(Article from Registered Funds Alert, October 2019)
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Earlier this year, the SEC proposed rules that would modify the registration, communication, and offering processes for business development companies (“BDCs”) and registered closed-end investment companies (“CEFs”) to align more closely with the rules that apply to traditional operating companies. In our previous Alert, we outlined the five main reforms that would benefit BDCs and CEFs and suggested ways that the SEC could clarify certain aspects of the proposed rules. In this Alert, we summarize the key themes in industry comment letters submitted to the SEC with respect to the proposed rules. In total, the SEC received 20 comment letters regarding the offering reforms.
Comment Letters Expressed General Support for the Rules as Proposed, but Identified Two Critical Areas for Improvement
In 2018, Congress passed legislation that directly requires most elements of the proposed rules, and that legislation was the result of sustained advocacy efforts by the industry. Unsurprisingly, industry comment letters were supportive of the proposed rules in general, especially those portions that were derived from the prompting legislation. Notwithstanding the general support, the prevailing weight of industry opinions did suggest modifications to the proposals around two issues of note: (i) the criteria that would permit a CEF or BDC to qualify as a Well-Known Seasoned Issuer (“WKSI”); and (ii) the circumstances that could disqualify a CEF or BDC from qualifying as a WKSI.
The Misplaced Emphasis on Public Float
The Proposed Reliance on Using Public Float to Classify a WKSI Frustrates the Intent Behind the Offering Reforms by Disqualifying the Majority of CEFs and BDCs
As highlighted in our previous Alert, the proposal would amend the WKSI definition to include qualifying CEFs and BDCs and therefore allow those qualifying funds to take advantage of the offering flexibility (i.e., automatic effectiveness of registration statements) that comes with a WKSI status. In order to qualify for WKSI status, the SEC proposed that a BDC or CEF must have at least $700 million in public float. The SEC also proposed a $75 million public float requirements for a BDC or CEF to qualify as a “seasoned issuer,” which allows filing of short-form registration statements. The public float standard was proposed by the SEC because it believed this standard was an appropriate proxy for investor awareness. Specifically, the SEC noted that tailoring the definition to public float “is meant to capture issuers . . . whose disclosures and other communications are subject to market scrutiny by investors, the financial press, analysts, and others.” The SEC concluded that it was appropriate to offer WKSI flexibility to entities that are widely followed and closely examined in the marketplace.
The public float standard would effectively eliminate a majority of BDCs and CEFs from qualifying as a WKSI. As one commenter noted, as of June 30, 2018, only 14% of BDCs and 12% of CEFs out of the universe of funds outlined in the proposal could meet the $700 million public float requirement. Furthermore, interval funds would rarely qualify as a WKSI since their shares are almost never listed on an exchange (the proposing release noted that “only one interval fund is currently exchange-traded”). Several commenters, including the Investment Company Institute (the “ICI”), highlighted the fundamental inconsistencies between that the strict public float requirement and Congressional intent. The legislation mandating the proposed rules was meant to alleviate some of the regulatory burdens that were impeding capital growth for CEFs and BDCs. In this respect, the ICI noted that Congress even discussed creating legislation that would require the SEC to adopt rules that would allow certain funds, including interval funds, to be treated as WKSIs. In sum, most commenters mostly argued that the insistence on using a public float requirement goes directly against the motivations behind the proposed offering reforms.
Tying WKSI Status to Public Float Ignores the Operational and Regulatory Differences Between Operating Companies and BDCs and CEFs
While market scrutiny may be necessary for operating companies, numerous commenters noted that BDCs and CEFs already have regulations in place that serve as an appropriate proxy for investor awareness and institutional due diligence. Unlike operating companies, BDCs (through election) and CEFs are subject to the strict oversight and governance requirements of the 1940 Act. While the valuation of operating companies can be complex and often times subjective in certain respects, the 1940 Act imposes general valuation guidelines for all BDCs and CEFs. This is an important distinction between BDCs/CEFs and operating companies, as one commenter indicated, “because, as all funds are subject to the same requirements and guidelines, it gives fund shareholders, and the market, comfort that the valuations are appropriate and comparable.” Furthermore, as other commenters pointed out, BDC and CEF valuations and holdings are more transparent compared to standard operating companies. BDCs, CEFs and interval funds are required to disclose their net asset value periodically—sometimes daily—and provide routine public reports regarding their fund holdings. This type of transparency allows investors to monitor their investment on their own, without needing to rely exclusively on institutional scrutiny in the form of research and analysis provided by brokerage firms and underwriters.
Moreover, the governance and oversight required by the 1940 Act further reduces dependence on market reports or institutional scrutiny. Commenters conceded that BDCs and CEFs may not receive the same level of coverage from the financial media as operating companies, but pointed to the responsibilities of independent directors under the 1940 Act in mitigation of the coverage discrepancy. Independent directors are required for approval of fundamental agreements including contracts with the investment adviser and underwriters. The 1940 Act also imposes certain requirements on BDCs and CEFs such as adoption of compliance programs, restrictions on certain share classes, and restrictions on leverage. This combination of internal governance oversight and strict regulatory guardrails provides investors in BDCs and CEFs with a similar level of protection as investors in large operating companies.
The WKSI Criteria Should be Modified to Allow More Traded and Non-traded BDCs and CEFs to Benefit Fully From the Offering Reforms
The majority of commenters urged the SEC to expand the definition of a WKSI to include NAV. For example, one commenter suggested defining a WKSI to have “either a NAV or a public float of $700 million or more.” The ICI suggested that the SEC should not use public float in any instance to classify BDCs or CEFs as WKSIs. That comment letter stressed that the rules and regulations that guide BDCs and CEFs already serve as an appropriate proxy for institutional scrutiny and investor protection. Instead of imposing any public float requirement, the ICI suggested that a BDC or CEF could qualify as a WKSI if it meets the other registrant and transaction requirements of Form S-3. This includes being subject to the requirements of Exchange Act Sections 12 or 15(d) or the 1940 Act Section 30 for at least one year and the timely filing of all reports and subsequent materials required to be filed under the Exchange Act during the previous year. Regardless of the alternative proposed, the widespread industry belief was that public float should not be a strict requirement for WKSI status.
The Negative Impact of the Proposed “Ineligible Issuer” Definition
The proposal also includes certain provisions that would disqualify an otherwise eligible BDC or CEF from WKSI status. In particular, one of these provisions states that a BDC or CEF would be ineligible for WKSI status if, “within the past three years any person or entity that at the time was an investment adviser to the issuer, including any sub-adviser, was made the subject of any judicial or administrative decree or order arising out of a governmental action that determines that the investment adviser aided or abetted or caused the issuer to have violated the anti-fraud provisions of the federal securities laws.”
This disqualification provision would appear to go beyond the scope of the standards applicable to traditional operating companies by factoring in whether external advisers caused a BDC or a CEF to violate the anti-fraud provisions of the federal securities laws. One commenter noted that the new definition could lead to unintended consequences for BDCs. For example, the SEC has viewed Section 206(4) of the Advisers Act as an anti-fraud provision, and a violation of the rules adopted pursuant to Section 206(4) could result in disqualification under the proposed rules. The commenter pointed out, that in reality, many of the rules adopted under Section 206(4) were designed to prevent anti-fraud violations (e.g., Rule 206(4)(7), which requires adoption of a written compliance program). As a result, a BDC could become an “ineligible issuer” and lose WKSI status because an adviser or sub-adviser violated a technical requirement that did not involve any actual fraud. The commenter proposed carving out exceptions for certain rules adopted under Section 206(4). While those rules are undoubtedly important, violations should not lead to an immediate loss of WKSI status for affiliated BDCs.
Additionally, a BDC or CEF would be disqualified so long as its investment adviser “at the time” it was found to have violated anti-fraud provisions of federal securities laws. This clause of the proposed ineligible issuer definition could lead to a scenario in which a BDC or CEF is deemed an ineligible issuer due to the actions of an adviser that is no longer managing the BDC or CEF (e.g., if the fund subsequently terminated its relationship with the adviser). The commenter asked the SEC to clarify this element of the definition so that there is a logical nexus between the violation and the time period in which the BDC or CEF seeks to take advantage of WKSI status. These suggestions exemplify the general concern among commenters that the proposed rules would obstruct BDCs and CEFs from realizing the full benefits of the offering reforms.
Comment Letters Expressed General Support for Additional Proposals
The SEC did not limit the scope of the rule proposal to the four corners of the prompting legislation. The proposed rules also included additional initiatives related to offering reform that were not mandated by Congress, and therefore were not a product of industry lobbying efforts. Still, industry commenters generally supported the additional proposals. Those proposals included:
- Allowing interval funds to pay registration fees on an annual net basis (no later than 90 days after the fund’s fiscal year) by amending Rules 23c-3 and 24f-2. These amendments would allow interval funds to use the same registration fee payment method as mutual funds and ETFs. Numerous commenters supported this proposal, and also asked the SEC to extend this privilege to other types of entities such as tender offer funds and exchange traded products (“ETPs”).
- Adding a Management’s Discussion of Fund Performance (“MDFP”) section in CEF periodic reports. The proposed section was derived from the Management Discussion and Analysis (“MD&A”) section found in public filings for operating companies. The ICI supported this proposal, noting that narrative disclosure through the lens of management provides investors with another perspective to aid their understanding of fund performance and the relevant markets.