SAN FRANCISCO (www.HedgeCo.Net) – In what could be characterize as an interesting allocation of internal resources, the Securities and Exchange Commission (the �SEC�) recently proposed new rulesunder the provisions of the Investment Company Act of 1940 (the �1940 Act�) that apply to little-known and even less understood, business development companies (�BDCs�). BDCs are closed endinvestment companies that raise capital through the underwritten issuance of a set number of shares that typically trade on a national securities exchange. BDCs differ from other closed endinvestment companies because the 1940 Act requires BDCs to invest at least 70% of their assets in securities on which margin is not extended, securities of financially troubled issuers, andadditional investments of the foregoing even if the issuer is no longer troubled or the securities become marginable. In short, the BDC structure can be used to allow retail investors to participatein the types of private equity transactions that are typically reserved for high net worth individual and institutional investors.
Because closed end investment companies are offered in underwritten offerings in which the underwriter takes 4% to 6% off the top, as a general rule, they tend to immediately trade at a discount to their initial public offering price. Sometimes it can take a closed end fund years for the market price to trade at the initial public offering price. For this reason, closed end funds tend to fall in and out of favor with investors and are often offered in clusters when, for example, sudden interest rate movements, the opening of new markets, or the development of new securities prompt investment bankers to revisit the closed end structure as a means of promoting a new investment opportunity to retail investors.
Such was the case this past spring, with the stock market going sideways and hedge funds unavailable to the general investing public, the investment du jour was the BDC that would provide retail investors access to the private equity markets. After all, private equity as an asset class had been performing well and was unreachable by most retail investors. The excitement grew to a fever pitch when Apollo amended its BDC registration statement to increase its offering from $600 million to over $900 million. Apollo, Ares, and a short list of others, successfully completed their public offerings and at least a dozen BDCs filed similar registration statements with the SEC within a two month period. But the glamour quickly faded and the appetite for these investment vehicles dried up almost overnight when the market became aware that it could take years for these funds to fully invest the proceeds of their public offerings and still more time before a positive return might be realized. Subsequently, most of these would-be issuers of BDCs have since abandoned or withdrawn their registration statements.
Given the level of market interest in BDCs generally, it is somewhat curious that on November 1, 2004, the SEC proposed rules under the provisions of the 1940 Act that apply solely to BDCs. This rulemaking is even more interesting given the fact that, although Congress created BDCs in 1980 when it added sections 54 through 65 to the 1940 Act in the Small Business Investment Incentive Act, the SEC has never engaged in any substantive rulemaking initiatives with respect to BDCs until this recent set of proposals. The reason for the proposed amendments, according to the SEC, was to correct certain inadvertent consequences that occurred in 1998 when the Federal Reserve Board (the �Fed�) amended Regulation T to expand the definition of �marginable security.� Section 2(a)(46) of the 1940 Act defines an �eligible portfolio security� to include, among other things, an issuer that does not have a class of securities on which margin may be extended pursuant to rules adopted by the Fed. When the Fed revised the definition of margin security, the universe of issuers in which a BDC could invest was instantly reduced. So with the stated intention of promoting the flow of capital to small, developing, and financially troubled companies, the SEC proposed new rules on behalf of BDCs.
Proposed Rule 2a-46 would expand the definition of �eligible portfolio security� to include any issuer that does not have a class of securities listed on a national securities exchange or on NASDAQ (collectively, �Exchange(s)�). However, the issuers of Exchange listed securities would be eligible investments for a BDC if the issuer had received notice from the Exchange that it no longer meets the listing standards and does not meet the listing criteria of any other securities exchange. Rule 2a-46 would also exclude as eligible investments for BDCs, issuers that either are investment companies, or specifically excluded from the definition of �investment company,� under the 1940 Act.
Proposed Rule 55a-1 would essentially mirror the statutory provision which permits a BDC to count as eligible portfolio securities certain follow-on investments in issuers that were eligible portfolio companies at the time the BDC�s initially invested, but that subsequently lost that status because the company subsequently issued marginable securities. These �follow on� investments are required to be acquired in private transactions from the issuer or certain of the issuer�s affiliates. In order to count such �follow on� investments as eligible investments, the BDC must maintain a �significant investment presence� in the issuer, typically by participating to some degree in the management of the issuer. The SEC did solicit comment on whether a time restriction should apply to such follow-on investments and whether such a restriction would interfere with a BDC�s ability to manage its investments in the best interests of shareholders.
It is encouraging to see that the SEC is still interested in promoting the efficiency of the capital markets through its rulemaking authority. However, it does not seem entirely consistent that at the same time the SEC expressed its concern regarding the �retailization� of hedge funds by recently adopting Rule 203(b)(3)-2 under the Investment Advisers Act, thereby essentially limiting investments in hedge funds to �qualified clients� (i.e., investors with $1.5 million in investable assets or $750,000 under management with that particular adviser), the SEC is also proposing to expand the universe of companies in which BDCs may invest to include certain issuers that trade in the over-the-counter bulletin boards and the �pink sheets.� Certainly, the argument could be made that retail investment in these issuers is already permitted because such companies enjoy a �public float.�
Certain of these issuers avail themselves of Regulation SB under the Securities Act, which provides for streamlined registration and reporting requirements and has been used by typical �penny stock� issuers and others of dubious pedigree to engage in questionable transactions under the guise of being a public company. The public float is often so small (it is not unusual for insiders to own in excess of 90% of the capital stock) and liquidity so thin, the quoted price will often not change for months at a time. Even a cursory review indicates that many of these issuers do not file their abbreviated periodic reports in a timely manner, nor, as is often the case, do their disclosures adequately explain the nature of the business activity in which the issuer purports to engage. Accordingly, among these issuers, there is often neither transparency nor liquidity. Perhaps the SEC is also planning a review of this area of the capital markets before BDCs stuffed with penny stocks become the next scandal.
Note:
White & Case LLP represents hedge fund sponsors and advisers, prime brokers, and administrators through its 38 offices in 25 countries around the world. For further information on the White & Case hedge fund practice, contact:
Jay B. Gould, Esq.
White & Case LLP
San Francisco, California 94111
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