By a strict reading of the law, it is quite possible that Yahoo! (Nasdaq: YHOO) would be treated by the Securities and Exchange Commission (SEC) not as an operating company, but as an investment company -- in other words, a mutual fund. It certainly would be a bizarre turn of events for one of the Rule Maker's best-performing securities to have to add the letter "X" to its ticker (the symbol for mutual funds). In effect, it would force us to admit that one of our Rule Makers is actually an agent of the Dark Side, a mutual fund.

Of course, Yahoo! is not a mutual fund, but its portfolio technically qualifies it as one. Yahoo!'s 34% stake in the Yahoo! Japan Corp. venture with Japanese Internet incubator Softbank (OTC: SFTBF) has been both a blessing and a potential curse. On the blessing side, Yahoo! Japan's stock has appreciated 5,000% since the beginning of 1999 -- great news for Yahoo!'s balance sheet. As a result of the increase, the value of the Yahoo! Japan holdings accounted for approximately 75% of Yahoo!'s assets at the end of the third quarter. So what's the problem?

(Note: This information is not self-evident on Yahoo!'s balance sheet, since they must mark it to purchase value. If you look at the footnotes, Note 7, however, you see the following: "At September 30, 1999, the carrying value of the Yahoo! Japan investment was $9.6 million and is recorded in other assets. The fair value of the Company's investment, based on the quoted trading price, was approximately $3.4 billion at September 30, 1999.")

Well, according to the SEC, any company with at least 40% of its assets in investments rather than its operating business can be deemed a mutual fund. What that means is that Yahoo! would be subject to the regulatory requirements of the Investment Company Act of 1940 (ICA), which would require Yahoo! to file annual, quarterly, and other periodic reports that would be subject to the scrutiny of the SEC, mutual fund industry watchdogs, and anyone else who wants to take a shot at the mutual fund industry... including plaintiffs' lawyers who have a penchant for filing class action suits.

Realizing the potential problems associated with being a mutual fund, Yahoo! has requested that the SEC grant it exclusion from this 40% ceiling. In order to do this, Yahoo! needs to convince the SEC that, among other things, it exercises a controlling influence over the management and policies of Yahoo! Japan. If the SEC agrees, then the stake in Yahoo! Japan would not be counted toward the 40% asset barrier.

The SEC retains authority to grant such exceptions for companies that can show that its primary undertaking is running a business rather than making investments. Also, there are certain tests that can be applied. For example, the "control" issue. Mutual fund companies do not run -- or even try to run -- the companies they invest in. In contrast, operating companies can have major influence on their investees. In this situation, however, Yahoo! is not the majority partner; Softbank is, with a 51% stake.

Still, this is the angle that Yahoo! is taking, that the presence of several Yahoo! executives on the Yahoo! Japan board of directors and its operational assistance constitute enough influence to deem its influence on Yahoo! Japan as controlling. Fortunately for Yahoo!, majority ownership is not central to this requirement, just operating influence. Counsel petitioning on behalf of Safeguard Scientific (NYSE: SFE) recently made the same argument for their exemption request in regard to its 14% ownership of Internet Capital Group (Nasdaq: ICGE).

Yahoo! also is likely to be able to meet the test of income limitations provided under the ICA. That is, the company can be issued an exemption if less than 45% of its net income over the last four quarters was derived from investment activity. So, where Yahoo! falls significantly beyond the asset base test, it has not derived a significant portion of its income from its holdings.

But how did Yahoo! end up here? Well, it's not all bad, and it's a pretty interesting tale of the reality of today's economic model being beholden to yesterday's rules. Yahoo! has used a fairly common tactic among Internet companies by forming strategic relationships with other companies by taking equity stakes in them. These "strategic holdings" have been used to expand offerings, cement relationships, and to co-brand and co-market new services. This strategy has paid off in two ways for Yahoo!: its wide web of valuable partnerships, and the explosive appreciation of the assets it has held in stock. Yahoo! Japan is currently priced at well over $500,000 per share, and this comes after a 2-for-1 split.

This ruling is important for several reasons, both to Yahoo! and to its kindred companies with substantial investments in other Internet companies. If Yahoo! is not granted an exemption and becomes regulated as a mutual fund, it will have to do as all mutual fund companies do and distribute almost all of its capital gains on investments every year, creating taxable events for Yahoo! shareholders. It also will be greatly limited as to what levels and types of debt the company can incur, and would no longer be able to issue stock options.

To other Internet companies, this ruling may be a bellwether as to how the SEC is going to treat their operational methodology. The difficulty arises because Internet companies require lower asset expenditures for operations, particularly in comparison to the heavy industry companies that were the bulwarks of the U.S. economy when the ICA was passed 60 years ago. An Internet company's tendency to buy portions of other entities is demonstrably operational in nature. It reflects the lack of vertical integration in this sector as companies seek to focus on their own service offerings, while also striking strategic partnerships with the companies they need to operate or to round out their products.

The business model used in cyberspace is almost guaranteed to run companies up over the 40% threshold. Moreover, the limitations have caused a good news/bad news situation for these companies in light of the incredible run-up of the stock prices of many Internet properties. The good news is, well, they own appreciated portfolios worth tons of dough. The bad news is that not only does the mere fact of their holding these assets put them at a pretty significant regulatory risk, but also they lose significant liquidity as a result of the ICA. Basically, they must be very careful not to derive too much of their income from selling any of their equity holdings lest they fall afoul of the 45% income rule.

For those of you who have read this far, particularly those of you who hold Yahoo! shares, let us say this: Don't panic. The chances of the SEC rejecting Yahoo!'s exclusionary petition are, if not zero, then within sniffing distance of it. But it will be interesting to see how the eventual exclusion is granted, since there are a bunch of other Internet and high-technology companies waiting to see if the SEC is willing to take a much more narrow interpretation of the statutes of the ICA. If not, other companies with big, appreciated investment assets -- including (Nasdaq: AMZN), CMGI (Nasdaq: CMGI), and Internet Capital Group -- may have to file to dodge the same bullet, and some of them have a much more tenuous claim to being operating, rather than investing, companies than Yahoo! does.

In closing, we are at that time again when we must decide on our monthly investment. Last month, I detailed why I believed that the Coca-Cola Company (NYSE: KO) was the best place for us to make our $500 investment. I'm going to play sell-sider here and simply reiterate my "strong buy" on Coca Cola for our monthly purchase in the Rule Maker. Remember, don't do as we say, nor do as we do. Be a Fool and decide for yourself what companies constitute Rule Makers.

Fool on!