The Securities and Exchange Commission (SEC) recently took two important

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1 The SEC Addresses Eligible Investments for Business Development Companies by Steven B. Boehm and Hannah L. Friedberg The Securities and Exchange Commission (SEC) recently took two important steps toward addressing the uncertainty surrounding the definition of eligible portfolio companies for business development companies (BDCs) under the Investment Company Act of 1940 (1940 Act). As far as BDCs are concerned, the SEC s attention to this issue could not have come soon enough, as BDCs have been vexed by the question of what are considered permissible investments for some time. This uncertainty has existed because, in general, BDCs must have at least 70 percent of their total assets invested in eligible portfolio companies at the time they make any new investment (the 70 percent basket). The 1940 Act defines eligible portfolio company to generally 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 (the Fed). Since that definition was enacted, however, the Fed has modified its definition of Steven B. Boehm is a partner of Sutherland Asbill & Brennan LLP in Washington DC. Hannah L. Friedberg earned her JD in May 2006 and her bar admission is pending. marginable securities. These modifications had the unintended result of expanding the definition of such marginable securities so much that almost any public or private company could have been deemed to issue marginable securities, which in turn dramatically narrowed the universe Congress had in mind for BDC investments. On October 25, 2006, the SEC addressed the consequences of the expansion of the definition of marginable securities by adopting two new rules under the 1940 Act, Rule 2a-46 and Rule 55a-1. These rules clarify that private companies,

2 and certain public companies, are eligible investments for BDCs regardless of whether they issue marginable securities. 1 On the same day, the SEC also reproposed for comment Rule 2a-46(b) that, if enacted, would deem certain public companies whose securities are traded on a national securities exchange to be eligible portfolio companies as well. 2 By significantly expanding the number of companies whose securities BDCs can include in their 70 percent baskets, these rules, when Rule 2a- 46(b) is ultimately promulgated, should realign the BDC investment universe with Congress intent in establishing the BDC structure of providing capital to small, developing, and financially distressed companies. Background A perceived crisis in the capital markets in the 1970s led Congress to enact the Small Business Investment Incentive Act of 1980, 3 which included amendments to the 1940 Act (the 1980 Amendments). This crisis arose from a limitation set forth in the regulatory exclusion for private investment funds that private equity and venture capital firms relied upon to avoid SEC regulation under the 1940 Act. 4 This limitation required that, if private equity and venture capital firms wanted to avoid being deemed an investment company for purposes of the 1940 Act, their securities not be beneficially owned by more than 100 persons. In essence, private equity and venture capital firms believed that their inability to raise equity capital due to this limitation stymied their capacity to provide financing to small, growing business. Because private equity investors were generally unwilling to subject themselves to 1940 Act regulation, they urged Congress to ameliorate the situation before the spigot of capital to small, growing businesses closed shut. Congress answered the private equity community s pleas by enacting the 1980 Amendments. The 1980 Amendments added to the 1940 Act a new category of closed-end investment company known as a BDC. In general, BDCs are publicly traded closed-end funds that make investments in private or thinly-traded public companies in the form of long-term debt or equity capital, with the goal of generating capital current income and/or appreciation. In establishing BDCs under the 1940 Act, Congress was hoping to encourage the finance community to establish public vehicles for investing in private equity that would in turn increase the flow of public capital to small, growing private and public companies. The 1980 Amendments sought to achieve this goal by lessening some of the restrictions under the 1940 Act that the investment community believed discouraged private equity managers from participating in the regulated portion of the investment management industry, most notably restrictions relating to compensation and borrowing. 5 Permissible Investments Consistent with Congress intent in the 1980 Amendments to increase cash flow to small and growing businesses, Section 55(a) of the 1940 Act generally requires that BDCs have at least 70 percent of their investments in eligible assets purchased in a private transaction from the issuer or an affiliate. Section 2(a)(46) of the 1940 Act defines eligible portfolio company to include a domestic company that is not itself an investment company (or a company excluded from the investment company definition under Section 3(c)) and that does not have a class of securities outstanding upon which margin credit can be granted, consistent with the rules and regulations of the Fed (marginable securities). 6 This standard reflected Congress view at the time it enacted the 1980 Amendments that issuers of marginable securities were mature enough to have access to conventional public markets, and therefore didn t fall within the category of companies Congress intended the 1980 Amendments to benefit (that is, small, developing, and financially troubled businesses). 7 At the time Section 2(a)(46) was enacted, Congress believed that the Fed s definition of marginable security would serve as a rational and objective test for determining whether companies had ready access to public capital markets or other sources of traditional financing. 8 However, in the years following the enactment of the 1980 Amendments, the Fed from time to time amended its standards for marginable securities. These amendments did not have a substantial impact on eligible BDC investments until 1998 when, for reasons unrelated to small business capital formation, the Fed expanded the definition of marginable security to include all publicly traded equities and most debt securities. This amendment had the unintended consequence of substantially reducing the universe of companies that could fit within the eligible portfolio company definition. The changes in the Fed s standard for the marginability of securities was clearly contrary to Congress intent in enacting the 1980 Amendments in the first place, as it not only created a legal impediment to the flow of capital to small and growing private companies, but THE INVESTMENT LAWYER 2

3 also effectively excluded all public companies from the definition of eligible portfolio companies. 9 At the time Congress enacted the 1980 Amendments, it recognized that changes in the financial environment could require that the categories of eligible portfolio companies be augmented. 10 Therefore, Congress granted the SEC rulemaking authority under Section 2(a)(46) to expand the definition of eligible portfolio company if such expansion ever became necessary. 11 Despite having authority to do so, however, the SEC did not address the marginable security issue until In response to the BDC community s request to address the eligible portfolio company issue, on November 1, 2004, the SEC proposed new Rules 2a-46(a), Rule 2a-46(b) and Rule 55a-1 with the intention that these rules would realign the definition of eligible portfolio company with the purpose of the 1980 Amendments. On October 25, 2006 the SEC adopted Rule 2a-46 and Rule 55a- 1, which makes it clear that all private companies are eligible investments. However, in light of commenters concerns that proposed Rule 2a-46(b), which relates to public companies that qualify as eligible portfolio companies, was both too narrow and unworkable, the SEC did not adopt that rule as proposed. Instead, it issued a rule reproposal addressing commenters concerns. These new rules and the reproposal take important steps towards addressing the uncertainty regarding the permissible investment activities of BDCs. Rule 2a-46 Rule 2a-46 defines eligible portfolio company to include all private companies and public companies whose securities are not listed on a national securities exchange. The SEC believes new Rule 2a-46 more closely aligns the definition of eligible portfolio company with the purpose of the 1980 Amendments because it recaptures small developing and financially distressed companies that may have been excluded from the 70 percent basket by the 1998 marginable security definition change as a result of having debt securities. 12 The SEC estimates that this new rule includes 6,041 public operating companies within its definition of eligible portfolio companies, which represents 61.4 percent of existing public operating companies. 13 While Rule 2a-46 restores the pool of eligible portfolio companies available for BDC investment, consistent with the intent of Congress when it enacted the 1980 amendments, it still excludes the substantial universe of issuers which, though their securities are traded on a national securities exchange, do not have access to traditional capital markets. In this regard, while listing on an exchange or on Nasdaq provides issuers with the opportunity to obtain visibility, marketability, third-party established valuation, and liquidity, all of which are valuable in capital formation, that listing does not necessarily guarantee such benefits. In fact, despite the fact that listed on an exchange or quoted through Nasdaq, certain companies are still unable to access the capital markets to secure additional capital. For example, during the market boom of the late 1990s, many companies became public that could not have done so in a more typical, less heated, equity market. Many of those small public companies, following the bursting of the market bubble in 2000, have found themselves without access to traditional forms of financing and in very much the position of the small public companies with limited or no access to the capital markets that Congress envisioned as appropriate investments for BDCs when it enacted the 1980 Amendments. Therefore, reproposed Rule 2a-46(b) is critical. Rule 55a-1 Rule 55a-1 allows a BDC to include in its 70 percent basket follow-on investments in a company that met the definition of eligible portfolio company at the time of the BDC s initial investment, but no longer meets the definition at the time of the follow-on investment because the company issued marginable securities. Incorporating the conditions set forth in Section 55(a)(1)(B), the Rule imposes several requirements that BDCs must meet if they wish to include follow-on investments in their 70 percent baskets. Specifically, at the time of the follow-on, the BDC must 1. Own at least 50 percent of (a) the greatest number of equity securities in the company, including equity securities that are convertible or exchangeable; and (b) the greatest amount of certain debt securities of the company held by the BDC at any time during the period when the company was an eligible portfolio company; and 2. Be one of the 20 largest outstanding voting securities holders of record. 14 The SEC believes this rule more closely aligns the definition of eligible portfolio company with the purpose of the 1980 Amendments by allowing BDCs to include these follow-on investments in their 70 percent baskets. 3

4 Reproposed Rule 2a-46(b) When first proposed in 2004, Rule 2a-46(b) defined eligible portfolio companies as public companies listed on a national exchange but in danger of de-listing for failure to maintain eligibility requirements. In essence, Rule 2a-46(b) aimed to include financially troubled issuers within the definition of eligible portfolio companies. This proposal was met with concern from BDCs, as many believed its narrow focus on financially distressed companies failed to fulfill the 1980 Amendments goal of increasing flow of capital to small and developing companies as well. On October 25, 2006, the SEC announced it was not adopting Rule 2a-46(b) as proposed, but rather responding to BDCs concerns by reproposing Rule 2a-46(b). As reproposed, Rule 2a-46(b) would expand the definition of eligible portfolio company to include some class public domestic operating companies. Proposed alternative classes include public companies with: 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 1940 Act. 15 When the SEC initially proposed Rule 2a-46(b) in 2004, it was concerned that any definition that relied on market capitalization would be too difficult to comply with, as a company s market capitalization may fluctuate. 16 However, the rule as reproposed includes market capitalization standards as two of its alternative classes of public companies included in the definition of eligible portfolio company. The SEC addressed its concerns regarding such fluctuation by proposing to calculate size using either the price at which a company s common equity last sold, or the average of bid and asked prices of common equity in a principal market for common equity on any day within a sixty day period immediately before the BDC s acquisition of its securities. The SEC believes that using a range of days ameliorates the otherwise problematic nature of fluctuating capitalization. 17 It would seem that the $250 market capitalization standard represents the most workable approach. Market capitalization as a standard in general is frequently regarded as an accurate barometer of a company s ability to obtain financing for growth. 18 Moreover, the reality is that companies will only seek BDC financing where traditional sources of financing, which ordinarily are less costly, are unavailable. Thus, public companies with market capitalizations of up to $250 million, or even much more, will only seek capital from BDCs for the reasons Congress intended in the 1980 Amendments. Support for a market capitalization standard is not a new concept for the SEC. In fact, the SEC currently uses market capitalization as an indicator of how a public company is perceived in the financial markets. For example, the well-known seasoned category of issuer rule adopted as part of the SEC s securities offering reform provides that issuers with market capitalization above $700 million would be considered well-followed. The SEC also recently issued an exemptive order granting certain smaller companies classified as accelerated filers additional time to comply with certain internal control reporting requirements under Section 404 of the Sarbanes-Oxley Act of 2002 based on market capitalization of $700 million as a threshold. 19 Thus, it appears that the SEC has already made a determination regarding the distinction between well-followed companies and small, developing companies based on the ease with which each is able to access the capital markets. Looking Ahead The effective date of Rule 2a-46 and Rule 55a-1 is November 30, Once promulgated, those rules go a long way toward solving the uncertainty with which BDCs have lived regarding their eligible investments. However, the adoption of Rule 2a-46(b), the comment period for which expires on January 2, 2007, is also critical. Its promulgation, ideally with the $250 million market capitalization standard as its benchmark, should finally put this issue fully to rest. NOTES 1. See Definition of Eligible Portfolio Company, Investment Company Act Release No. 27,538 (Oct. 25, 2006) (hereinafter Final Rule Release); see also Steven B. Boehm, Cynthia M. Krus, Harry S. Pangas, and Lisa A. Morgan, Shedding New Light on Business Development Companies, The Investment Lawyer, Oct. 2004, at 15 (discussing the impact the uncertainty of the definition of marginable securities had on BDCs ability to include certain portfolio companies in their 70 percent baskets). THE INVESTMENT LAWYER 4

5 2. See Definition of Eligible Portfolio Company, Investment Company Act Release No. 27,539 (Oct. 25, 2006) (hereinafter Rule Reproposal Release). 3. Pub. L. No , 94 Stat (Oct. 21, 1980). 4. See Section 3(c)(1) of the 1940 Act. 5. For a more detailed discussion of the structure of and regulatory regime for BDCs, see Boehm, supra n.1, at Section 2(a)(46) enumerates a number of categories of eligible portfolio companies, but the one that covers companies without a class of marginable securities outstanding is the one on which BDCs have historically relied to the greatest extent. 7. See H.R. Rep. No. 1341, 96th Cong., 2d Sess. 21 (1980), at 23 ( The restrictions [placed on BDCs] are designed to assure that companies electing special treatment as [BDCs] are in fact companies providing capital and assistance to small, developing or financially troubled businesses that are seeking to expand, not passive investors in large, well-established businesses. ). 8. See Final Rule Release, supra n.1, at At the time Congress enacted the 1980 Amendments, it intended that all privately held companies, and we estimate, two thirds of all companies [would] fall within the definition of an eligible portfolio company ]. See Hearings before the Subcommittee on Consumer Protection and Finance of the Committee of Interstate and Foreign Commerce of the House of Representatives on H.R and H.R (June 17, 1980). 10. See Final Rule Release, supra n.1, at See Section 2(a)(46)(C)(iv). 12. Id. at Id. at See Final Rule Release, supra n.1, at See Rule Reproposal Release, supra n.2, at See Definition of Eligible Portolio Company, Investment Company Act Release No. 26,647 (Nov. 1, 2004). 17. See Final Rule Release, supra n.1, at A $250 million market capitalization standard for determining whether an issuer would be deemed an eligible portfolio company was introduced in the House in See H.R (2004). That proposal passed unanimously in the House but it never came before the Senate for a vote. 19. See SEC Release No (November 30, 2004). In footnote 1 of such release, the SEC notes that, This threshold is designed to ensure that the largest companies with the most active market comply with the current deadline and to provide needed relief to smaller companies. We believe that the accelerated filers with the relevant fiscal year ends and public equity float thresholds exceeding $700 million, representing approximately 96 percent of the US equity market capitalization, will be able to complete their internal control work by the existing Form 10-K deadline. Reprinted from The Investment Lawyer December 2006, Volume 13, Number 12, pages 3-7, with permission from Aspen Publishers, Inc., Wolters Kluwer Law & Business, New York, NY, , 5