As detailed in our Legal Update, on December 18, 2018, the Securities and Exchange Commission (“SEC”) adopted a final rule requiring companies to disclose their hedging policies for employees, officers and directors. However, in a change from the proposed rule, the SEC decided not to apply the new disclosure requirement to listed closed-end funds following receipt of industry comments opposing application of the rule to such funds. However, the SEC decided to apply the final rule to BDCs (a category of closed-end investment companies) after not receiving any industry comments specifically suggesting that BDCs should be excluded from the rule’s application (no comments specifically addressing BDCs in any manner were submitted to the SEC). As part of its decision to exclude closed-end funds, the SEC noted that nearly all closed-end funds are externally managed and have few, if any, employees who are compensated by the fund (approximately 87.5% of BDCs are similarly externally-managed). Commenters noted that closed-end funds generally have compensation practices, a regulatory regime and disclosure obligations that differ in various aspects from operating companies. As a result, the SEC was persuaded that it was unnecessary to apply the hedging disclosure requirement to listed closed-end funds. The SEC estimates that approximately 80 BDCs will now be subject to the new rule with the economic impact likely to depend upon the BDC’s management structure (incremental effect is expected to be greater for internally managed BDCs). A copy of the final adopting release may be found using the below link: https://www.sec.gov/rules/final/2018/33-10593.pdf.

On December 19, 2018, the Securities and Exchange Commission (the “SEC”) proposed a new rule (Rule 12d1-4) intended to modernize and improve the regulatory framework for fund of funds arrangements (fund investing in shares of another fund). Currently, funds are required to rely on existing statutory exemptions or exemptive rules or seek exemptive relief prior to creating a fund of funds arrangement, resulting in unnecessary and avoidable costs and delays and an inconsistent regulatory framework. The proposed rule would permit registered investment companies (“RICs”) and business development companies (“BDCs”) to acquire the securities of any RIC or BDC in excess of the limits in Section 12(d)(1) of the Investment Company Act of 1940, as amended. RICs and BDCs relying on the proposed rule would need to comply with the following conditions:

  • RICs/BDCs holding more than 3% of a fund’s outstanding voting securities would be required to vote those securities in a prescribed manner and would be prohibited from redeeming more than 3% of the fund’s outstanding shares during any 30-day period.
  • RICs/BDCs would be required to evaluate the layering of duplicative or excessive fees associated with its investment in a fund and the complexity of the fund of funds arrangement (specific considerations would vary given the particular structure).
  • RICs/BDCs would be prohibited from creating three-tier fund of funds arrangements, except in certain limited circumstances.

Unfortunately, the proposed rule does not address industry concerns relating to “Acquired Fund Fees and Expenses” (“AFFE”) disclosure requirements, which require acquiring funds to aggregate and disclose in their prospectuses the amount of total annual acquired fund operating expenses and express the total amount as a percentage of an acquiring fund’s net assets. As a consequence, some index providers removed acquired funds from their indices, causing a significant reduction in institutional ownership of such funds.

The SEC has requested public comment on the proposed rule and industry suggestions to improve AFFE disclosure (see pages 74-77 of the proposed rule).

Given that the proposed rule would provide a holistic exemption for fund of funds to operate, the SEC also proposes to rescind Rule 12d1-2 and individual exemptive orders for certain fund of funds arrangements, with the idea of creating a consistent rules-based regime for fund of funds arrangements. In addition, in connection with the proposed rescission of Rule 12d1-2, the SEC also proposed amendments to Rule 12d1-1 to allow funds that rely on Section 12(d)(1)(G) to invest in money market funds that are not part of the same group of investment companies.

The proposed rule and related rule amendments can be found using the following link: https://www.sec.gov/rules/proposed/2018/33-10590.pdf.

SEC Chair Clayton testified on December 11, 2018 before the U.S. Senate Committee on Banking, Housing and Urban Affairs.  In his testimony, Chair Clayton reviewed the Commission’s Strategic Plan and outlined the agency’s priorities.  Consistent with his remarks delivered at Columbia University, Chair Clayton reviewed some of the principal accomplishments in 2018, including proposed Regulation Best Interest, the amendments to the smaller reporting company definition, the disclosure simplification amendments, and the proposed changes to financial disclosures for guarantors.  He noted that there were other proposals “on the horizon,” including:

  • A proposal to amend the definition of “accelerated filer” (triggering SOX 404(b) attestation);
  • Extension of the test-the-waters accommodation to non-EGCs;
  • Rulemaking to expand Regulation A eligibility to public reporting companies;
  • A release soliciting input on reducing compliance burdens on reporting companies with respect to quarterly reports;
  • A concept release on the exempt offering framework;
  • Changes to Rule 701 to address the comments received on the Commission’s concept release on the exemption;
  • Improvements to the proxy process;
  • Regulation of proxy advisory firms;
  • Revisions of the offering rules for BDCs as required by the Small Business Credit Availability Act; and
  • Revisions of the offering rules for closed-end funds as required by the Economic Growth, Regulatory Relief, and Consumer Protection Act.

On November 30, 2018, the Securities and Exchange Commission (the “Commission”) adopted a new rule establishing a non-exclusive research report safe harbor (“Rule 139b”) for unaffiliated brokers or dealers that publish or distribute research reports regarding qualifying investment funds.  The Commission took this action in furtherance of the mandate of the Fair Access to Investment Research Act of 2017 (the “FAIR Act”).  The FAIR Act required that the Commission expand the Rule 139 safe harbor for research reports in order to cover research reports on investment funds.

Continue reading our Legal Update.

On October 12, 2018, the Securities and Exchange Commission’s Division of Investment Management issued a no-action letter permitting a fund’s board of directors (“Board”) to rely upon quarterly compliance certifications from the fund’s chief compliance officer (“CCO”) that address the fund’s compliance when the fund is engaging in certain affiliate transactions under the Investment Company Act of 1940, as amended (the “1940 Act”), instead of requiring the Board to itself determine compliance.  Funds permitted to rely on the no-action relief include both registered investment companies and business development companies.  The no-action relief is limited to the CCO making a determination of whether a particular transaction that is exempt pursuant to Rule 10f-3 (exempts certain securities purchases by an affiliated underwriting syndicate), Rule 17a-7 (exempts certain cross trade transactions between affiliated entities) or Rule 17e-1 (exempts certain affiliated broker’s commissions) of the 1940 Act complied with the procedures previously adopted by the Board.  This relief allows the Board to avoid duplicating certain functions more appropriately performed by, or under the supervision of, the CCO and instead focus on an oversight role.

A copy of the no-action letter can be found using the below link:
https://www.sec.gov/divisions/investment/noaction/2018/independent-directors-council-101218.htm

Thursday, October 4, 2018
1:00 p.m. – 2:00 p.m. EDT

Interest in the formation of business development companies, especially private BDCs, remains high. BDCs have also recently been in the spotlight as a result of significant changes to the regulatory framework affecting them. During the session, Partner Anna T. Pinedo and Counsel Brian D. Hirshberg will provide a brief overview of the legal and regulatory requirements applicable to BDCs generally, and focus on recent developments.

Topics will include:

  • The 40 Act requirements applicable to BDCs;
  • The tax treatment and diversification requirements;
  • The registration process;
  • Using a BDC to address Volcker Rule constraints;
  • Statutory changes affecting leverage and related rating agency actions; and
  • Different approaches to structuring private BDCs.

West LegalEdcenter will provide CLE credit.

For more information, or to register, please visit the event website.

Access our BDC Facts & Stats for a compendium of information regarding the business development companies (BDCs) that have taken measures to increase their use of leverage, the terms of BDC advisory agreements, and more.

On May 30, 2018, the Division of Investment Management of the Securities and Exchange Commission issued an exemptive order that permits private business development companies (“BDCs”) to conduct an exchange offer pursuant to which BDC investors, including directors and officers of the BDC, may elect to exchange their BDC shares for shares in a new split-off extension fund.  The new split-off extension fund would receive a pro rata portion of the BDC’s assets and liabilities, including each of the BDC’s portfolio investments, in proportion to the percentage of the BDC shares exchanged.  Relief from the Division was required to allow the BDC’s investment adviser to also act as the investment adviser of the new split-off extension fund and avoid potentially triggering common control prohibitions under the Investment Company Act of 1940.  As private BDCs do not have publicly traded shares, this new exchange option would provide private BDC investors with a liquidity opportunity following the extension fund’s initial public offering.  This new liquidity option should be considered when drafting a private BDC’s organizational documents in order to maximize its liquidity options at a later stage.  A copy of the exemptive order can be found here.