United States: Proposed Legislation for Business Development Companies H.R. 5929: A Capital Increase for Business Development Companies

Business Development Companies (BDCs) are an increasingly important source of funding for small and mid-sized U.S. companies with limited access to traditional capital markets. On June 8, 2012, Representative Michael M. Grimm (R-N.Y.) joined Representative Nydia Velazquez (D-NY) in introducing the Next Steps for Credit Availability Act (H.R. 5929).¹ The bipartisan bill aims to increase the availability of funding to small to mid-level companies and startups by increasing the capital available to BDCs and reducing certain regulatory burdens on BDCs.² By "modernizing the BDC regulatory framework," Representatives Grimm and Velazquez hope to "provide financial fuel for young, rapidly growing companies."³ H.R. 5929 currently sits in the House Committee on Financial Services awaiting a favorable report.

Overview

BDCs are closed-end investment companies designed to facilitate capital raising by small and mid-sized U.S. businesses. They are subject to requirements under the Investment Company Act of 1940, as amended (the 1940 Act) that are, in many cases, less onerous than the provisions of the 1940 Act applicable to traditional closed-end investment companies.⁴ Nevertheless, certain aspects of the regulatory scheme governing BDCs limit their ability to invest efficiently in small and mid-sized companies. In particular, 1940 Act limitations on borrowings and other forms of leverage and a prohibition on investing in a registered investment adviser have been seen to have impeded BDCs from more extensive investments in small and mid-size businesses. In addition, unlike traditional closed-end funds, BDCs are required to register under the Securities Act of 1933, as amended (the 1933 Act) as well as the 1940 Act. As such, they are subject to registration and related requirements under the 1933 Act as well as reporting requirements under the Securities Exchange Act of 1934, as amended (the 1934 Act). Currently, certain 1933 Act rules that facilitate capital raising by operating companies are not available to BDCs or are applied to BDCs in a less favorable manner than to other 1933 Act registrants.

H.R. 5929 attempts to promote capital raising by small- and mid-sized companies by making capital more readily available to BDCs to invest in their target companies. If enacted in its current form, H.R. 5929 would amend Sections 60 and 61 of the 1940 Act⁵ and compel the Securities Exchange Commission (SEC) to amend certain rules under the 1933 Act to:

permit BDCs to own interests in registered investment advisers;

• loosen the 1940 Act leverage limits applicable to BDCs by (a) reducing the asset coverage require-ments for indebtedness from 200% asset cover-age to 150% asset coverage (equivalent to a 66-2/3% debt-to-total capital ratio); (b) facilitating the issuance of multiple classes of senior securi-ties, regardless of whether such securities consti-tute indebtedness or "stock"; and (c) eliminating asset coverage and other requirements applicable to senior (i.e., preferred) stock.
• reduce disparities in treatment for BDCs as compared to other 1933 Act registrants related to offering and reporting requirements, streamlining securities registration and reporting for BDCs, including permitting incorporation by reference and more flexible shelf registration requirements for larger, more established BDCs.

The Next Steps for Credit Availability Act

H.R. 5929 Section 2: Amendments to Permit BDCs to Own Registered Investment Advisers

Currently, the 1940 Act prevents BDCs (as well as other registered investment companies) from owning any interest in a registered investment adviser.⁶ H.R. 5929 would except BDCs from this prohibition, although it would continue to apply to registered investment companies other than BDCs.

The importance of this proposed amendment results from changes to the Investment Advisers Act that were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act). Prior to the enactment of the Dodd-Frank Act, an investment adviser having fewer than 15 clients could generally avoid registration under the Advisers Act, and BDCs could and did own unregistered investment advisers. ⁷ BDCs typically used this flexibility to form and manage captive investment advisers that would manage investments on behalf of third party investors or the BDC itself, permitting stockholders in the BDC to benefit from the stream of advisory fees generated by such investment advisers. Following implementation of the Dodd-Frank Act, which repealed this registration exemption for "private advisers," BDCs owning (or wishing to acquire) a registered investment adviser must apply to the SEC for exemptive relief. If H.R. 5929 is enacted, it would no longer be necessary for BDCs to seek such exemptive relief, levelling the playing field between those BDCs that have been granted exemptive relief and those that have not.

The proposed amendments to Section 60 of the 1940 Act, marked to show changes from the current text, is included as Exhibit A.

H.R. 5929 Section 3: Amendments to Increase BDC Leverage

Asset Coverage

The 1940 Act's asset coverage requirements limit the ability of BDCs to incur leverage. As a result, BDCs typically incur much lower levels of leverage than private funds such as hedge funds or private equity funds, small business investment companies (SBICs) and operating companies. Under the asset coverage requirements of the 1940 Act, a BDC currently cannot borrow or issue a senior security unless, immediately following such borrowing or issuance, the BDC has asset coverage (total assets divided by total debt) of at least 200%, equivalent to a 50% debt-to-total capital ratio. H.R. 5929 would reduce this 200% asset coverage requirement for BDCs to 150%, equivalent to a 66-2/3% debt to total capital ratio.⁸ Put another way, a BDC currently must hold two dollars in assets for every dollar borrowed; under the proposed amendments, the BDC would need only $1.50 in assets for each dollar borrowed. This reduction in the asset coverage requirements would allow BDC to incur more leverage, enabling them to raise additional assets to invest in small to mid-size U.S. companies, with a corresponding increase in the default risk associated with investments in BDCs.

Preferred Stock

The 1940 Act currently treats preferred stock similarly to other types of senior securities and imposes a number of restrictions on the issuance of preferred stock and similar securities. Among these are: (i) a 200% asset coverage requirement at issuance; (ii) prohibition on the declaration of dividends and distributions (other than those payable in the BDC's common stock) on the BDC's common stock, or repurchases of common stock, unless every class of senior securities of the BDC has, at such time, 200% asset coverage after giving effect to such dividend, distribution or repurchase; (iii) a requirement that holders of senior securities, voting as a class, may elect at least two directors of the BDC (subject under certain circumstances to the rights of the holders of other classes of senior securities to elect a majority of such directors) if more than a threshold amount of dividends remains in arrears; (iv) such class of senior stock has complete priority over any other class of capital stock as to the distribution of assets and the payment of (cumulative) dividends. H.R. 5929 would facilitate the issuance of senior securities that constitute "stock." In particular, H.R. 5929 (i) eliminates the asset cover-age and other requirements described above and (ii) permits BDCs to issue multiple classes of preferred stock.⁹ These changes would make it easier for BDCs to raise additional capital through the issuance of preferred stock while still satisfying asset coverage requirements of the 1940 Act. However, it would appear that preferred stock would still be treated as a senior security for purposes of the asset coverage requirement applicable to senior debt securities and borrowings, which could result in different results under the asset coverage test depending on the sequence of security issuances by BDCs.

The proposed amendments to Section 61, marked to show changes from the current text, is included as Exhibit B.

H.R. 5929 Section 4: Registration Parity for BDCs

Finally, H.R. 5929 would streamline the SEC registration and reporting requirements applicable to BDCs by requiring the SEC to revise relevant rules and forms so that a BDC can "use the securities offering rules that are available to other 1934 Act registrants."¹⁰ Currently, for example, BDCs: (i) are excluded from the definition of "well-known seasoned issuer," or WKSI, and thus cannot enjoy the benefits of such status, such as enjoying flexibility to add different types of securities to an effective shelf registration statement; (ii) file on Form N-2, which is not within the definition of "automatic shelf registration statement," so that even established BDCs must undergo a full SEC review of even routine registration statement filings; (iii) cannot benefit from universal registration by incorporating prior SEC filings into a registration statement by reference as other 1934 Act registrants have done for several decades. H.R. 5929 would require the SEC to amend relevant rules under the 1933 and 1934 Acts to grant BDCs the registration and reporting benefits available to other 1934 Act registrants. A chart detailing these rules is included as Exhibit C.

Conclusion

H.R. 5929 aims to facilitate capital formation by BDCs, thereby increasing the availability of funding for small to mid-size U.S. companies and startups, by increasing the amount of leverage BDCs may incur, permitting BDCs more flexibility to issue senior, or preferred, stock and by conforming BDC registration and reporting to established norms for other public companies. The passage of H.R. 5929 would have broad, favorable implications for the BDC industry; however its enactment appears uncertain in the current legislative environment.

Footnotes

1 Next Steps for Credit Availability Act, H.R. 5929 112th Cong. (2012).

2 Press Release, U.S. Congressman Michael Grimm, 13th District of N.Y. (June 11, 2012).

3 Id.

4 Investment Company Act of 1940, 15 U.S.C. §§ 80a-1 to -64 (2006).

5 Exhibit A includes a marked changes version of these sections as they would read if H.R. 5929 is enacted in its current form.

6 Investment Company Act of 1940, 15 U.S.C. §§ 80a-1 to -64 (2006), §60.

7 For an additional DechertOnPoint discussing the Dodd-Frank Act's impact on registration of investment advisers, see "SEC Adopts Final Rules Regarding Investment Adviser Registration and Amends Form ADV."

8 Compared with the 300% asset coverage requirement applicable to other types of investment companies, BDCs already enjoy a less restrictive regime.

9 Closed-end funds that are not BDCs cannot issue more than one class of senior security. Currently, BDCs may issue multiple classes of senior securities that constitute indebtedness but only one class of senior securities that constitute stock.

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