Overview of SEC’s Proposed Rule Changes for Business Development Companies
Investment Management Update
Date: April 17, 2019
On March 20, 2019, the Securities and Exchange Commission (SEC) proposed rules that would modify the registration, communications and offering processes for certain closed-end funds (CEFs), including interval funds, and business development companies (BDCs), under the Securities Act of 1933, as amended (Securities Act). The proposed rules would, among other things, allow certain CEFs and BDCs to utilize securities offering reforms previously made available to other operating companies and permit broader communications with shareholders. This alert examines the impact of the proposed rules on BDCs, while a subsequent alert will examine the impact of the proposed rules on CEFs, including interval funds.
In 2005, the SEC adopted securities offering reforms and created new classes of issuers that had significant public float and were current and timely in their filing of periodic reports in an effort to modernize the securities offering and communication processes and to facilitate the ability of such issuers to more efficiently access the capital markets. As part of the securities offering reform rules in 2005, the SEC designated investment companies, including CEFs and BDCs, as “ineligible issuers,” which had the effect of specifically excluding such entities from the scope of the reforms.
In March 2018, the Small Business Credit Availability Act (SBCAA) was signed into law. The SBCAA sought to update the rules and regulations governing BDCs through two major reforms, the first of which went into effect immediately and permitted BDCs to incur additional amounts of leverage so long as certain requirements were met. The second part of the SBCAA instructed the SEC to promulgate rules that would allow BDCs to take advantage of the securities offering reforms made available to other operating companies as part of the 2005 rulemaking. The proposed rules, among other things, would allow BDCs to:
- Use a short-form registration statement to sell securities “off the shelf” more quickly and efficiently in response to market opportunities.
- Qualify as well-known seasoned issuers (WKSIs) under Rule 405 of the Securities Act.
- Satisfy final prospectus delivery requirements using the same method as operating companies.
- Communicate with shareholders through the use of “free writing prospectuses.”
- Rely on safe harbors relating to the use of regularly released factual and forward-looking information, including “tombstone ads.”
The proposed rules would also require additional information in periodic shareholder reports and that all BDCs tag their financial statements using Inline eXtensible Business Reporting Language (Inline XBRL). BDCs have historically not been subject to XBRL reporting requirements. Notably, this provision was not included in the SBCAA but appears to be part of a broader effort by the SEC to harmonize certain reporting requirements across registrants.
Timing of Implementation
Pursuant to the SBCAA, the SEC was required to adopt offering reform rules for BDCs by March 23, 2019. If rules were not finalized by such date, the changes set forth in the SBCAA became self-implementing. As a result, since final rules have not yet been promulgated, as of today, the offering reform provisions in the SBCAA are effective and will continue to be effective until such time as final rules are promulgated by the SEC. This presents unique challenges to BDCs that wish to take advantage of the offering reforms set forth in the SBCAA. Even though the offering reforms in the SBCAA are legally in effect, the SEC, in certain cases, is not practically able to accommodate issuers that want to take advantage of such reforms.
Summary of Offering-Related Reforms
Short-Form Registration Statements on Form N-2
The proposed rules would permit a BDC that is a “seasoned fund,” as defined in the proposed rules (seasoned BDC), to use the more flexible registration process currently available to “seasoned issuers,” a category of issuer designated in the 2005 securities offering reform. In order to be considered a seasoned BDC, a BDC must have at least $75 million in public float held by non-affiliates and must also meet the registrant and transaction requirements of Form S-3, which require that the BDC be current and timely in its reporting requirements under § 13(a) of the Securities Exchange Act of 1934 (Exchange Act).
The proposed rules would allow seasoned BDCs to sell securities off the shelf more quickly and efficiently in response to market opportunities. Under the proposed rules, seasoned BDCs could: (1) file a short-form registration statement on Form N-2 that will function like a Form S-3 registration statement; (2) omit certain information from their base prospectuses; and (3) incorporate by reference additional information in periodic reports to update their registration statements. This proposal would allow seasoned BDCs to incorporate certain past and future Exchange Act reports, such as quarterly and annual reports, by reference, allowing such BDCs to reduce the expenses associated with the filing of post-effective amendments to their registration statements. For seasoned BDCs, this reform is significant, since there is otherwise no mechanism for a post-effective amendment filed by a BDC to go effective automatically or on a date determined by the issuer, as is available to open-end investment companies and CEFs that are interval funds.
In order to take advantage of this, a seasoned BDC would be required to incorporate by reference information into its prospectus (and statement of additional information, if applicable) from: (1) its latest annual report on Form 10-K; (2) all other reports filed pursuant to § 13(a) or 15(d) of the Exchange Act since the end of the fiscal year covered by the annual report on Form 10-K; and (3) all future filings made pursuant to § 13(a), § 13(c), § 14 or § 15(d) prior to the termination of the offering.
Well-Known Seasoned Issuer (WKSI)
The proposed rules would permit a BDC to qualify as a WKSI. To qualify as a WKSI, a BDC must be a seasoned BDC and generally must have at least $700 million in public float held by non-affiliates. This proposal would allow BDCs that qualify as WKSIs to register amounts of different types or classes of securities on an automatic shelf registration statement, which would be effective immediately upon filing. This would enable BDCs that qualify as WKSIs to have significant flexibility to take advantage of market windows, structure terms of securities on a real-time basis to accommodate investor demand, and determine or change the plan of distribution in response to changing market conditions. In order to facilitate this, the proposed rules would add a new general instruction to Form N-2 that would permit BDCs that qualify as WKSIs to file automatic shelf registration statements on Form N-2.
Moreover, a WKSI is permitted to communicate at any time, through a permitted free writing prospectus, without violating the “gun jumping” provisions of the Securities Act.
Omitting Information from a Base Prospectus and Prospectus Supplement
The SEC also proposed modifications to the process for filing prospectus supplements. Presently, operating companies depend solely on Securities Act Rule 424, whereas investment companies rely solely upon Securities Act Rule 497. Securities Act Rule 424 provides an operating company additional flexibility by only requiring an issuer to file a prospectus if the issuer makes substantive changes from or additions to a previously-filed prospectus, whereas Securities Act Rule 497 requires a fund to file every prospectus that varies from any previously-filed prospectus. The proposed rules allow seasoned BDCs to be able to file any type of prospectus enumerated under Securities Act Rule 424(b) to update or include information omitted from a prospectus or in connection with a shelf takedown. Moreover, the proposed rules would amend Securities Act Rule 497 to provide that Securities Act Rule 424 would be the exclusive rule for BDCs to file prospectus supplements, with the exception of advertisements deemed to be a prospectus under Securities Act Rule 482.
Furthermore, the proposed rules would allow a shelf registration statement filed by a WKSI to omit the plan of distribution and certain other information regarding whether the registration statement is for a primary offering or on behalf of selling security holders. In addition, seasoned BDCs that register securities for selling security holders would be able to omit the identities of selling security holders and the amount of securities to be registered from the registration statement, as operating companies are permitted to do today.
Final Prospectus Delivery Reforms
The Securities Act requires registrants to deliver to each investor a final prospectus prior to the delivery of a security for the purpose of a sale or for delivery after sale. Furthermore, the Securities Act prohibits a written communication that offers a security for sale, or confirms the sale of a security, unless a final prospectus is given at the same time. Rules 172 and 173 under the Securities Act permit operating companies to satisfy prospectus delivery requirements through the filing of a final prospectus under Rule 424 of the Securities Act. The proposed rules would allow a BDC to satisfy the prospectus delivery requirements by filing its final prospectus with the SEC.
The proposed rules also included a number of changes in the way that seasoned BDCs can communicate with their shareholders and provided for greater regulatory certainty through the ability of such issuers to rely on safe harbors available to operating company issuers. As noted previously, BDCs and other investment companies were designated ineligible issuers as part of the 2005 securities offering reform rulemaking and were, therefore, excluded from a number of provisions designed to enhance the ability of operating company issuers to better communicate with their shareholders. The proposed rules would amend the current prohibitions to allow BDCs to:
- Rely on the safe harbor found in Rule 134 of the Securities Act relating to the publishing of certain factual information about the issuer or offering, including through tombstone ads.
- Qualify for the communication safe harbor provided by Rule 163A of the Securities Act, which grants issuers a bright-line time period, ending 30 days prior to the filing of a registration statement, to communicate with the public without such communication being deemed an offer to sell a security.
- Rely on the safe harbors found in Rules 168 and 169 of the Securities Act relating to the publishing or dissemination of regularly released factual business information.
- Use free writing prospectuses under Rules 164 and 433 under the Securities Act.
- In the case of WKSIs, engage at any time in oral or written communications, including through the use of free writing prospectuses.
Broker-Dealer Research Reports
The proposed rules would permit a broker-dealer participating in a distribution of a BDC’s common stock and similar securities to rely on the non-exclusive safe harbor found in Rule 138 of the Securities Act, which permits such broker-dealer to publish or distribute research about the BDC’s securities that are not part of the offering, if such research is distributed in the regular course of its business.
Other Proposed Rule Amendments
The proposed rules would also amend a number of other rules and regulations impacting BDCs. The proposals include:
- XBRL Reporting Requirements
- Expansion of Form 8-K Items Specific to BDCs and CEFs
- Periodic Reporting Requirements
- Online Availability of Information Incorporated by Reference
- Modifications to Supplemental Information Requirements
XBRL Reporting Requirements
The proposed rules would create new structured data reporting requirements for all BDCs. Specifically, the proposed rules would require all BDCs to submit financial statement information using Inline XBRL format. Previously, BDCs were not required to tag their financial statements in XBRL format. In addition, BDCs would be required to include structured cover page information in registration statements on Form N-2 using Inline XBRL format and tag certain other information required in a BDC’s prospectus using Inline XBRL format. Since this requirement was not included in the SBCAA, BDCs are not currently required to tag their financial statements using Inline XBRL. However, should the proposed rules go into effect as written, seasoned BDCs would be required to begin tagging their financial statements 18 months following the date the final rules are published in the Federal Register. For all other BDCs, the effective date would be 24 months from the date the final rules are published in the Federal Register.
Expansion of Form 8-K Items Specific to BDCs and CEFs
Since BDCs are subject to the reporting requirements found in Section 13(a) of the Exchange Act, they are already required to file current reports on Form 8-K to disclose certain events. The proposed rules would require that CEFs also file reports on Form 8-K and modify Form 8-K to include two new reportable events (Items 10.01 and 10.02) for all BDC and CEF issuers as follows:
- Item 10.01 – any material change in investment objectives or policies that has not been, and will not be, submitted to shareholders for approval. Item 10.01 would require disclosure regarding the date the change would go into effect as well as a description of the change. No 8-K would need to be filed if the change was reported in a post-effective amendment to the fund’s registration statement or a supplement filed pursuant to Rule 424 of the Securities Act.
- Item 10.02 – any material write-down in the fair value of a significant investment. The level of disclosure required would be consistent with the disclosure of a material impairment by an operating company.
Periodic Reporting Requirements
BDCs that register securities using a short-form registration statement would be required to include information in their annual reports regarding fees and expenses as required by Item 3 of Form N-2, share price data as required by Item 8.5 of Form N-2, and the senior securities table as required by Item 4.3 of Form N-2. Each of these items was previously only required to be disclosed in a BDC’s prospectus. In addition, the proposed rules would require BDCs to provide financial highlights in their registration statements and annual reports. Finally, BDCs that register securities using a short-form registration statement would be required to disclose in their registration statements or annual reports any material unresolved SEC comments.
Online Availability of Information Incorporated by Reference
The proposed rules would revise Form N-2’s current general instruction for incorporation by reference to permit seasoned BDCs to backward and forward incorporate by reference their financial information into their registration statements. The proposed rules would remove the requirement that a BDC deliver to new investors information that it has incorporated by reference into the BDC’s prospectus or statement of additional information (SAI), and instead would require the BDC to make the incorporated materials readily available and accessible on a website.
Modifications to Supplemental Information Requirements
Rule 418 under the Securities Act provides that the SEC may request supplemental information concerning a registrant that a registrant should be prepared to promptly provide the SEC upon request. The proposed rules would allow seasoned BDCs to be exempt from the requirement to furnish supplemental information pursuant to Rule 418(a)(3) under the Securities Act to the SEC. Furthermore, the proposed rules would allow seasoned BDCs to incorporate by reference certain financial information into proxy statements, without delivering these documents to shareholders. Both of these provisions were included in the SBCAA, so seasoned BDCs are currently exempt from Rule 418(a)(3) of the Securities Act and are eligible to incorporate by reference certain financial information into their proxy statements.
Many of the reforms included in the proposed rules were dictated by the SBCAA and did not come as a surprise. As noted under “Timing of Implementation” above, the offering-related provisions applicable to BDCs under the SBCAA are currently in effect. However, in some cases, the SEC is not yet able to implement certain of the reforms. For example, there is no mechanism for a registration statement on Form N-2 to go effective automatically, so BDCs that qualify as WKSIs will need cooperation from the SEC staff in order to file an automatic shelf registration statement.
Further complicating the situation is that, in situations where the SBCAA conflicts with the proposed rules, there is risk associated with taking advantage of SBCAA provisions in effect today, since the final rules may differ once they come out. It is unlikely that the SEC staff will give specific comfort to issuers in these situations, although they may release interpretive guidance prior to the issuance of final rules.
In other cases, the proposed rules were more of a surprise. For example, the requirement that all BDCs tag their financial statements using Inline XBRL was not part of the SBCAA and was, therefore, not expected to be included in this rulemaking. Having said that, when BDCs and other CEFs were initially excluded from the XBRL requirements, the reasoning was that there was not yet a developed taxonomy for such entities to use. Many years later, that argument is less persuasive, and operating companies as well as ETFs and open-end funds are all required to tag certain information using XBRL, so requiring BDCs and CEFs to be subject to these rules is supportable.
However, the XBRL mandate is required for all BDCs, even BDCs that engage in private offerings to institutional and accredited investors (private BDCs). Private BDCs are subject to the reporting requirements found in Section 13(a) of the Exchange Act only because of the requirement in Section 54 of the Investment Company Act of 1940 that all BDCs must have a class of securities registered under Section 12 of the Exchange Act. Private BDCs are not eligible to take advantage of any of the offering-related or communication-related reforms in the proposed rules unless they seek to engage in a public offering or listing of their shares. The SEC, as part of the cost-benefit analysis contained in the proposed rules, concedes that there are significant costs associated with Inline XBRL and data tagging of financial statements, much of which would be passed on to shareholders. It remains to be seen whether all BDCs, including private BDCs, will be subject to the XBRL requirements in the final rules.
One other area that the SEC did not address in the proposed rules is the ability of a BDC that conducts a continuous public offering, but is not a seasoned BDC, to backward incorporate by reference financial information from its previously filed Exchange Act reports. For example, publicly registered, non-listed BDCs conduct continuous offerings pursuant to Rule 415(a)(x) of the Securities Act but are unable to meet the public float threshold in order to be considered seasoned BDCs. The proposed rules do not allow such entities to incorporate by reference information, such as financial statements and management discussion and analysis (MD&A), from previously filed annual reports on Form 10-K in their annual post-effective amendments. This contrasts with operating companies, such as publicly registered, non-traded real estate investment trusts (REITs), that are permitted to incorporate by reference information from their previously filed annual report on Form 10-K in their annual post-effective amendments. Providing parity for non-listed BDCs would result in lower printing and filing expenses and potentially result in a more efficient SEC staff review of annual post-effective amendments.
One of the themes from the proposed rules seems to be an attempt to harmonize disclosure requirements applicable to different categories of investment companies. This theme came through with the XBRL requirements, the requirement that CEFs file 8-Ks and the requirement of CEFs that are eligible to file a short-form registration statement to include MD&A-type disclosure in their annual and semi-annual reports. Efforts to harmonize reporting requirements are ultimately beneficial to shareholders and securities analysts, but BDCs continue to have significantly greater disclosure requirements than other types of CEFs, so if this is the ultimate goal, there remains work to be done.
The comment period for the proposed rules will close 60 days after publication of the proposed rules in the Federal Register, which occurred on April 10, 2019. The proposed rules include a number of questions from the SEC for the industry to consider, which could result in changes in the final rules. It is worth noting, however, that many of the BDC offering-related and communication-related rule proposals come straight from the SBCAA and are legally in effect today, so it would be surprising if there were material changes related to the implementation of those rules. However, there are other provisions in the proposed rules that do not come from the SBCAA, and the industry may provide comments to these proposals, which could result in changes.
FOR MORE INFORMATION
For more information, please contact:
Owen J. Pinkerton
Christopher D. Carlson
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