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Roger George, SkyStream Networks Inc.’s general counsel, was finishing up the documents for a $50 million cash infusion from investors last summer when he hit a snag. The investors wanted documentation — as a formality, for the file — that SkyStream was not an investment company, because it was amassing cash like one. “You take a look at the law and get nervous,” George says. The law in question is the Investment Company Act of 1940, which governs mutual fund companies and similar financial institutions. Most general corporate lawyers have had few direct experiences with the law, but that’s been changing in the past year. As the market hit some dizzying highs, some companies ended up with stock portfolios more valuable than the income from their more nascent core businesses. Enter the so-called 40 Act. The act’s provisions come into play when operating companies amass too much cash, relative to their assets, or make too much money on investments, relative to operating income. “That subjects you to regulation you don’t even want to begin to contemplate,” says George, who spent five years at Wilson Sonsini Goodrich & Rosati before going in-house in the spring. The company — like most — was able to get an exemption from the Securities and Exchange Commission. In fact, the SEC doesn’t nab many operating companies for breaking the investment company law, says one former SEC official who worked with investment companies. While relatively few companies sought SEC input, Kenneth Berman said, there seemed to be many companies wrestling with the issue. Most of the time, the issue is a temporary one — an especially valuable investment took off, or a pending or an especially large expenditure prompted a company to collect a large cash infusion. Under SEC rules, companies typically have time to divest their holdings or file for an exemption. That is what Yahoo! Inc. did when it encountered problems with the 40 Act. One of the earliest technology companies to deal with the act, Yahoo first wrestled with the issue in 1996 after it raised significant cash selling stock. The key task for Yahoo as it sought an exemption from the SEC was showing that despite the huge stock gains, the company’s core business was not investing. If it had failed to do so, the company would have been forced to park the money in low-yield government securities. When Yahoo first encountered problems, the 40 Act was an arcane matter that was a new one on the company’s general counsel. “Look, I was an intellectual property attorney; I’d never dealt with the Investment Company Act,” says John Place Jr., the company’s general counsel. Though biotech companies had faced the 40 Act, the issue wasn’t obvious when dot-coms took off. “The dot-com world sort of launched a new kind of company — an operating company with no revenues and all their income is coming from investments,” says Julie Allecta, a Paul, Hastings, Janofsky & Walker partner who works with investment companies. Yahoo’s Place says more and more companies are becoming aware of the issue. But Berman, the former SEC official who is now at Debevoise & Plimpton’s Washington, D.C. office, says Silicon Valley companies may still be on the learning curve. He says there are probably many companies out there that the SEC would consider non-compliant with the act. “And I’m sure they don’t know they have a problem,” he says. If there is a problem, it’s usually revealed during a financing when investors ask for the kind of documentation SkyStream’s George was asked to produce. Richard Phillips, a partner at Kirkpatrick & Lockhart in Washington, D.C., who specializes in investment company work, says complying with the law may seem like a formality but it has serious repercussions. “If the Investment Company Act says you should be registered [as an investment company] and you’re not, all your transactions are voidable,” Phillips says. “That puts a company in a precarious legal position.”

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