UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 THE CHAIR October 21, 2013 The Honorable Scott Garrett Chairman Subcommittee on Capital Markets and Government Sponsored Enterprises U.S. House ofrepresentatives Washington, DC 20515 Ranking Member Subcommittee on Capital Markets and Government Sponsored Enterprises U.S. House ofrepresentatives Washington, DC 20515 Dear Chairman Garrett and Ranking Member Maloney: I understand that the Capital Markets Subcommittee of the House Financial Services Committee will be discussing at an upcoming legislative hearing three bills that would amend provisions of the Investment Company Act of 1940 (Act) concerning business development companies (BDCs): H.R. 31 (the Next Steps for Credit Availability Act); H.R. 1800 (the Small Business Credit Availability Act); and H.R. 1973 (the Business Development Company Modernization Act). I write to briefly provide background on BDCs and to draw your attention to certain features ofthese bills. Please note that the views expressed in this letter are my own and do not necessarily reflect the views of the full Commission or any Commissioner. As ofjune 30, 2013, there were 68 active BDCs with aggregate total assets of $53.7 billion. While BDCs account for a small percentage ofthe assets managed by all regulated investment companies, assets managed by BDCs have grown rapidly over the past decade from net assets ofjust $5 billion at the end of 2003. Much of this growth is from newly organized BDCs sponsored by large private capital managers. Most BDCs sell a fixed number of shares in periodic offerings and most (about 85%) provide investors with liquidity by listing their shares on a stock exchange. Significantly, most securities issued by BDCs, whether traded or not, are held by retail investors. Congress created BDCs in 1980 as a specialized type of closed-end investment company (i.e., a fund that is notrequired to repurchase or redeem its securities) whose principal activities consist of investing in, and providing managerial assistance to, small, growing, or financially troubled domestic businesses. To this end, the Act generally requires a BDC to invest at least 70% of its portfolio assets in cash (or high quality, short-term debt securities), securities issued by financially troubled businesses, orcertain securities issued by domestic companies that: do not have a security listed on a national securities exchange (i.e., are private companies), or have a security listed on a national securities exchange but have less than $250 million ofcommon shares outstanding; are not investment companies; and
Page 2 would not be investment companies but for an exclusion from the definition of "investment company" in section 3(c) ofthe Act. The remaining 30% ofa BDCs portfolio assets are not limited by these investment restrictions and can be invested freely. Under the Act, BDCs enjoy greater operating flexibility than mutual funds or other closed-end funds. A BDC, for example, may issue long term options and warrants, may issue multiple classes ofdebt securities, and may issue approximately 50% more debt securities as a percentageofcapital than other investmentcompanies. As discussed below, H.R. 31 and H.R. 1800 would ease that regulatory structure by permitting a BDC to double its permitted borrowingsand issue an unlimited amount ofpreferred stock, thereby increasing the risk of loss from such leverage for BDC shareholders and holders ofsenior securities issued by BDCs. H.R. 31 and H.R. 1800 Both H.R. 31 and H.R. 1800 would amend section 61(a) ofthe Act to: (a) reduce the asset coverage for senior securities representing indebtedness from 200% to 150%; and (b) make inapplicable the 200% asset coverage requirement for senior securities that are stock, le.t preferred stock, and other provisions ofthe Act intended to protect holders ofpreferred stock.1 In my view, this increase in theability of BDCs to use leverage, and theelimination of provisions of the Actintended to protect holders of preferred stock issued by a BDC, gives rise to investor protection concerns, particularly because most BDC shareholders are retail investors. The Act's asset coverage requirements existfor the protection of both a BDCs shareholders on one hand and investors in its senior securities on the other.2 Leverage amplifies both negative and positive portfolio performance. As the percentage of a BDCs capital from senior securities increases, the greater is theamplification. Increased leverage increases earnings volatility. Atthe same time, the risk increases that the BDC will lack the resources to pay 1 Asset coverage is the ratio oftotal assets less liabilities other than senior securities to senior securities. The asset coverage requirement for senior securities issued by abdc is 200%. For other closed-end funds, the asset coverage requirement is 300% for debt securities and 200% for preferred stock. An asset coverage of300% is approximately equivalent to adebt to equity ratio of1:2; an asset coverage of200% is approximately equivalent to adebt to equity ratio of 1:1. 2 When Congress enacted the Act, the highly capitalized and simplified capital structure that the Act imposes on investment companies was regarded as being ofcentral importance to the protection ofinvestors. Prior to 1940, the use ofexcessive leverage and complex capital structures by certain closed-end funds led to personal gain for insiders at the expense ofpublic security holders. In some instances, debt and preferred stock sold to the public accounted for adisproportionate amount ofafund's capital, but common stock concentrated in the hands ofinsiders controlled the fund. Although a fund's assets might be insufficient to liquidate the senior securities, insiders could induce the fund to pay distributions with respect to the common stock or repurchase common stock. See Investment Trusts and Investment Companies pt. 3, H.R. Doc. No. 279, 76th Cong., 1st Sess. 1001, 1582-97 (1939). In this regard, section 1(b) ofthe Act identifies "excessive borrowing and the issuance ofexcessive amounts ofsenior securities [i.e., preferred stock or debt securities]" as one ofthe principal abuses the Act was designed to address.
Page 3 promised interest or dividends, or the principal or liquidation preference, to the holders ofits senior securities. The risk that a BDC will be unable to make timely payments to senior security holders is, in my view, ofparticular concern in view ofthe illiquid types ofinvestments that BDCs make. The asset coverage provisions act as a circuit breaker. Ifa BDCs asset coverage ofits senior securities is less than 200% (after giving effect to the distribution, issuance or repurchase), the BDC may not make cash distributions to shareholders, issue additional senior securities, or repurchase common stock and must retain for the BDCs use cashthat the BDC otherwise would pay to its shareholders as distributions.3 Both H.R. 31 and H.R. 1800 would permit a BDC to significantly increase its leverage in two specific ways. First, the amendments to the Act proposed inthose bills would reduce the asset coverage requirement for debt securities to 150% from 200%, thereby increasing the debt to equity ratio from approximately 1:1 to 2:1. By way of example, under current law, a BDC with $100 in equity could borrow $100 (equal to $200 total assets). If that BDCs assets lost 50% oftheir value, its shareholders wouldexperience a total loss on their equity investment. Reducing the required asset coverage to 150% would permit the same BDC toborrow $200, effectively doubling its leverage. A BDCs assets would only have to lose 33 1/3% oftheir value before exposing shareholders to a total loss oftheir investment. Second, the proposed amendments would allow abdc to issue an unlimited amount of preferred stock, effectively eliminating the Act's limitations on leverage. Because the proposed amendments would treat the issuance of preferred stock as the equivalent of the issuance of common stock for purposes ofcalculating asset coverage, abdc could increase its leverage by issuing preferred stock and thereby actually increase its capacity for issuing additional debt securities. Both H.R. 31 and H.R. 1800 also would eliminate all ofthe provisions in the Act specifically intended to protect the holders ofpreferred stock issued by abdc. A potential 3 Debt securities issued by abdc also provide that if: (a) asset coverage declines to less than 100% for one year then the holders ofthose securities have the right toelect a majority ofthe BDCsdirectors; or(b) asset coverage declines to less than 100% for 24 consecutive months then a default shall be deemed tohave occurred. Failing to meet the asset coverage requirements, however, is not aviolation ofthe Act, and the BDC is not forced to sell assets. 4The Act provides that holders ofpreferred stock, voting separately as aclass, are entitled to: (a) elect at least two directors at all times; (b) elect amajority ofthe directors ifat any time dividends on the preferred stock have been in arrears for two full years; (c) approve or disapprove any plan ofreorganization adversely affecting their interests; and (d) approve or disapprove certain other major corporate events, such as converting to amutual fund format. These voting rights help balance the sometimes conflicting interests of the holders ofthe common stock and the holders ofthe preferred stock issued by the same fund. Under the Act, abdc may not issue different classes of preferred stock, i.e., classes with different priorities as to the payment ofdividends or liquidation preference. In liquidation, ifthe value ofabdcs assets is insufficient to satisfy the claims ofall security holders, holders ofa class with ahigher priority have aclear advantage. Absent liquidation, that priority can influence the market value ofasecurity, particularly during times when aparticular BDCs prospects dim. Retail investors might find ajunior class ofpreferred stock with ahigh dividend rate attractive but fail to appreciate the risks in the event that the BDC
Page 4 consequence is the sale to retail investors ofpreferred stock with a confusing mix of characteristics and rights. Under the Act, for example, preferred stockhas "complete priority" over the common stock as to payment ofdividends, and dividends are cumulative. This provision prohibitsthe sale ofparticipating preferred stock or preferred stock that is preferred only as to assets in liquidation but not as to dividends. But for these provisions, holders of preferred stock could find that dividends not paid during lower earnings periods are never paid, even ifthe BDC subsequently prospers. The two bills also would: (a) amend section 60 ofthe Act to permit a BDC to purchase securities issued by registered investment advisers; and (b) direct the Commission to revise certain rules under the Securities Act of 1933 to put BDCs on parity with other issuers that are required to file certain reports under the SecuritiesExchangeAct of 1934. In my view, these provisions do not raise significant investor protection concerns. H.R. 1973 By amending the Act's definition of "eligible portfolio company" to include currently excluded financial institutions, H.R. 1973 would change the definition and stated purpose of BDCs. The Act defines "business development company" as a closed-end fund that is "operated for the purpose of making investments in securities" issued by small or financially distressed companies, generally companies that meet the Act'sdefinition of"eligible portfolio company." This definition requires that, with one exception,5 an eligible portfolio company be neither an investment company, as defined inact, nor a company that is excluded from the definition of investment company solely by section 3(c) ofthe Act, i.e., financial institutions such as hedge funds, private equity funds, brokers and consumer finance companies. The Act, however, does not prohibit a BDC from investing infinancial institutions orother companies that are not eligible portfolio companies; under the Act, a BDC can invest up to 30% ofits portfolio in securities issued by these companies. The explicit exclusion ofinvestment companies and other financial institutions from the definition of"eligible portfolio company" was intended to encourage a BDC to focus its investment activities onoperating companies that directly produce goods orprovide services rather than on other financial institutions that serve primarily as conduits of capital. Congress created BDCs inresponse to"the slowing ofthe flow ofcapital to American enterprise, particularly to smaller, growing businesses."6 To the extent that abdc concentrates its experiences financial reversals. ABDC in financial distress, for example, might eliminate dividend payments to holders ofajunior class ofpreferred stock but continue dividend payments to holders ofa senior class. 5 The one exception allows an eligible portfolio company to be asmall business investment company (SBIC) licensed by the Small Business Administration that is a wholly owned subsidiary ofa BDC. ASBIC makes investments that are consistentwith the purpose ofbdcs. 6 H.R. Rep. No. 1341,96th Cong., 2d Sess. 20 (1980). The House Report states that "[t]he importance ofthese businesses tothe American economic system interms ofinnovation, productivity, increased competition and the jobsthey create is,of course, critical." Id
Page 5 investments in other financial institutions, it would divert capital from small, growing businesses that BDCs were originally created to help. While Congress obviously can choose to change the purpose of BDCs in this manner, of particular concern is the prospect of a BDC concentrating its investments in hedge and other private funds because of the riskier strategies associated with some of these funds. This raises potential investor protection concerns, as it would allow non-accredited investors to invest in a BDC comprised entirely ofprivate funds. As such, BDCs could be used to circumvent the general prohibition on selling interests in private funds to retail investors. 1hope that this information is helpful to you and to the other members ofthe Subcommittee. Please do not hesitate to contact me at (202) 551-2010, or have your staffcontact Tim Henseler, Director ofthe Office oflegislative and Intergovernmental Affairs, at (202) 551-2015, if I can be ofany further assistance. Sincerely, 'X-^toUr Mary Jo White Chair cc: Chairman Jeb Hensarling Ranking Member Maxine Waters