company will have to disclose them in the IPO's registration statement, just as CMGI did.

Emily S. Plishner is a freelance writer in Brooklyn, New York.




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