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.

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.

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