United States: SEC Publishes Rulemaking For BDCs On Eligible Investments

The Securities and Exchange Commission (the "SEC") took two important steps toward addressing the uncertainty regarding the permissible investment activities of business development companies ("BDCs").¹ First, the SEC adopted two new rules under the 1940 Act, Rules 2a-46 and 55a-1, that will clarify that private companies, and certain public companies, are eligible portfolio companies. Second, the SEC also reproposed for comment a rule that would expressly permit certain public companies whose securities are traded on a national securities market to fall within the definition of eligible portfolio company.

Congress established BDCs in 1980 as a special type of closed-end investment company for the purpose of making capital more readily available to small, developing and financially troubled companies that do not have ready access to the capital markets. To encourage investment in these types of companies, the 1940 Act requires that BDCs have at least 70% of their total investments invested in "eligible portfolio companies" at the time they make any new investment. Section 2(a)(46) of the 1940 Act defines "eligible portfolio company" to include domestic operating companies that, among other things, do not have any class of securities that are marginable under rules promulgated by the Federal Reserve Board. By 1998, for reasons unrelated to the BDC industry, the Federal Reserve Board had expanded its definition of margin security to include all publicly traded equity securities and most debt securities. These changes had the unintended effect of reducing the number of companies that met the definition of "eligible portfolio company" as defined in Section 2(a)(46) of the 1940 Act. The new rules adopted by the SEC are intended to address this issue.

• Rule 2a-46 defines an eligible portfolio company to include all private companies and companies whose securities are not listed on a national securities exchange.

• Rule 55a-1 conditionally permits a BDC to include in its 70% "eligible investment basket" follow-on investments in a company that met the new definition of eligible portfolio company at the time of the BDC’s initial investment in it, but no longer meets that definition.

These new rules will become effective 30 days after publication in the Federal Register.

In addition to the foregoing, the SEC also reproposed for comment an additional definition of eligible portfolio company under the 1940 Act (the "Reproposal"). As reproposed, Rule 2a-46(b) would expand the definition of eligible portfolio company to include certain companies that list their securities on a national securities exchange. Specifically, the SEC seeks comment on the appropriate standard from the following range of possible alternatives for defining the class of covered public companies:

• a public float of less than $75 million;

• a market capitalization of less than $150 million;

• a market capitalization of less than $250 million; or

• any other levels of public float or market capitalization that commenters might suggest, consistent with the purpose of the Investment Company Act.

The SEC is seeking public comment on all aspects of the Reproposal. Comments should be submitted within 60 days of the reproposal’s publication in the Federal Register.

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.