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(Article from Registered Funds Alert, May 2019)

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In a welcome development, the SEC recently proposed rules that would modify the registration, communications and offering rules for BDCs and registered closed-end investment companies (“CEFs”) to more closely align such processes with those that apply to operating companies. The SEC was obligated to propose rules in this area pursuant to The Small Business Credit Availability Act (the “BDC Legislation”) and the Economic Growth, Regulatory Relief, and Consumer Protection Act (the “CEF Legislation”), passed by Congress in March and May 2018, respectively.

The proposed rules introduce five main reforms that would benefit BDCs and CEFs:

• Registration Process. The proposal would streamline the registration process to allow eligible BDCs and CEFs to use a short-form registration statement on Form N-2 to sell securities “off the shelf” more quickly and efficiently in response to market opportunities. A key benefit in this context is the ability to forward-incorporate information in future filings by reference.
• Well-Known Seasoned Issuer Status. The proposal would allow BDCs and CEFs with at least $700 million in public float to qualify as well-known seasoned issuers (“WKSIs”) under the Securities Act of 1933 (the “Securities Act”). WKSIs enjoy automatic effectiveness of registration statements and amendments, among other benefits.
• Final Prospectus Delivery Reforms. The proposal would remove the requirement that BDCs and CEFs deliver a final prospectus with or prior to each sale when a final prospectus is already filed with the SEC.
• Communications Reforms. The proposal would allow BDCs and CEFs to rely on specific exemptions for communicating with investors without violating “gun-jumping” prohibitions, putting them on the same footing as operating companies.
• Public Reporting Parity. For funds that use a short-form registration statement, there is a proposed requirement to provide information regarding fees, expenses, premiums/discounts and outstanding senior securities in annual reports (which can be incorporated by reference into a previously filed registration statement). CEFs would be required to make Form 8-K filings for material developments under the Securities and Exchange Act of 1934 (the “Exchange Act”). Additionally, the proposal includes new Form 8-K requirements relating to material changes to investment objectives or policies and material write-downs of significant investments.

In this Alert, we summarize the above aspects of the proposal, and propose that the SEC should revise and clarify certain aspects of the proposal relating to the new public reporting requirements for BDCs and CEFs.

Registration Process

The proposal would provide BDCs and CEFs parity with operating companies by permitting eligible BDCs and CEFs to file a short-form registration statement on Form N-2 that will function like a “shelf” Form S-3 registration statement for operating companies. Short-form registration statements incorporate relevant information from periodic filings by the issuer and can be used for multiple future offerings of one or more types of securities. Once the SEC declares a shelf registration statement effective (or if it automatically becomes effective as for WKSIs) the issuer can use a prospectus to supplement the shelf for a specific offering. Such prospectus would include specific information about the offering that was omitted in the shelf. SEC review of the prospectus for a specific offering is not required, so once an issuer has an effective shelf registration statement it can quickly conduct an offering “off the shelf” without needing to navigate an SEC review process. Future periodic reports filed by the issuer are automatically incorporated by reference into the registration statement, so the issuer does not need to separately update the registration statement to include updated financial statements or other items already disclosed in its periodic reports prior to conducting an offering.

A BDC or CEF would be eligible to file a short-form registration statement if it meets the registrant requirements (i.e., timely filed all reports and other materials required under the Exchange Act during the prior year) and transaction requirements (i.e., at least $75 million of public float) of Form S-3. Registered CEFs also must be registered under the 1940 Act for at least one year immediately preceding the filing of the registration statement and have timely filed all reports required to be filed under Section 30 of the 1940 Act (e.g., Forms N-PORT and N-CSR). We note that the public float requirement effectively excludes unlisted BDCs and CEFs, including interval funds and tender offer funds, from eligibility to file a short-form registration statement.

Improving the Proposal for Registration Requirements

The proposal’s exclusion of unlisted CEFs and BDCs, while consistent with the treatment of operating companies, would perpetuate unnecessary updates for BDCs and CEFs that conduct continuous offerings pursuant to Rule 415 under the Securities Act and provide liquidity through periodic tender offers. Currently, these tender offer funds are not permitted to forward incorporate, which necessitates their updating their registration statements and undergoing SEC disclosure review at least annually in order to incorporate the fund’s annual financial statements, even if no other material updates are being made. This process adds expenses to tender offer funds, but does not provide meaningful benefit to investors as the requirement to update the registration statement is triggered by incorporating financial statements that are already available to investors in the tender offer fund’s annual report. The SEC should consider allowing tender offer funds (and interval funds) to use forward incorporation by reference to streamline the offering process for these products or, as an alternative, allow tender offer funds the ability to use Rule 486 (which is currently only available to interval funds) to make immaterial updates to their registration statement without requiring SEC disclosure review.

Well-Known Seasoned Issuer Status

In addition, the proposal would amend the WKSI definition under Rule 405 to include qualifying BDCs and CEFs, and BDCs and CEFs that qualify as WKSIs would be able to file an automatic shelf registration statement and register an unspecified amount of securities.

To qualify as a WKSI, a BDC or CEF must have at least $700 million in public float and be eligible to file a short-form registration statement, which means that the BDC or CEF must have: (i) been subject to the requirements of Exchange Act Sections 12 or 15(d) or 1940 Act Section 30 for at least one year and (ii) timely filed all reports required to be filed during the past year (other than certain current reports on Form 8-K). As with short-form registration statement eligibility, the public float requirement effectively excludes unlisted BDCs and CEFs, including interval funds, from eligibility to qualify as a WKSI. A BDC or CEF would also be ineligible to qualify as a WKSI if it (or a subsidiary) is the subject of a judicial or administrative decree or order arising out of a governmental action involving violations of the anti-fraud provisions of the federal securities laws.

Qualifying as a WKSI would come with a few key benefits. A WKSI can file a registration statement or amendment that becomes effective automatically, which would give the fund flexibility to take advantage of market windows, structure terms of securities on a real-time basis or change the plan of distribution in response to market conditions. A WKSI also can pay filing fees at any time in advance of a shelf takedown or pay at the time of each takedown.

Final Prospectus Delivery Reforms

Currently, BDCs and CEFs (or broker-dealers in a BDC or CEF offering) are required to deliver to each investor in a registered offering a statutory “final prospectus.” BDCs and CEFs are not permitted to rely on the rules that allow issuers to satisfy the final prospectus delivery obligations when a final prospectus is or will be filed with the SEC within certain time frames.

Under the proposal, the prospectus delivery rules available to operating companies would be amended to remove the exclusion for BDCs and CEFs. As a result, BDCs and CEFs (or broker-dealers in a BDC or CEF offering) would no longer be required to deliver a final prospectus with or prior to each sale if the final prospectus is filed with the SEC and the securities are delivered with a notice to that effect.

Communications Reforms

The proposal would give BDCs and CEFs increased flexibility in their communications with investors and potential investors. Under the proposal, BDCs and CEFs would be eligible to rely on certain rules previously only available to operating companies, including:

• Rule 134, which permits issuers to publish factual information about the issuer or the offering, including “tombstone ads” (limited factual information about an offering);
• Rule 168, which permits issuers to publish or disseminate regularly released factual business information and forward-looking information at any time, including around the time of a registered offering;
• Rule 164 and 433, which permits the use of a “free writing prospectus” after a registration statement is filed—a written communication deemed to be an offer to sell a security that does not qualify as a statutory prospectus or preliminary prospectus (e.g., term sheets); and
• Rule 163, which permits WKSIs to engage at any time in oral and written communications, including use of a free writing prospectus at any time (before or after a registration statement is filed).

The proposal would also amend the rules applicable to broker-dealer research reports to include a reference to registration statements filed on Form N-2 to expand coverage to BDCs and CEFs. Operating companies that file a registration statement on Form S-3 may rely on Rule 138, which permits a broker-dealer participating in a distribution to publish research about the issuer’s other securities. For example, a broker-dealer participating in a distribution of an issuer’s common stock could publish research about the issuer’s fixed income securities pursuant to Rule 138. Although Rule 138 does not specifically exclude BDCs and CEFs from coverage, it does include references to Form S-3 but not Form N-2.

Public Reporting Parity

The proposal would amend certain rules and forms to tailor the disclosure and regulatory framework for BDCs and CEFs in light of the proposed amendments to the offering rules applicable to them.

Periodic Reporting Requirements

Forward Incorporation

A BDC or CEF filing a short-form registration statement on Form N-2 would forward incorporate all periodic reports into its registration statement. As a result, periodic reports would make up a substantial portion of a fund’s registration statement. The proposal would require BDCs and CEFs using short-form registration statements to include in their annual reports: fee and expense tables; premiums and discounts; and outstanding senior securities.

Annual Reports

The proposal would also amend Form N-2 to require a registered CEF to include narrative disclosure about factors that materially affected the fund’s performance during the most recently completed fiscal year (referred to as “management’s discussion of fund performance,” or “MDFP”) in its annual report. This would apply to all CEFs, even those not using short-form registration statements. Although the SEC has required mutual funds and ETFs to include MDFP disclosure and BDCs (like operating companies) to include a narrative discussion of the financial statements of the company (referred to as “management discussion and analysis,” or “MD&A”), Form N-2 does not include an MDFP or MD&A requirement for registered CEFs. The SEC believes that registered CEF investors would benefit from MDFP disclosure in a registered CEF’s annual report because such disclosure would aid investors in assessing the fund’s performance over the prior year (MDFP disclosure requirements are more appropriately tailored to the financial reporting of registered investment companies than MD&A requirements).

Further, the proposal would require BDCs to include their financial highlights in their registration statements and annual reports. Registered CEFs are required to include financial highlights in their registration statements and in annual reports; however, while BDCs include their full financial statements in their prospectuses, they are currently permitted to omit the financial highlights summarizing these financial statements (although many BDCs already include financial highlights in the footnotes to their financial statements). The SEC believes BDC investors would benefit from this disclosure given the importance of financial highlights information.

Lastly, the proposal would require BDCs and CEFs filing a short-form registration statement to disclose in their annual reports any outstanding SEC staff comments that remain unresolved and that the fund believes are material. This new requirement may create an issue for funds that are part of a larger complex, where a comment given to one fund arguably may apply to other funds. We believe the SEC should clarify in the adopting release (or the final rule) that the requirement only applies to comments directly received by a given fund.

Current Reporting Requirements

Form 8-K requires BDCs to disclose specific events and information on a current basis in the same manner as operating companies. In contrast, registered CEFs generally are not required to report information on Form 8-K, although some do so voluntarily. The proposal would require registered CEFs (even those that do not use short-form registration statements) to provide current disclosure on Form 8-K.

The proposal would also amend Form 8-K to add two new reporting items for BDCs and CEFs:

• Item 10.01: material changes to investment objectives or policies; and
• Item 10.02: material write-downs in fair value of significant investments (an investment would be considered significant if a BDC’s or CEF’s investment in a portfolio company exceeds 10% of its total assets).

Failure to file timely reports on Form 8-K under new Items 10.01 and 10.02 would not disqualify a BDC or CEF from eligibility to file a short-form registration statement.

Improving the Proposal’s Current Reporting Requirements

Although we applaud the SEC’s effort to improve current reporting of important information by BDCs and CEFs to investors and the market, we believe the requirement to disclose a material write-down in fair value of a significant investment should not be imposed on BDCs and CEFs. The SEC likens the requirement to an existing requirement in Form 8-K applicable to operating companies to report a material impairment to an asset (such as goodwill, accounts receivable or a long-term asset). Unlike operating companies, the purpose of BDCs and CEFs is to invest in securities, which inherently change in value. While a material change in a balance sheet asset of an operating company may be an unusual event, a material change in the value of a security is not an unusual event.

While the SEC’s proposal would only apply to significant assets (i.e., those that make up at least 10% of the BDC’s or CEF’s total assets), a requirement to disclose a material change in only one asset does not seem consistent with what is relevant to an investor. Ultimately investors are affected by a change in the overall net asset value (“NAV”) per share of a BDC or CEF. Information about the value of a single asset is not as useful to an investor as stating the NAV per share of a BDC or CEF.

Additionally, as a practical matter, BDCs and CEFs value their securities when they strike their NAV. Some BDCs and CEFs only strike NAV monthly or quarterly. These BDCs and CEFs would not typically assess the value of a significant asset outside of their typical NAV valuation process. Therefore, the BDC or CEF would confirm the amount of the material write-down of a significant asset simultaneously with confirming the BDC’s or CEF’s overall NAV. Because the overall NAV is the more important measure to an investor and will be available at the same time, the requirement to report a material write-down of an individual asset (even a significant asset) does not meaningfully assist investors.