United States: Section 12(d)(1) And Business Development Companies

Last Updated: August 10 2016
Article by Kelley A. Howes

 Business development companies (BDCs), which provide a growing and important alternative source of capital to smaller companies, face challenges raising money due to a quirk in the federal securities laws that limits how much mutual funds can invest in them. But if BDCs, mutual funds, ETFs, and other participants in the capital markets raise their voices, there is some hope that the Securities and Exchange Commission can ease the restriction so that BDCs can fulfill their statutory mission of raising capital for smaller companies that cannot otherwise find bank financing.

As investment companies, BDCs are subject to certain provisions of the Investment Company Act of 1940 (the "1940 Act") including the limitations in Section 12(d)(1) of the 1940 Act. Among other things, this section limits the ability of other registered investment companies (including exchange-traded funds (ETFs) to acquire more than three percent of a BDC's total outstanding stock. Given the relatively small size of many BDCs, this meaningfully restricts their ability to raise money from key institutional investors. Unfortunately, the trickle-down effect of this restriction limits the ability of BDCs to use their capital to provide small and middle market businesses the ability to continue to develop and grow.

It may be time for the Securities and Exchange Commission (the SEC)—or its staff—to consider rule making or exemptive relief to address this limitation on the capital markets.


BDCs are closed-end investment companies that have elected to be subject to the provisions of Sections 55 through 65 of the 1940 Act.1 BDCs primarily invest in "eligible portfolio companies," which are domestic issuers that either (1) do not have any class of securities listed on a national securities exchange or (2) have a class of equity securities listed on a national securities exchange, but have an aggregate market value of less than $250 million. In recent years, BDCs have increasingly focused on mezzanine and debt investments that generate current income.

Many BDCs are listed on a national securities exchange. They therefore provide investors with the same liquidity as any other publicly traded security, but they are held and traded primarily by retail investors. Interestingly, many BDCs do not have a large institutional shareholder base. This may be attributable, at least in part, to the fact that Section 12(d)(1) of the 1940 Act limits the ability of registered investment companies, including ETFs, to hold more than three percent of the outstanding shares of another investment company, including a BDC. This restriction limits the ability of BDCs to raise meaningful amounts of capital from a key participant in the institutional marketplace and, in turn, restricts the ability of BDCs to use that capital to invest in the small- and middle-market companies that they serve, to the detriment of such companies, including small, startup businesses.

Policy Concerns

Prior to the enactment of the 1940 Act, individuals could acquire control of a fund and use its assets to acquire control of the assets of another fund, which, in turn, could use its assets to control a third fund. As a result, a few individuals effectively could control millions of dollars in shareholder assets invested in various acquired funds and could influence the investments in such funds for their benefit. Such structures also resulted in the duplication of fees, which were borne by investors. Section 12(d)(1) of the 1940 Act was precisely designed to limit the opportunity for such "pyramid" structures or investments in multiple funds.

In order to eliminate the opportunity for pyramid structures or investments, Section 12(d)(1)(A) prohibits a registered investment company from:

  • acquiring more than three percent of another investment company's voting securities;
  • investing more than five percent of its total assets in any one acquired investment company; or
  • investing more than ten percent of its total assets in all acquired investment companies.

Since BDCs are closed-end investment companies, the ability of registered investment companies—whether open-end or closed-end—to invest in BDCs is restricted by the provisions of Section 12(d)(1)(A).


BDCs are inappropriately disadvantaged by the restrictions imposed by Section 12(d)(1)(A) on registered funds that seek to invest in BDCs in order to gain exposure to private companies in the small and middle markets. In particular, BDCs do not present the kind of policy concerns that the three percent ownership limit is designed to address because of the statutory and regulatory restrictions already imposed on a BDC's investment portfolio.

Under Section 55(a) of the 1940 Act, a BDC must generally have at least 70 percent of its total assets in the following investments:

  • privately issued securities purchased from issuers that are eligible portfolio companies (or from certain affiliated persons);
  • securities of eligible portfolio companies that are controlled by the BDC and of which an affiliated person of the BDC is a director (a controlling interest is presumed if the BDC owns more than 25 percent of a portfolio company's voting securities);
  • privately issued securities of companies subject to a bankruptcy proceeding, reorganization, insolvency, or similar proceeding or otherwise unable to meet their obligations without material assistance;
  • cash, cash items, government securities, or high-quality debt securities maturing in one year or less; and
  • office furniture and equipment, interests in real estate and leasehold improvements, and facilities maintained to conduct the business of the BDC.

BDCs are also required to offer eligible portfolio companies "significant managerial assistance," which may include operational and management advice or membership on the board of directors of a portfolio company. In other words, unlike most registered investment companies, BDCs are not passive investors. BDCs operate more like private equity investors. Moreover, Section 60 of the 1940 Act imposes the restrictions of Section 12 on BDCs to the same extent as though BDCs were registered closed-end investment companies. Accordingly, BDCs cannot have significant investments in other registered or unregistered investment companies.2 In other words, the investment portfolio of a BDC is distinguishable from passive investments made by other investment companies and the opportunity for pyramid structures or investments does not exist.3

BDCs could, however, provide an opportunity for registered funds to gain exposure to private companies in the small and middle markets, including SBICs, in the form of a registered security. BDCs are typically registered under the Securities Act of 1933, as amended, and are subject to all of the registration and reporting requirements of that statute and the Securities Exchange Act of 1934, as amended. BDCs also are often listed on an exchange and subject to the exchange's corporate governance requirements. More importantly, BDCs are closed-end investment companies and thus are subject to many of the restrictions and requirements of the 1940 Act. These include limitations on the ability to use leverage, routine reporting requirements, valuation obligations, and the oversight of a board of directors that includes members that are not "interested persons" (as defined in the 1940 Act) of the BDC or its adviser, if applicable. In addition, the board of directors of a BDC must approve, and the BDC must implement, a written compliance program reasonably designed to ensure compliance with the federal securities laws.

In short, acquiring more than three percent of the outstanding voting securities of a BDC does not seem to present the types of policy concerns that Section 12(d)(1)(A) was designed to address. Indeed, the SEC Staff on more than one occasion has granted exemptive relief to enable registered funds operating as exchange-traded funds to invest in BDCs in excess of the three percent limitation.4

In granting such relief, the SEC Staff has imposed conditions designed to address the public policy concerns of pyramid structures or investments, including oversight by the acquiring investment company's board of trustees, limitations on layering fees, adoption of policies regarding proxy voting, limitations on the ability to exercise control over an underlying BDC, and the requirement for the acquiring fund and the BDC to enter into participation agreements and provide records to monitor compliance with the provisions of the exemptive relief. These conditions could, however, be included in a general exemptive rule rather than requiring that investment companies bear the significant cost and the delay of seeking individual exemptive relief.


Over the last several years, recognizing that access to traditional forms of capital has become increasingly difficult, Congress has moved decisively to help small businesses more easily access the capital markets. The SEC could do its part by adopting a new exemptive rule under Section 12(d)(1)(A) to enable registered investment companies (including ETFs) to invest in BDCs in excess of the three percent threshold. Alternatively, the SEC and the SEC Staff could work with registrants to grant individual exemptive relief. In either event, BDCs stand ready to use that capital to provide small- and middle-market businesses the ability to continue to develop and grow.


1 BDCs are subject to many, but not all, of the provisions of the 1940 Act. For more information regarding BDCs and their operations, see our "Frequently Asked Questions about Business Development Companies," available at: http://media.mofo.com/files/Uploads/Images/FAQ-Business-Development-Companies.pdf.

2 BDCs may create wholly owned subsidiaries that operate as "small business investment companies" (SBICs),which rely on an exclusion from the definition of "investment company" under the 1940 Act.

3 However, the staff (the "SEC Staff") of the Division of Investment Management of the SEC has granted no-action relief from Sections 2(a)(48) and 55(a) of the 1940 Act to enable a feeder fund to elect to be treated as a BDC notwithstanding the fact that the feeder fund's investment in the master fund would not be an investment in an eligible portfolio company and the feeder fund would not make significant managerial assistance available to the issuers of securities held by the master fund. Carey Credit Income Fund and Carey Credit Income Fund 2015 T, SEC No-Action Letter (July 15, 2015).

4 See, e.g., In the matter of Global X Funds et al., Rel. No. IC-30454 (Apr. 9, 2013); In the matter of PowerShares Exchange-Traded Fund Trust et al., Rel. No. 32035 (Mar. 22, 2016). As made applicable to BDCs by Section 60 of the 1940 Act, Section 12(d)(1)(C) of the 1940 Act limits the ability of any investment company (whether registered or not) to acquire more than 10 percent of the total outstanding voting stock of a BDC. However, the exemptive relief granted to date has also provided relief from this limitation.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Kelley A. Howes
Similar Articles
Relevancy Powered by MondaqAI
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions