Podcast: Credit Funds: Hot Topics in BDC Regulation
In this Ropes & Gray podcast, Mike Doherty, Brian McCabe and Paul Tropp discuss important regulatory developments and current issues affecting business development companies (BDCs). The SEC recently (1) issued a rule proposal intended to streamline the registration, communications and offering practices of BDCs and (2) proposed a new Rule 12d1-4 under the Investment Company Act of 1940 intended to enhance the regulation of funds that invest in other funds. This podcast explains how these new rules affect BDCs. In addition, the podcast explores the argument for modifications to the disclosure requirements for registered investment companies relating to acquired fund fees and expenses (AFFEs).
Brian McCabe: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in a series of podcasts aimed at credit funds. I’m Brian McCabe, and joining me today are Paul Tropp and Mike Doherty. Mike and I are partners in the asset management group at Ropes & Gray, and Paul’s a partner in the firm’s securities and public companies group. Today, we hope to summarize a few important regulatory developments and current issues affecting business development companies (or “BDCs”). BDCs are a type of closed-end investment company that typically invests in debt securities of private middle-market issuers. Paul, perhaps you can tell us a bit about the recent offering reform proposals for BDCs?
Paul Tropp: Sure, Brian. In March this year, the SEC issued a rule proposal intended to streamline the registration, communications, and offering practices of BDCs and registered closed-end investment companies. If adopted as proposed, the rules would allow BDCs to use a variety of rules that are currently only available to operating companies. These rule proposals were made as a result of legislation enacted by Congress in March 2018. And in reliance on the legislation, which was self-effectuating as of March 2019, many BDCs have actually already started to take advantage of the proposed rules, even though the rules have not yet been formally adopted by the SEC.
Brian McCabe: Thanks, Paul. Can you give us a high-level overview of the key parts of the reforms?
Paul Tropp: Sure, absolutely. Let me mention four key areas affected by the reforms:
- First, the proposals would streamline the registration process for eligible BDCs by, among other things, introducing a short-form shelf registration statement on Form N-2. This would allow those BDCs to effect securities sales “off the shelf” more quickly.
- Second, the proposed reforms would allow BDCs to rely on certain communications rules previously available only to operating companies. These would include rules regarding the publication of factual information about the issuer or the offering, the dissemination of regularly released factual and forward-looking information, and the use of a so-called “free writing prospectus” or FWP. The proposal would also give BDCs more flexibility with respect to broker-dealer research reports.
- Third, the proposed reform package would authorize BDCs to qualify as so-called “well-known seasoned issuers” or WKSI’s under the Securities Act of 1933. This would provide eligible BDCs additional flexibility in communications and registration and reduce the time to market.
- Last, the proposed rule revisions would allow BDCs to satisfy their prospectus delivery requirements in the same manner as operating companies, including by filing with the SEC. Among other things, this would permit BDCs to rely on the so-called “access equals delivery” means of satisfying the final prospectus delivery requirements, which is currently available only to operating companies.
Brian McCabe: Thanks, Paul. This would be a welcome development for the industry, and it’ll be interesting to see whether the reform package is adopted as proposed. Let’s shift focus a little bit to the SEC’s proposed rule on fund-of-fund investments. Mike, would you be able to give us an update on the SEC’s proposal and how it could affect BDCs?
Mike Doherty: Sure, Brian. In December last year, the SEC proposed new Rule 12d1-4 under the Investment Company Act of 1940. The rule is intended to enhance and streamline the regulation of funds that invest in other funds, which is currently a patchwork of statutes, rules and other regulatory guidance. By way of background, Section 12(d)(1)(A) of the ‘40 Act currently limits investments in BDCs and registered investment companies by other funds through the so-called “3-5-10%” limits. While certain types of fund of funds arrangements that exceed these limits have been permitted by rule or by SEC exemptive orders, the proposed rule would create a consistent framework for all registered funds and BDCs.
Brian McCabe: So how would the new framework affect BDCs?
Mike Doherty: Well, under the current regime, investments in BDCs by other funds are generally subject to the 3-5-10% limits in Section 12(d)(1), although many open-end investment companies and ETFs are permitted to invest in listed BDCs in excess of the limits pursuant to SEC exemptive orders. The fund-of-funds rule would allow any investment company or BDC to invest in any BDC in excess of the limits in Section 12(d)(1), subject to certain conditions. As a result, the rule would for the first time permit UITs and closed-end funds to invest in BDCs in excess of the 3-5-10% limits, and would for the first time permit open-end funds and ETFs to invest in unlisted BDCs in excess of the limits. Further, BDCs would be permitted to invest in excess of the 3-5-10% limits in open-end funds, UITs, closed-end funds and other BDCs.
Brian McCabe: I understand that the proposal has attracted significant comment from the industry. Would you be able to give us an overview of the key points emerging from public comments?
Mike Doherty: Many commenters have focused on the voting restrictions that apply to holdings greater than 3% of acquired funds. Some argue that the proposed voting restrictions effectively create two classes of the same security – one with voting rights and one without. Others focus on the ability of activist investors to influence the acquiring fund given the limit on acquiring funds’ voting ability. Voting restrictions may serve to discourage acquiring funds from taking advantage of the new relaxed ownership provisions.
Brian McCabe: Thanks, Mike. One last thing to note with respect to the fund-of-funds proposal is that Jay Clayton’s current short-term rulemaking agenda mentions the fund-of-funds rule, and a final rule has likely moved up the priority list recently, as the SEC has just finalized its ETF rulemaking.
Before we leave you today, we wanted to raise one last hot topic in BDC regulation. For a long time, the BDC industry has been recommending that the SEC modify the disclosure requirements for registered investment companies relating to “acquired fund fees and expenses” (also known as “AFFEs”). Under the current disclosure regime, registered investment companies must disclose as a separate line item in their prospectus fee table any fees and expenses incurred indirectly through investments in shares of “acquired funds,” which would include investments in BDCs. This has the effect of increasing the acquiring fund’s disclosed total expense ratio, which is a key data point for gatekeepers and investors. Many practitioners have suggested that the requirement to disclose AFFEs is meant primarily to capture only typical fund-related expenses and not ordinary business expenses such as those incurred by an operating company or a BDC. And there is some suggestion that the fees and expenses of a BDC are more closely analogous to the expenses of a traditional operating company than they are to the expenses of a registered investment company or private fund. Therefore, the argument goes, including BDCs within the “acquired funds” subject to the AFFE disclosure requirements overstates the fund’s expenses and creates a misleading picture that distorts the cost of a BDC investment.
Mike Doherty: That’s an interesting argument, Brian. And this question is particularly important because many mutual funds are facing increasing pressures to disclose lower fees and may therefore be reluctant to invest in BDCs because of the distortive impact such investments would have on the funds’ AFFE and total expense ratio. You might recall that S&P and Russell removed BDCs from their respective indices in 2014 because of concerns cited by the mutual fund industry about the impact investments in BDCs would have on the expense ratios of mutual funds that were tracking the indices.
Brian McCabe: Right. And many practitioners believe the area is ripe for SEC action. The House Committee on Appropriations has recommended that the SEC revisit the rule because in the committee’s view “the AFFE rule unnecessarily harms the BDC industry.” Separately, a group of BDCs filed an application for SEC exemptive relief in September 2018 that would exclude BDC fees and expenses from the calculation of AFFEs. And more recently, in proposing the fund-of-funds rule, the SEC asked for comments on whether BDCs should continue to be treated as acquired funds for purposes of the AFFE disclosure rules.
Mike Doherty: Thanks, Brian. Let me just add that the BDC industry’s support on Capitol Hill remains steady. Earlier this year, the House Appropriations Committee reiterated its recommendation that the SEC “make necessary regulatory . . . changes to limit the adverse effect of [the AFFE regime]” on BDCs. And while the redemption limits and voting restrictions in the fund-of-funds rule proposal have received significant comment from the public, those particular issues have no direct connection to the AFFE disclosure issue. In light of that, many industry participants remain optimistic that the SEC will make appropriate revisions to the AFFE provisions when the final fund-of-funds rule is adopted. To the extent relief is given on AFFE for BDCs and they become index eligible again, it will have a meaningful impact on capital into the BDC sector.
Brian McCabe: Mike and Paul, thanks so much for joining me here today. And thank you to our listeners. For more information on the topics that we discussed or other topics of interest to the asset management and credit funds communities, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed – please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.