[Federal Register Volume 71, Number 210 (Tuesday, October 31, 2006)]
[Proposed Rules]
[Pages 64093-64102]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-18257]
Federal Register / Vol. 71, No. 210 / Tuesday, October 31, 2006 /
Proposed Rules
[[Page 64093]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 270
[Release No. IC-27539; File No. S7-37-04]
RIN 3235-AJ31
Definition of Eligible Portfolio Company Under the Investment
Company Act of 1940
AGENCY: Securities and Exchange Commission (the ``Commission'').
ACTION: Reproposed rule.
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SUMMARY: The Commission is reproposing for comment an additional
definition of the term ``eligible portfolio company'' under the
Investment Company Act of 1940 (``Investment Company Act'' or ``Act'').
The reproposed rule is intended to more closely align the definition of
eligible portfolio company, and the investment activities of business
development companies (``BDCs''), with the purpose that Congress
intended. The reproposed rule would expand the definition of eligible
portfolio company to include certain companies that list their
securities on a national securities exchange (``Exchange'').
DATES: Comments should be received on or before January 2, 2007.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed); or
Send an e-mail to [email protected]. Please include
File Number S7-37-04 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Nancy M. Morris,
Secretary, Securities and Exchange Commission, 100 F Street, NE,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-37-04. This file
number should be included on the subject line if e-mail is used. To
help us process and review your comments more efficiently, please use
only one method. The Commission will post all comments on the
Commission's Internet Web site (http://www.sec.gov/rules/proposed).
Comments are also available for public inspection and copying in the
Commission's Public Reference Room, 100 F Street, NE., Washington, DC
20549. All comments received will be posted without change; we do not
edit personal identifying information from submissions. You should
submit only information that you wish to make available publicly.
FOR FURTHER INFORMATION CONTACT: Rochelle Kauffman Plesset, Senior
Counsel, or Elizabeth G. Osterman, Assistant Chief Counsel, Office of
Chief Counsel, (202) 551-6825, Division of Investment Management,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549-5030.
SUPPLEMENTARY INFORMATION: The Commission today is reproposing Rule 2a-
46(b) [17 CFR 270.2a-46] under the Investment Company Act [15 U.S.C.
80a et seq.].\1\
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\1\ The Commission today issued a release adopting Rule 2a-46,
which defines eligible portfolio company as a company whose
securities are not listed on an Exchange, and Rule 55a-1, which
conditionally permits BDCs to make additional (follow-on)
investments in certain companies. Definition of Eligible Portfolio
Company under the Investment Company Act of 1940, Investment Company
Act Release No. 27538 (Oct. 25, 2006) (``Adopting Release'').
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Table of Contents
I. Background
II. Discussion
A. Comments Received on 2004 Proposing Release
B. Reproposed Rule 2a-46(b)
1. Size-Based Standard
2. Alternative Proposals
(a) $75 Million Public Float (Alternative One)
(b) $150/$250 Million Market Capitalization (Alternative Two)
3. Solicitation of Comments
III. General Request for Comment
IV. Cost-Benefit Analysis
A. Benefits
B. Costs
C. Request for Comments
V. Consideration of Promotion of Efficiency, Competition and Capital
Formation
VI. Paperwork Reduction Act
VII. Initial Regulatory Flexibility Analysis
A. Reasons for the Proposed Action
B. Objectives of the Proposed Action
C. Small Entities Subject to the Rule
D. Reporting, Recordkeeping and Other Compliance Requirements
E. Duplicative, Overlapping or Conflicting Federal Rules
F. Significant Alternatives
G. Solicitation of Comments
VIII. Statutory Authority
I. Background
BDCs are closed-end investment companies that Congress established
for the purpose of making capital more readily available to certain
types of companies.\2\ To accomplish this purpose, the Investment
Company Act prohibits a BDC from making any investment unless, at the
time of the investment, at least 70 percent of its total assets (``70%
basket'') are invested in securities of certain specific types of
companies, including ``eligible portfolio companies.'' \3\
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\2\ Small Business Investment Incentive Act of 1980, Pub. L. No.
96-477, 94th Stat. 2274 (1980) (codified at scattered sections of
the United States Code) (``SBIIA''). See also generally H.R. Rep.
No. 1341, 96th Cong., 2d Sess. 21 (1980) (``House Report'').
\3\ See Section 2(a)(46) of the Investment Company Act
(statutory definition of eligible portfolio company) [15 U.S.C. 80a-
2(a)(46)]. See also Section 55(a) of the Investment Company Act
(regulating the activities of BDCs) [15 U.S.C. 80a-54(a)].
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The Investment Company Act defines eligible portfolio company to
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.\4\ In 1998, for reasons
unrelated to small business capital formation, the Federal Reserve
Board amended its definition of margin security to increase the types
of securities that would fall within that definition under its rules.
This amendment had the result of reducing the number of companies that
qualify as eligible portfolio companies.
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\4\ Section 2(a)(46)(C)(i) of the Investment Company Act. See
also Section 2(a)(46)(C)(ii) (defines eligible portfolio company to
include companies that are controlled by the investing BDC or
certain of its affiliates); Section 2(a)(46)(C)(iii) (defines
eligible portfolio company to include certain very small companies).
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In November 2004, the Commission proposed Rule 2a-46 \5\ and Rule
55a-1
[[Page 64094]]
to address the impact of the Federal Reserve Board's 1998 amendments on
the definition of eligible portfolio company.\6\ As proposed, Rule 2a-
46(a) would have defined eligible portfolio company to include any
domestic operating company \7\ that does not have a class of securities
listed on an Exchange; \8\ and Rule 2a-46(b) would have defined
eligible portfolio company to include any domestic operating company
that has a class of securities listed on an Exchange, but is in danger
of having its securities delisted because of financial difficulties. As
proposed, Rule 55a-1 would have conditionally permitted a BDC to
continue to invest in a company that had met the proposed definition of
eligible portfolio company at the time of the BDC's initial
investment(s) in it, but did not subsequently meet that definition.
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\5\ Under Section 2(a)(46)(C)(iv), the term eligible portfolio
company includes any issuer that, in addition to meeting the
requirements of Sections 2(a)(46)(A) and (B), ``meets such other
criteria as the Commission may, by rule, establish as consistent
with the public interest, the protection of investors, and the
purposes fairly intended by the policy and provisions of [the
Act].'' See House Report at 23 (``* * * the Commission is given
rulemaking authority to expand the class of eligible portfolio
companies, following certain specific standards.''). The legislative
history of the SBIIA also makes clear that the intent of this
provision ``is to enable the Commission through the administrative
process to broaden, if appropriate, the category of eligible
portfolio company.'' While stating that BDCs ``already have
substantial freedom of action to purchase securities of companies
which are not eligible portfolio companies,'' referring to the
investments permitted to be made outside of the 70% basket, Congress
also noted its expectation that ``the Commission would institute
[rulemaking] proceedings to consider whether the definition of
eligible portfolio company can be expanded, consistent with the
purpose of the legislation, to increase the flow of capital to
small, developing businesses or financially troubled businesses. In
providing the Commission with rulemaking authority, Congress noted
``[a]mong the objective factors which the Commission may consider in
[rulemaking] proceedings are the size of such companies, the extent
of their public ownership, and their operating history as going
concerns and public companies.''). See House Report at 31.
\6\ The rules were proposed in Definition of Eligible Portfolio
Company under the Investment Company Act of 1940, Investment Company
Act Release No. 26647 (Nov. 1, 2004) [69 FR 64815 (Nov. 8, 2004)]
(``2004 Proposing Release'').
\7\ The proposed rule would have incorporated the provisions of
Section 2(a)(46)(A) and (B). Section 2(a)(46)(A) of the Investment
Company Act defines eligible portfolio company to include (among
other things) companies organized under the laws of, and with their
principal business in, one or more states of the United States.
Section 2(a)(46)(B) of the Investment Company Act generally excludes
from the definition of eligible portfolio company any company that
meets the definition of investment company under Section 3 of the
Investment Company Act, or that is excluded from the definition of
investment company by Section 3(c) of that Act, but includes as an
eligible portfolio company a small BDC that is licensed by the Small
Business Administration and that is a wholly-owned subsidiary of a
BDC.
\8\ The rule as proposed also would have defined eligible
portfolio company to include any domestic operating company that
does not have any class of securities listed on an automated
interdealer quotation system of a national securities association
(i.e., The NASDAQ Stock Market LLC) (``Nasdaq''). On August 1, 2006,
Nasdaq began operating as a national securities exchange registered
under Section 6(a) of the Exchange Act. See www.nasdaq.com/newsroom/news/pr2006/ne_section06_097.stm.
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Today, the Commission adopted Rule 2a-46, initially proposed as
Rule 2a-46(a), and Rule 55a-1.\9\ The Commission did not adopt proposed
Rule 2a-46(b) based on commenters' concerns that the proposed rule
would be unworkable and too narrow.
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\9\ See supra note 1.
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II. Discussion
A. Comments Received on 2004 Proposing Release
We received thirty-six comment letters that addressed the proposed
rules.\10\ Most commenters argued that proposed Rule 2a-46(b), which
would have defined eligible portfolio company to include domestic
operating companies whose securities were listed on an Exchange but
were in danger of being delisted because of financial difficulties,
would be unworkable.\11\ Some commenters also argued that the proposed
rule would be too narrow because it would not include some small
companies that list their securities on an Exchange, but that
nevertheless may have difficulties accessing conventional sources of
capital and raising additional capital on the public capital markets.
They argued that these companies should qualify as eligible portfolio
companies under the rule.\12\ Many commenters urged us to adopt a size-
based standard and suggested a specific numeric threshold.\13\
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\10\ Commenters included members of Congress, BDCs, law firms,
trade associations and small businesses that had received financing
from a BDC. The comment letters are available for inspection in the
Commission's Public Reference Room at 100 F Street, NE., Washington,
DC 20549 (File No. S7-37-04). They also may be viewed at http://www.sec.gov/rules/proposed/ic-26647.htm.
\11\ See, e.g., comments of Shearman & Sterling LLP (Jan. 7,
2005) (``* * * we believe that the requirement for a delisting
notice would frustrate one of the purposes of proposed Rule 2a-
46(b), which as expressed in the proposing release, seeks to address
the need of, and provide access to capital readily to, financially
troubled issuers that have not reached the dire financial straits
contemplated by Section 55(a)(3) of the 1940 Act. In our experience,
the delisting process often lags the `facts on the ground,' and
properly so, as Exchanges are reluctant to impose a premature death
sentence on listed companies. Thus, we submit that a company that
receives a delisting notice would likely be in severe financial
distress.''); comments of American Capital Strategies Ltd. (Jan. 7,
2005) (generally arguing that the minimum initial listing standards
of an Exchange would exclude many of the companies Congress intended
to benefit from BDC financing, and noting that the requirement for a
delisting notice ``could result in substantially the same situation
as was caused by the Federal Reserve Board changes to the margin
securities regulations'').
\12\ See, e.g., comments of Allied Capital (Jan. 7, 2005);
comments of UTEK (Jan. 7, 2005). But see comments of the Committee
on Federal Regulation of Securities of the Business Law Section of
the American Bar Association (Jan. 5, 2005) (supporting proposal in
full); comments of the Investment Company Institute (Jan. 6, 2005)
(supporting proposal in full).
\13\ See, e.g., comments of Capital Southwest Corporation (Dec.
28, 2004); comments of Representative Sue Kelly and Representative
Nydia Vel[aacute]zquez (Jan. 5, 2005); comments of Shearman &
Sterling LLP (Jan. 7, 2005); comments of UTEK (Jan. 7, 2005);
comments of Allied Capital (Jan. 7, 2005); comments of Williams &
Jensen (Feb. 17, 2006).
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B. Reproposed Rule 2a-46(b)
After considering the comments received, the Commission believes
that it is appropriate to seek further input on including additional
companies in the definition of eligible portfolio company. Accordingly,
the Commission is revising and reproposing Rule 2a-46(b) to provide an
additional definition of eligible portfolio company.\14\ We have
included two alternatives of reproposed Rule 2a-46(b) for comment. Each
alternative would include certain domestic, operating companies that
list their securities on an Exchange.\15\ The first alternative would
include companies whose public float is less than $75 million
(``Alternative One'').\16\ The second alternative (two versions) would
include companies whose market capitalization is less than either $150
million or $250 million (``Alternative Two'').
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\14\ We are also proposing to renumber Rule 2a-46 as Rule 2a-
46(a). We are not proposing any other changes to that rule.
\15\ Like Section 2(a)(46) and proposed Rule 2a-46, reproposed
Rule 2a-46(b) would define eligible portfolio company to include
only domestic operating companies. See supra note 7.
\16\ Public float is the aggregate market value of a company's
outstanding voting and non-voting common equity (i.e., a company's
market capitalization) minus the aggregate market value of common
equity held by the company's affiliates. See, e.g., Simplification
of Registration Procedures for Primary Securities Offerings,
Securities Act Release No. 6964 (Oct. 22, 1992) [57 Fed. Reg. 48970
(Oct. 29, 1992)]. Rule 2a-46(b)(2) would define the term
``affiliate'' for purposes of Alternative One by reference to the
definition of the same term in Rule 405 under the Securities Act of
1933 (``Securities Act'') [17 CFR 230.405].
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Under both alternatives, a company's size would be calculated using
the price at which the company's common equity was last sold, or the
average of the bid and asked prices of the company's common equity, in
the principal market for such common equity on any day in the 60-day
period immediately before the BDC's acquisition of its securities.\17\
This provision is similar to the methodology used in current Commission
rules that differentiate among companies based on their size,\18\ and
is intended to reduce regulatory complexity.
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\17\ Reproposed Rule 2a-46(b)(1). Reproposed Rule 2a-46(b)(2)
would define the term ``common equity'' for purposes of Rule 2a-
46(b) by reference to the definition of the same term in Rule 405
under the Securities Act.
\18\ See Form S-3 [17 CFR 239.13]; Securities Offering Reform,
Securities Act Release No. 8591 (July 19, 2005) [67 FR 44722 (Aug.
3, 2005)] (``Securities Offering Reform'').
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We discuss the use of a size-based standard and each of the
alternatives below.
1. Size-Based Standard
In the 2004 Proposing Release, we questioned whether a size-based
standard could: (1) Result in a company's eligible portfolio company
status fluctuating frequently as a result of market and economic
conditions; (2) allow a company to manipulate its capital structure to
fall below a specified level; and (3) introduce regulatory arbitrage by
encouraging
[[Page 64095]]
registered closed-end funds to elect BDC status so that they could have
the benefit of the lighter regulatory burdens applicable to BDCs under
the Investment Company Act. We also noted that it was unclear what
level of market capitalization would be appropriate to define an
eligible portfolio company.\19\
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\19\ See 2004 Proposing Release, supra note 6 at nn. 34-36 and
accompanying text.
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After careful review, we have reconsidered our initial concerns
about using a size-based standard and believe that these concerns may
be addressed. First, we have addressed our concern that a company's
eligible portfolio company status may fluctuate based on market
conditions by proposing, in both Alternative One and Alternative Two of
Rule 2a-46(b), that the size would be computed using the price at which
the company's common equity was last sold, or the average of the bid
and asked prices of the company's common equity, in the principal
market for such common equity, determined as of a single date within 60
days immediately prior to a BDC's acquisition of the company's
securities. Second, permitting a company to meet the size-based
standard on a single date within the 60-day period immediately prior to
a BDC's acquisition of the company's securities also lessens our
concern that a company might manipulate its capital structure to meet
that standard. Third, with respect to our regulatory arbitrage concern,
based upon further evaluation of the differences between registered
closed-end funds and BDCs, we believe that most closed-end funds
probably would not elect BDC status merely because of the different
regulatory framework. Unlike BDCs, most closed-end funds are not
structured so as to be able to offer managerial assistance to their
portfolio companies. In addition, we believe that most closed-end funds
probably would not choose a regulatory framework that would cause them
to forego some investment flexibility by requiring them to invest a
large percentage of their assets in privately negotiated transactions.
One commenter also noted that a closed-end fund would be unlikely to
elect BDC status ``unless it was committed to the BDC mission to
finance small and developing companies'' because of certain regulatory
requirements to which BDCs, but not closed-end funds, currently are
subject.\20\ Finally, based on our review of the comments, we believe
that a size-based standard would provide a bright-line test that is
easy to administer.
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\20\ Comments of Allied Capital (Jan. 7, 2005). See also
comments of UTEK (Jan. 7, 2005). These commenters noted compliance
costs related to the Sarbanes-Oxley Act of 2002, Pub. L. No. 107-
204, 116 Stat. 745 (2002), and reporting obligations under the
Exchange Act, as some of the regulatory burdens that might act to
deter a closed-end fund that has no reason to elect BDC status,
other than an interest in a different regulatory framework, from
seeking to elect that status.
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2. Alternative Proposals
As one commenter pointed out, there is no single standard that
precisely defines the types of companies that could benefit from BDC
financing.\21\ After carefully considering the comments on the original
proposal and with this in mind, we are proposing the following two
alternatives of Rule 2a-46(b) that we believe are consistent with the
purpose Congress intended. In addition, as noted above, we have
addressed the concerns we originally had regarding the use of a size-
based standard.
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\21\ Comments of Allied Capital (Jan. 7, 2005).
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(a) $75 Million Public Float (Alternative One)
Alternative One would define eligible portfolio company to include
companies whose securities are listed on an Exchange and have a public
float of less than $75 million.\22\ Alternative One incorporates the
size-based standard used in Form S-3 and Rule 12b-2 under the Exchange
Act.\23\ We have used this standard to delineate between small,
unseasoned companies, and larger, seasoned companies whose securities
are listed on an Exchange.\24\ For example, to register a primary
securities offering for cash on Form S-3, a company must have public
float of at least $75 million.\25\ Companies that meet the eligibility
requirements of Form S-3 are mature enough to be able to take advantage
of short-form registration, including the resultant benefits of
incorporation by reference and quick access to the capital markets
through ``shelf registration.'' Similarly, under Rule 12b-2 under the
Exchange Act, a company with $75 million public float or more would be
an ``accelerated filer,'' and thus be required to meet accelerated
deadlines in filing certain Exchange Act reports.\26\
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\22\ Reproposed Rule 2a-46(b).
\23\ Alternative One, while based on the requirements of Form S-
3 and Rule 12b-2, does not incorporate any of the reporting
requirements found in those rules out of concern that doing so could
capture some companies that may not qualify to use Form S-3 or be
considered an accelerated filer only because they were not in
compliance with the reporting requirements. We are soliciting
comments on this concern.
\24\ Under recently adopted rules, an ``unseasoned issuer'' is
defined as a company that is required to file reports under Section
13 or Section 15(d) of the Exchange Act [15 U.S.C. 78m or 78o(d)],
but does not satisfy the requirements of Form S-3 for a primary
offering of its securities; a ``seasoned issuer'' is defined as a
company that is eligible to use Form S-3 for a primary offering of
securities; and a ``well-known seasoned issuer'' is defined to
include a company that, among other things, has at least $700
million public float. Securities Offering Reform, supra note 18.
\25\ In addition to having public float of at least $75 million,
a company is eligible to use Form S-3 to register a primary offering
of its securities for cash if it: (1) is organized under the laws of
the United States or any state and has its principal business
operations in the United States; (2) has a class of securities
registered under Section 12(b) or a class of equity securities
registered under Section 12(g) of the Exchange Act [15 U.S.C. 78l(b)
or (g)], or is required to file periodic reports under Section 15(d)
of the Exchange Act [15 U.S.C. 78o(d)]; (3) has been subject to the
requirements of Section 12 or Section 15(d) of the Exchange Act and
has filed in a timely manner all of the material required to be
filed under Sections 13, 14 or 15(d) of the Exchange Act for at
least one year [15 U.S.C. 78m, 78n or 78o(d)]; and (4) has not
failed to pay a dividend or sinking fund installment on preferred
stock or defaulted on certain specified obligations since the end of
the last fiscal year.
\26\ Accelerated filers, in addition to having a public float of
$75 million or more, are companies that meet the following
conditions as of the end of their fiscal year: (1) they have been
subject to the reporting requirements of Section 13(a) or 15(d) of
the Exchange Act for a period of at least 12 calendar months; (2)
they previously have filed at least one annual report pursuant to
Section 13(a) or 15(d) of the Exchange Act; and (3) they are not
eligible to use Forms 10-KSB and 10-QSB [17 CFR 249.310(b) and 17
CFR 249.308(b)]. See Acceleration of Periodic Report Filing Dates
and Disclosure Concerning Web site Access to Reports, Securities Act
Release No. 8128 (Sept. 5, 2002) [67 FR 58480 (Sept. 16, 2002)].
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We believe that Alternative One would capture companies that
Congress intended to benefit from BDC financing. In this regard, the
Commission's Office of Economic Analysis (``OEA'') estimates that,
based on June 2006 data, Alternative One would increase the percentage
of public domestic operating companies that would meet the definition
of eligible portfolio company by 9.1 percent (a total of 896
companies). OEA's calculations relating to public float are based, for
the most part, on a public float definition that is similar to the
definition of public float used for purposes of Form S-3 and is
included in Alternative One.\27\ New
[[Page 64096]]
Rule 2a-46, based on June 2006 data, includes approximately 61.4
percent of public domestic operating companies (a total of 6,041
companies).\28\ Thus, approximately 70.5 percent (6,937/9,845) of
existing domestic public operating companies could qualify as eligible
portfolio companies under new Rule 2a-46 and Alternative One of
reproposed Rule 2a-46(b).\29\
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\27\ OEA relied on the estimate of public float provided by
Bloomberg LLP in calculating the estimates used in this Release.
Bloomberg defines public float as the number of shares outstanding
less shares held by insiders and those deemed to be ``stagnant
shareholders.'' ``Stagnant shareholders'' include ESOPs, ESOTs,
QUESTs, employee benefit trusts, corporations not actively engaged
in managing money, venture capital companies and shares held by
governments. Bloomberg provides estimates of public float for 3,471
out of 3,804 (91%) of the domestic operating companies identified.
For the 333 companies for which OEA was unable to obtain an estimate
of public float, OEA used each company's market capitalization.
Since small public companies often have a high percentage of insider
investors, using market capitalization most likely results in a
number that underestimates the number of companies that have a
public float of less than $75 million.
\28\ See Adopting Release, supra note 1 at text following n.17.
\29\ We note that our estimates reflect only those companies
with less than $75 million public float whose securities are listed
on Nasdaq, the New York Stock Exchange (``NYSE'') and the American
Stock Exchange (``Amex''). The estimates do not reflect those
companies whose securities are exclusively listed on a regional
exchange (i.e., those companies whose securities are not dually
listed on the NYSE, the Amex or Nasdaq) because such information is
not available on our primary data source. While there are only a
limited number of these companies, we believe that most of them have
a public float of less than $75 million and thus would also be
eligible portfolio companies under either of the proposed
alternatives of Rule 2a-46(b).
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We note that Alternative One is similar to a suggestion made by one
commenter, a BDC.\30\ This commenter suggested that we define eligible
portfolio company to include public companies that have market
capitalization of less than $100 million to ensure that BDCs continue
to invest most of their assets in smaller companies.\31\
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\30\ Comments of Capital Southwest Corporation (Dec. 28, 2004).
\31\ We estimate that there is little difference between the
number of companies that would be included under the standard
proposed under Alternative One and a standard using $100 million
market capitalization. OEA estimates that approximately 918 public
domestic operating companies would be included under a $100 million
market capitalization standard, compared to 896 public domestic
operating companies that would be included under a $75 million
public float standard (a difference of 22 companies).
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Finally, we note that Congress intended that we consider a number
of factors in engaging in any rulemaking to define eligible portfolio
company, including the extent of companies' public ownership.\32\ We
have considered this factor in proposing Alternative One, which, by
using public float, excludes insider ownership of a company.\33\
Nevertheless, as discussed below, we are also soliciting comment on
using a market capitalization test.
(b) $150/$250 Million Market Capitalization (Alternative Two)
Alternative Two would define eligible portfolio company to include
companies that have securities listed on an Exchange based on their
market capitalizations. As discussed below, we propose two ceilings
under this alternative--$150 million market capitalization and $250
million market capitalization.\34\
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\32\ See supra note 5.
\33\ See supra note 16.
\34\ Reproposed Rule 2a-46(b).
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We solicited comment on the possibility of using a market
capitalization standard in the 2004 Proposing Release. Many commenters
urged us to adopt a numeric threshold based on market
capitalization.\35\ Some commenters noted that companies with market
capitalization up to $300 million generally are followed by fewer
analysts, have lower institutional ownership and have lower trading
volume than companies at higher levels of market capitalization.\36\
These commenters concluded that such companies have difficulty
accessing the public capital markets. We recognize that, at some level
of market capitalization, there may be a difference in public awareness
of a company as measured by analyst coverage, institutional ownership
and other factors that may be related to the company's ability to
attract capital.\37\
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\35\ Supra note 13.
\36\ Comments of Representatives Sue Kelly and Nydia Velazquez
at n.12 (Jan. 5, 2005); comments of Williams & Jensen (Feb. 17,
2006). These commenters referred to analysis prepared by OEA in
connection with Securities Offering Reform. See memorandum dated
December 3, 2004 (``OEA Memorandum'') attached to comments of
Williams & Jensen (Feb. 17, 2006) (exhibit entitled ``SEC Data
Demonstrates Lack of Market Following for Companies with Market
Capitalizations of $300 million or less''). We note that OEA
prepared this memorandum to support differentiating among public
companies for purposes of defining well-known seasoned issuers. See
supra note 24. Also, the OEA Memorandum does not exclude foreign
companies and certain domestic, financial companies. See Sections
2(a)(46)(A) and (B), supra, note 5. The set of companies discussed
in that memorandum therefore is not directly comparable to the set
of companies that might be defined as eligible portfolio companies
under Rule 2a-46 and proposed Rule 2a-46(b). See also comments of
Allied Capital (Jan. 7, 2005) (data compiled by Banc of America
Securities LLC at Appendix A used to make similar point); comments
of UTEK (Jan. 7, 2005) (general statement of similar point).
\37\ See Background Statistics: Market Capitalization & Revenue
of Public Companies, August 1, 2005 revision, prepared by OEA and
included at Appendix I of Exposure Draft of Final Report of Advisory
Committee on Smaller Public Companies, Securities Act Release No.
8666 (modified Mar. 15, 2006), available at www.sec.gov/rules/other/33-8666.pdf. This data does not exclude foreign companies and
certain domestic, financial companies. Like the set of companies
discussed in the OEA Memorandum, it therefore is not directly
comparable to the set of companies that might be defined as eligible
portfolio companies under Rule 2a-46 and proposed Rule 2a-46(b). See
Sections 2(a)(46)(A) and (B), supra, note 5.
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In addition, we note that many investment companies classify
themselves with reference to the size of the companies in which they
invest.\38\ Similar size-based classifications also are often used by
market participants. These classifications generally assist investors
in making their investment choices. In particular, we note the general
use of the term ``microcap'' to identify some small, public companies.
This classification typically refers to companies with market
capitalization of less than $150 million to less than $300 million.\39\
Microcap issuers often include, among others, small start-up
companies.\40\
---------------------------------------------------------------------------
\38\ See, e.g., http://biz.yahoo.com/funds/sm_mf2.html.
\39\ There is no one generally accepted definition of microcap
issuer. Morgan Stanley and the Motley Fool define a microcap issuer
to be issuers with market capitalizations of less than $150 million.
See e.g., http://www.fool.com/school/glossary/glossaryc.htm; http://www.morganstanleyindividual.com/customerservice/dictionary. Yahoo
generally refers to microcap funds as funds that invest in companies
with less than $250 million. Supra note 38. See also http://www.investorwords.com/3050/micro_cap.html (microcap companies
include those companies with market capitalization of under $250
million). Lipper Inc. defines microcap funds as those funds that
invest primarily in companies with market capitalization less than
$300 million at the time of purchase. Lipper, U.S. Open-End, Closed-
End, Variable Annuity, and Overseas Fund Classifications
Descriptions (Version 1.2, updated: April 11, 2006), available at
www.Lipperweb.com.
\40\ Some larger, more established public companies, in addition
to small, start-up public companies, would qualify as eligible
portfolio companies under Alternative Two. We note that certain
larger companies were historically included under the definition of
eligible portfolio company before 1998. See 2004 Proposing Release,
supra note 6.
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We believe that market-based classifications are useful to consider
in designing a standard to define the type of company that could
benefit from BDC financing. Nevertheless, we note that market
participants use different bases to determine these classifications.
Accordingly, we are proposing for comment two different market
capitalization ceilings. The first ceiling would define an eligible
portfolio company to include companies that have securities listed on
an Exchange that have less than $150 million market capitalization.
This is similar to the classification that some market participants use
to identify some small, public companies.\41\ The second ceiling would
define an eligible portfolio company to include companies that have
securities listed on an Exchange that have less than $250 million
market capitalization. This ceiling mirrors legislation proposed last
year \42\ and is
[[Page 64097]]
also similar to the classification that other market participants use
to identify some small, public companies.\43\
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\41\ See supra note 39.
\42\ The ``Increased Capital Access for Growing Business Act''
was passed by the House of Representatives on April 6, 2005. H.R.
436, 109th Cong., 1st Sess. (2005) (previously H.R. 3170); S. 1396,
109th Cong., 1st Sess. (2005) (mirrors H.R. 436). Both H.R. 436 and
S. 1396 currently are pending before the Senate Committee on
Banking, Housing and Urban Affairs.
This ceiling is also consistent with some commenters'
suggestions. See comments of Williams & Jensen (Feb. 17, 2006)
(``The $250 million market capitalization level included in the
legislation is consistent with the original Congressional
intent.''). See also comments of Representatives Sue Kelly and Nydia
Velazquez (Jan. 5, 2005); comments of UTEK (Jan. 7, 2005); comments
of Allied Capital (Jan. 7, 2005); comments of American Capital (Jan.
7, 2005); comments of Representative Michael Oxley, Representative
Richard Baker and Representative Sue Kelly (Nov. 15, 2005); comments
of Chamber of Commerce of the United States of America (Dec. 13,
2005); comments of Senator Charles Schumer and Senator Robert
Menendez (Apr. 24, 2006).
\43\ See supra note 39.
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OEA estimates that based on June 2006 data, Alternative Two would
increase the percentage of public domestic operating companies that
would meet the definition of eligible portfolio company. A ceiling of
$150 million market capitalization would increase the percentage of
eligible portfolio companies by 11.8 percent (a total of 1,168
companies). Since new Rule 2a-46, based on June 2006 data, includes
approximately 61.4 percent of public domestic operating companies (a
total of 6,041 companies), approximately 73.2 percent (7,209/9,845) of
existing domestic public operating companies could qualify as eligible
portfolio companies under the combination of the two provisions. A
ceiling of $250 million market capitalization would increase the
percentage of eligible portfolio companies by 16 percent (a total of
1,562 companies), for a total of approximately 77.2 percent (7,603/
9,845) of existing domestic public operating companies under the
combination of new Rule 2a-46 and this version of Alternative Two.
3. Solicitation of Comments
We are requesting comment on whether Alternative One, one of the
two versions of Alternative Two, or another alternative not discussed
in this Release, would accomplish the objective of more closely
aligning the definition of eligible portfolio company with the purpose
that Congress intended. We are particularly interested in comments from
small businesses with respect to the impact that the alternatives
(Alternative One and both versions of Alternative Two) may have on
them. We are also interested in receiving information about small
businesses' experiences relating to their ability to raise capital
through securities offerings or to borrow money through conventional
sources (e.g., banks).
We specifically request comment on the following points:
Please provide your view as to whether Alternative One or
one of the two versions of Alternative Two more closely aligns the
definition of eligible portfolio company with the purpose that Congress
intended. Do any of the proposals (Alternative One or one of the two
versions of Alternative Two) better expand the definition of eligible
portfolio company consistent with the purpose of SBIIA? Please provide
empirical and analytical evidence that supports your response. If you
believe that none of the proposals meets the objective of expanding the
definition consistent with the purpose of SBIIA, please provide us with
another suggestion that meets this objective, with supporting empirical
and analytical evidence. In particular, please comment on whether the
ceiling in any suggestion should be lower or higher than those included
in the proposals. Please also comment on whether it is more appropriate
to use a standard based on public float or market capitalization. For
example:
[cir] Alternative One mirrors the standard used in Form S-3 and
Rule 12b-2 of $75 million public float. Would it be more appropriate to
use a lower ceiling based on Regulation S-B under the Securities Act of
1933 and the Exchange Act, which defines a ``small business issuer''
as, among other things, an issuer that has revenues of less than $25
million, but would not include an issuer that has public float of $25
million or more?
[cir] Would a ceiling other than the one included under Alternative
One or one of the two versions of Alternative Two, or another ceiling
not discussed in this Release, be a better way of achieving our
objective of more closely aligning the definition of eligible portfolio
company with Congress's intent? For example, one commenter suggested a
ceiling of $300 million market capitalization based on its analysis of
companies that have difficulty accessing capital.\44\
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\44\ Comments of Williams & Jensen (Feb. 17, 2006).
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[cir] We are particularly mindful of the unique position of BDCs as
regulated investment companies under the Investment Company Act.
Congress amended the Investment Company Act in recognition of the
differences between BDCs and other investment companies, and the
``valuable function in the capital formation process'' that BDCs
provide.\45\ In enacting these amendments, Congress was careful to
balance investor protections against the benefits of increasing the
flow of public capital to certain companies.\46\ One commenter
expressed its concern that a high size-based standard could result in
BDCs focusing their investment activities on larger companies to the
detriment of the companies that BDCs were intended to help.\47\ We
solicit comment on this concern. We also request comment on whether
either of the proposed alternatives, or a different alternative, would
have a negative impact on BDC investors.
---------------------------------------------------------------------------
\45\ House Report at 21. See Section I, 2004 Proposing Release,
supra note 6.
\46\ House Report at 22 (``the Committee is cognizant of the
need to avoid compromising needed protection for investors in the
name of reducing regulatory burdens. * * * Consequently, [SBIIA] is
intended to preserve to the fullest possible extent [the application
of investor protections of the federal securities laws to BDCs and
their operators], while at the same time reducing unnecessary
regulatory burdens.''). See 2004 Proposing Release, supra note 6 at
n.4 and accompanying text (discussing regulatory flexibility given
to BDCs).
\47\ See supra notes 30-31and accompanying text. See also
comments of Investment Company Institute (Jan. 6, 2005).
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[cir] Congress noted that we may consider a number of factors in
adopting rules to define eligible portfolio company, including the
extent of companies' public ownership.\48\ We have used public float
(which excludes insider ownership of a company \49\) as the basis for
Alternative One. We have used market capitalization (which includes all
public ownership, including insiders' interests) as the basis for
Alternative Two. Please comment on which standard (public float or
market capitalization) you believe more closely aligns the definition
of eligible portfolio company with Congress's purpose.
---------------------------------------------------------------------------
\48\ See supra note 5.
\49\ See supra note 16.
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[cir] We understand that it is more difficult to obtain a company's
public float from reliable third-party sources than it would be to
obtain a company's market capitalization, which is readily available
through such sources.\50\ Although public float information is not
readily available through third-party sources, we expect that the costs
involved in a BDC complying with these requirements would be minimal.
Section 55 of the Investment Company Act generally requires a BDC to
invest in eligible portfolio companies through privately negotiated
transactions, and we anticipate that a BDC would be able to obtain this
information from the company during the course of those
[[Page 64098]]
negotiations.\51\ Are these assumptions accurate, or would it be
burdensome for a BDC to determine a company's eligible portfolio
company status if it is based on public float rather than market
capitalization?
---------------------------------------------------------------------------
\50\ Although companies required to file reports with us under
the Exchange Act are required to disclose their public float on the
cover page of Form 10-K [17 CFR 249.310], that information may be
outdated at the time a BDC seeks to invest in that company.
\51\ We also understand that the question of whether a company
would meet the public float standard would only be at issue if that
company has a market capitalization of the dollar amount specified
under the standard (e.g., in the case of Alternative One, $75
million) or greater.
---------------------------------------------------------------------------
Unlike Form S-3 and Rule 12b-2, Alternative One of
reproposed Rule 2a-46(b) does not incorporate any of the qualifying
requirements included in Form S-3 or Rule 12b-2 based on the issuer's
reporting history under the Exchange Act out of concern that doing so
could capture some larger companies that may not qualify to use Form S-
3, or be considered accelerated filers, solely because they had not
complied with the respective regulation's reporting requirements (e.g.,
company missed deadlines because of auditing issues). We solicit
comment on this concern. Should such reporting requirements be included
in the definition of eligible portfolio company under Alternative One?
In other words, to the extent that you believe Alternative One is an
appropriate standard, should it exclude a company from the definition
of eligible portfolio company because the company cannot meet all of
the eligibility requirements for use of Form S-3 or because it does not
meet the definition of accelerated filer under Rule 12b-2?
We are proposing that a company must only meet the
standard on a single date within the 60-day period immediately prior to
the BDC's acquisition of the company's securities for purposes of
determining its status as an eligible portfolio company under the
reproposed definition. Is this timing appropriate? Should a company be
required to meet the standard for more than one day during the 60-day
period (e.g., at least for 5, 10, 20 non-consecutive days within the
60-day period, or an average over a specified period of time)? Should
the requirement be that a company must meet the size-based standard
using the average of the 60-day period immediately before an
acquisition by a BDC? Is the 60-day period appropriate? Would a shorter
or longer time period (e.g., 30 days, 75 days), or an average over a
specified period of time, be more appropriate? In your response, please
explain why your alternative would be more appropriate than the 60-day
period that we are proposing.
The 2004 Proposing Release was intended to address the
need of financially troubled companies that are at risk of losing their
listing status to access BDC capital, as well as small, developing
companies.\52\ One commenter indicated that proposed Rule 2a-46(b)
would not include all of the financially troubled companies that
provision was intended to include--that is, companies that have a class
of securities listed on an Exchange, but that are in danger of having
their securities delisted because they no longer meet the relevant
Exchange's quantitative requirements for continued listing on that
Exchange and that do not satisfy an Exchange's initial quantitative
requirements for listing any class of their securities.\53\ We believe
that many of such companies would meet the size-based criteria
specified under either alternative of reproposed Rule 2a-46(b), and
therefore be included under the reproposed definition. In addition,
such companies might be permissible investments for BDCs to make under
Section 55(a)(3), which permits a BDC to include in its 70 percent
basket securities of a company purchased from the company or certain
affiliates of the company in specific situations demonstrating
financial distress, including bankruptcy proceedings. Nevertheless, we
request comment as to whether there are some financially troubled
companies that could benefit from BDC financing but would not meet the
definition of eligible portfolio company under Alternative One or
Alternative Two of reproposed Rule 2a-46(b). If you believe that there
are, we request comment on how such companies could be defined. For
example, should the definition be based on a company's failure to meet
one or more initial or continuing quantitative listing standards of any
Exchange for a certain period of time? If yes, which quantitative
listing standard(s) would be appropriate on which to base eligibility?
How long must a company be out of compliance with the quantitative
listing standard(s) before it would meet the definition?
---------------------------------------------------------------------------
\52\ See 2004 Proposing Release, supra note 6 at nn. 37-41 and
accompanying text.
\53\ Comments of Shearman & Sterling LLP (Jan. 7, 2005).
---------------------------------------------------------------------------
III. General Request for Comment
We request comment on reproposed Rule 2a-46(b) and on other matters
that might have an effect on our proposal. For purposes of the Small
Business Regulatory Enforcement Fairness Act of 1996, we also request
information regarding the potential impact of reproposed Rule 2a-46(b)
on the economy on an annual basis. Commenters are requested to provide
empirical data to support their views.
IV. Cost-Benefit Analysis
We are sensitive to the costs and benefits that result from our
rules. In the Proposing Release we requested public comment and
specific data regarding the costs and benefits of reproposed Rule 2a-
46(b). While commenters agreed that proposed Rule 2a-46 would benefit
some companies, most urged the Commission to modify the proposed rule
to expand the definition to include more companies.
A. Benefits
Both Alternative One and Alternative Two of the expanded definition
of eligible portfolio company are designed to benefit many of the
companies that may have lost their eligible portfolio company status
because of the 1998 changes to the Federal Reserve Board's definition
of margin stock. Specifically, both alternatives are designed to
benefit certain companies by expanding the definition of eligible
portfolio company to include any domestic operating company with a
class of securities listed on an Exchange that meets the specified
size-based standard. Many public companies that would be included under
reproposed Rule 2a-46(b) may need capital for continued development and
growth, but, notwithstanding that their securities are listed on an
Exchange, may find it difficult to raise capital through additional
offerings or borrow money through other conventional sources. By
including such companies within the definition of eligible portfolio
company, those companies and their shareholders would benefit because
of the expanded sources of capital from which the companies may seek to
obtain financing.
Both Alternative One and Alternative Two of reproposed Rule 2a-
46(b) would also benefit BDCs by expanding the universe of investments
that BDCs may include as part of their 70 percent basket. In addition,
both would benefit BDCs by addressing the uncertainty caused by changes
in the margin rules in the operation of BDCs.\54\ Industry participants
have informed us that the 1998 amendment to the margin rules has
substantially reduced the number of issuers which BDCs may include in
their 70 percent basket and accordingly has adversely affected their
business operations.
---------------------------------------------------------------------------
\54\ See, e.g., comment of American Capital Strategies (Jan. 7,
2005).
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OEA estimates that as of June 30, 2006, there were a total of 896
domestic operating companies whose securities
[[Page 64099]]
are listed on Nasdaq, the NYSE and the Amex that have a public float of
less than $75 million, and therefore would qualify as eligible
portfolio companies under Alternative One. OEA reached this estimate by
first calculating the number of companies whose securities were listed
on Nasdaq, the NYSE and the Amex (a total of 6,786 companies),
corrected for cases where individual companies had multiple classes of
securities listed (60 companies), and then removing from the estimate
all foreign companies, investment companies and companies that are
excluded from the definition of investment company by Section 3(c) of
the Investment Company Act (e.g., REITS, banks, insurance companies)
because both Section 2(a)(46) of the Investment Company Act and Rule
2a-46 exclude these types of companies from the definition of eligible
portfolio company (a deduction of 2,982 companies) to reach a total of
3,804 companies.\55\ OEA determined that of these companies, 896 had a
public float of less than $75 million.\56\ OEA further estimates that
Alternative One, together with new Rule 2a-46 (which would be
redesignated as Rule 2a-46(a)),\57\ would include within the definition
of eligible portfolio company 6,937 companies, representing 70.5
percent (6,937/9,845 \58\) of public domestic operating companies.
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\55\ As we discussed in the Adopting Release, one commenter
argued that the Commission incorrectly calculated the number of
companies that the proposed rule would benefit and wrote that the
proposal would benefit even fewer companies than the Commission
estimated. The commenter's figure is lower than the figure
calculated by OEA. It appears that the commenter did not deduct from
its calculation foreign companies, investment companies and
companies that are excluded from the definition of investment
company by Section 3(c). See Adopting Release, supra note 1 at n.33.
\56\ See supra note 27.
\57\ OEA estimated that, based on June 2006 data, Rule 2a-46 as
adopted today includes 6,041 domestic operating companies (61.4% of
all domestic operating companies). See Adopting Release, supra note
1 at Section III.A.
\58\ OEA estimates that, as of June 2006, there were 9,845
public domestic operating companies by calculating the number of
companies whose securities are listed on Nasdaq, the NYSE and the
Amex, in addition to those companies whose securities are trading
through the over-the-counter bulletin board and on Pink Sheets LLC,
correcting these figures for cases where individual companies had
multiple classes of securities listed, and then removing from these
figures foreign companies, investment companies, and companies that
are excluded from the definition of investment company by Section
3(c).
---------------------------------------------------------------------------
OEA estimates that there are a total of 1,168 domestic operating
companies whose securities are listed on Nasdaq, the NYSE and the Amex
that have a market capitalization of less than $150 million,\59\ and
therefore would qualify as eligible portfolio companies under the $150
million market capitalization standard set forth in Alternative
Two.\60\ Accordingly, OEA estimates that this standard, together with
new Rule 2a-46 (which would be redesignated as Rule 2a-46(a)), would
include within the definition of eligible portfolio company 7,209
companies, representing 73.2 percent (7,209/9,845) of public domestic
operating companies.\61\
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\59\ As with Alternative One, OEA reached this estimate after
first calculating the number of companies whose securities are
listed on Nasdaq, the NYSE and the Amex, corrected for cases where
individual companies had multiple classes of securities listed, and
then removing from these figures all foreign companies, investment
companies and companies that are excluded from the definition of
investment company by Section 3(c) (e.g., REITS, banks, insurance
companies) because both Section 2(a)(46) and Rule 2a-46 exclude
these types of companies from the definition of eligible portfolio
company.
\60\ Market capitalization data was obtained from CRSP, Center
for Research in Security Prices, Graduate School of Business, The
University of Chicago [2006]. Used with permission. All rights
reserved. www.crsp.uchicago.edu.
\61\ See supra note 57.
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Finally, OEA estimates that there are a total of 1,562 domestic
operating companies whose securities are listed on Nasdaq, the NYSE and
the Amex that have a market capitalization of less than $250
million,\62\ and therefore would qualify as eligible portfolio
companies under the $250 million market capitalization standard set
forth in Alternative Two.\63\ Accordingly, OEA estimates that this
standard, together with new Rule 2a-46, would include within the
definition of eligible portfolio company 7,603 companies, representing
77.2 percent (7,603/9,845) of public domestic operating companies.\64\
---------------------------------------------------------------------------
\62\ See supra note 59.
\63\ See supra note 60.
\64\ See supra note 57. OEA's analysis of the number and
percentage of companies that could qualify as eligible portfolio
companies under Alternative One and the two versions of Alternative
Two are based on market capitalization and public float calculated
as of a particular day. Because both Alternative One and Alternative
Two allow for companies to meet the test on any date within a 60-day
period, OEA's figures may underestimate the number of companies that
would be eligible under either version.
---------------------------------------------------------------------------
B. Costs
Both Alternative One and Alternative Two of reproposed Rule 2a-
46(b) might impose certain administrative compliance costs on BDCs. It
is our understanding, however, that these costs are similar to the
types of compliance costs that a BDC currently undertakes when it
invests in an issuer.
Under Alternative One, a BDC would need to determine, prior to
investing in a company, if the company has a class of securities on an
Exchange and whether that company's public float was less than $75
million as of a date within 60 days prior to the date of the BDC's
investment. Although public float information is not readily available
through third-party sources,\65\ we expect that the costs involved in a
BDC complying with these requirements would be minimal. Section 55 of
the Investment Company Act generally requires a BDC to invest in
eligible portfolio companies through privately negotiated transactions,
and we anticipate that a BDC would be able to obtain this information
from the company during the course of those negotiations.
---------------------------------------------------------------------------
\65\ Although companies required to file reports with us under
the Exchange Act are required to disclose their public float on the
cover page of Form 10-K [17 CFR 249.310], that information may be
outdated at the time a BDC seeks to invest in that company.
---------------------------------------------------------------------------
Under the $150 million market capitalization version of Alternative
Two, a BDC would need to determine, prior to investing in a company, if
the company has a class of securities on an Exchange and whether that
company's market capitalization was less than $150 million as of a date
within 60 days prior to the date of the BDC's investment. Similarly,
under the $250 million market capitalization version of Alternative
Two, a BDC would need to determine, prior to investing in a company, if
the company has a class of securities on an Exchange and whether that
company's market capitalization was less than $250 million as of a date
within 60 days prior to the date of the BDC's investment. We expect
that the compliance costs on BDCs might be slightly lower under either
version of Alternative Two because information about the market
capitalization of companies is readily available from third-party
sources. Finally, we anticipate that both Alternative One and
Alternative Two of reproposed Rule 2a-46(b) would impose only minimal,
if any, costs on portfolio companies.
C. Request for Comments
We request comment on the potential costs and benefits identified
above and any other costs and benefits that may result from either
Alternative One or Alternative Two of reproposed Rule 2a-46(b). Are
there any direct or indirect costs that we have not identified? For
purposes of the Small Business Regulatory Enforcement Fairness Act of
1996, the Commission also requests information regarding the impact of
each alternative on the economy on an annual basis. Commenters are
requested to provide data to support their views.
[[Page 64100]]
V. Consideration of Promotion of Efficiency, Competition and Capital
Formation
Section 2(c) of the Investment Company Act mandates that the
Commission, when engaging in rulemaking that requires it to consider or
determine whether an action is necessary or appropriate in the public
interest, to consider, in addition to the protection of investors,
whether the action will promote efficiency, competition and capital
formation.\66\ In the 2004 Proposing Release, we requested comment on
our analysis of the impact of proposed Rule 2a-46 on efficiency,
competition and capital formation. As discussed in Section II of this
Release, some commenters argued that proposed Rule 2a-46(b) would be
too narrow and would not capture all of the companies that could
benefit from BDC financing. We interpreted these comments to suggest
that capital formation may have been limited under the proposed rule.
In addition, one commenter wrote that the proposal failed to identify
private investments in public equity (``PIPE'') as one source of
competition for BDC financing.\67\ The commenter also believed that the
proposal failed to consider the impact on the shareholders of companies
receiving BDC or PIPE financing.\68\
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\66\ 15 U.S.C. 80a-2(c).
\67\ The commenter explained that entities that provide
financing through PIPE transactions include hedge funds and private
venture capital funds, both of which compete with BDCs in providing
capital in the small business market. The commenter also noted its
belief that the use of PIPE transactions illustrates the lack of
access to traditional forms of capital for certain public companies.
Comments of Williams & Jensen (Feb. 17, 2006).
\68\ Id.
---------------------------------------------------------------------------
In light of the comments received, the Commission is reproposing
Rule 2a-46(b) to more closely align the definition of eligible
portfolio company, and the investment activities of BDCs, with the
purpose intended by Congress. Both alternatives of the reproposed
definition are designed to promote efficiency, competition and capital
formation.
Specifically, efficiency would be enhanced because both Alternative
One and Alternative Two of reproposed Rule 2a-46(b) would expand the
definition of eligible portfolio company so as to allow BDCs to compete
with other entities that provide capital to certain companies. To the
extent that BDCs provide capital at lower cost to these companies, the
rules promote a more efficient flow of capital, potentially allowing
those companies to take on additional or different investment projects.
Both alternatives of reproposed Rule 2a-46(b) in our view also would
promote efficiency by providing a workable test for determining whether
a company is an eligible portfolio company.
We also believe that both Alternative One and Alternative Two of
reproposed Rule 2a-46(b) would promote competition. The market for
private equity and debt investments can be highly competitive. Since
their establishment, BDCs have competed with various sources of
capital, including private equity funds, hedge funds, investment banks
and other BDCs, to provide financing to certain companies. We believe
that both alternatives of the reproposed rule would encourage such
competition.\69\ In addition, to the extent that BDCs provide either
additional or less expensive capital to these companies, those
companies may be more competitive in the marketplace.
---------------------------------------------------------------------------
\69\ Williams & Jenson commented that we did not consider PIPE
transactions in our discussion in the 2004 Proposing Release of how
proposed Rule 2a-46 would promote competition. This argument,
however, focuses on one particular type of financing that is used by
entities that compete with BDCs in funding small businesses. Neither
Rule 2a-46 adopted today, nor reproposed Rule 2a-46(b), however,
differentiates among the types of financing that may be offered to
eligible portfolio companies. Instead, the rule, as adopted and
reproposed, provides a definition of eligible portfolio company that
would permit BDCs to invest their 70% baskets without regard to the
type of financing offered. Thus, BDCs and eligible portfolio
companies would be permitted to negotiate the type of financing
(including PIPE transactions) that is most appropriate under the
circumstances.
---------------------------------------------------------------------------
In response to the commenter's concern that the proposal did not
consider the impact on shareholders of companies receiving BDC or PIPE
financing, we note that shareholders of companies that had lost their
status as eligible portfolio companies would benefit under either
version of the reproposed rule because such companies would be able to
more readily consider BDCs as a source of financing. We anticipate that
these companies would consider both the type of financing offered and
the entity offering the financing when determining the type and source
of financing that would be in their best interests and the best
interests of their shareholders.
Finally, we believe that both Alternative One and Alternative Two
of reproposed Rule 2a-46(b) would promote capital formation. BDC
investments represent additional capital to companies. Each version
would expand the definition of eligible portfolio company. We estimate
that a total of 896 public domestic operating companies would qualify
as an eligible portfolio company under Alternative One, 1,168 public
domestic operating companies would qualify as an eligible portfolio
company under the $150 million market capitalization version of
Alternative Two, and 1,562 public domestic operating companies would
qualify as an eligible portfolio company under the $250 million market
capitalization version of Alternative Two.\70\
---------------------------------------------------------------------------
\70\ See supra notes 55-64 and accompanying text.
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VI. Paperwork Reduction Act
The Commission has determined that these rules do not involve a
collection of information pursuant to the provisions of the Paperwork
Reduction Act [44 U.S.C. 3501 et seq.].
VII. Initial Regulatory Flexibility Analysis
This Initial Regulatory Flexibility Analysis (``IRFA'') has been
prepared in accordance with 5 U.S.C. 603. It relates to reproposed Rule
2a-46(b) under the Investment Company Act. The Commission is proposing
two alternatives of an additional definition of eligible portfolio
company. Both alternatives would expand the definition of eligible
portfolio company to include certain companies whose securities are
listed on an Exchange. Alternative One would define eligible portfolio
company to include a company whose securities are listed on an Exchange
but that has public float of less than $75 million. Alternative Two
would define eligible portfolio company to include a company whose
securities are listed on an Exchange but has a market capitalization of
less than either $150 million or $250 million.
A. Reasons for the Proposed Action
As described in Section I of this Release, the reason for
reproposed Rule 2a-46(b) is to further address the unintended impact of
the Federal Reserve Board's 1998 amendments to the definition of
eligible portfolio company.
B. Objectives of the Proposed Action
As described in Section II of this Release, the Commission today
adopted Rule 2a-46 under the Investment Company Act, which defines
eligible portfolio company to include all companies whose securities
are not listed on an Exchange. Reproposed Rule 2a-46(b) would expand
the definition of eligible portfolio company to include certain
companies with a class of securities listed on an Exchange. These
companies may need BDC financing for continued development and growth,
[[Page 64101]]
but, notwithstanding the fact that their securities are listed on an
Exchange, may find it difficult to raise additional capital in new
offerings or borrow money through other conventional sources.
C. Small Entities Subject to the Rule
Both Alternative One and Alternative Two of reproposed Rule 2a-
46(b) would affect BDCs and companies that qualify as small entities
under the Regulatory Flexibility Act. For purposes of the Regulatory
Flexibility Act, a BDC is a small entity if it, together with other
investment companies in the same group of related investment companies,
has net assets of $50 million or less as of the end of its most recent
fiscal year.\71\ As of December 2005, there were 87 BDCs, of which 66
were small entities. A company other than an investment company is a
small entity under the Regulatory Flexibility Act if it had total
assets of $5 million or less on the last day of its most recent fiscal
year.\72\ We estimate that there are approximately 2,500 companies,
other than investment companies, that may be considered small entities.
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\71\ 17 CFR 270.0-10.
\72\ 17 CFR 230.157; 17 CFR 240.0-10.
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As discussed in this Release, reproposed Rule 2a-46(b) is intended
to benefit certain companies that need capital for continued
development and growth, but may be unable to borrow money through
conventional sources despite their securities being listed on an
Exchange. Both Alternative One and Alternative Two of reproposed Rule
2a-46(b) would also benefit BDCs, including those that are small
entities, by expanding the universe of investments that BDCs may
include as part of their 70 percent basket. We have no reason to expect
that those BDCs and companies that are small entities for purposes of
the Regulatory Flexibility Act would be disproportionately affected by
either alternative. We request comment on the effects and costs of both
Alternative One and Alternative Two on small entities.
D. Reporting, Recordkeeping and Other Compliance Requirements
Neither Alternative One nor Alternative Two of reproposed Rule 2a-
46(b) would impose any new reporting or recordkeeping requirements on
BDCs or on companies. They also would impose only minimal, if any,
compliance requirements on portfolio companies.
Both Alternative One and Alternative Two of reproposed Rule 2a-
46(b), however, would impose minimal compliance requirements on BDCs,
including small entities. It is our understanding that these costs are
similar to the types of compliance costs that a BDC currently
undertakes when it invests in an issuer.
Under Alternative One, a BDC, prior to investing in a company,
would need to determine whether the company has a class of securities
listed on an Exchange and whether that company's public float was less
than $75 million as of a date within 60 days prior to the date of the
BDC's investment in the company. Public float information is not
readily available through third-party sources. Section 55 of the
Investment Company Act, however, generally requires a BDC to invest in
eligible portfolio companies through privately negotiated transactions,
and so we anticipate that a BDC would be able to obtain this
information from the company during the course of these negotiations.
Similarly, we expect that the compliance burden imposed on BDCs,
including those that are small entities, would be minimal under either
the $150 million market capitalization version of Alternative Two or
the $250 million market capitalization version of Alternative Two.
Under the $150 million market capitalization version, a BDC would need
to determine, prior to investing in a company, if the company has a
class of securities on an Exchange and whether that company's market
capitalization was less than $150 million as of a date within 60 days
prior to the date of the BDC's investment. Similarly, under the $250
million market capitalization version, a BDC would need to determine,
prior to investing in a company, if the company has a class of
securities on an Exchange and whether that company's market
capitalization was less than $250 million as of a date within 60 days
prior to the date of the BDC's investment. We expect that the
compliance burden imposed on BDCs, including those that are small
entities, would be slightly lower under either version of Alternative
Two than it would be under Alternative One because information about
the market capitalization of companies is readily available from third-
party sources.
Finally, we anticipate that both Alternative One and Alternative
Two of reproposed Rule 2a-46(b) would impose only minimal, if any,
compliance requirements on portfolio companies, including those that
are small entities.
E. Duplicative, Overlapping or Conflicting Federal Rules
There are no rules that duplicate, overlap or conflict with either
Alternative One or Alternative Two of reproposed Rule 2a-46(b).
F. Significant Alternatives
The Regulatory Flexibility Act directs us to consider significant
alternatives that would accomplish our stated objectives, while
minimizing any significant adverse impact on small entities.
Alternatives in this category would include: (1) Establishing different
compliance or reporting standards that take into account the resources
available to small entities; (2) clarifying, consolidating, or
simplifying the compliance requirements for small entities; (3) the use
of performance rather than design standards; and (4) exempting small
entities from the coverage of the rules, or any part thereof.
Establishing different compliance or reporting requirements for
small entities would not be appropriate under reproposed Rule 2a-46(b).
As discussed above, neither Alternative One nor Alternative Two would
impose any reporting requirements on BDCs or on companies. In addition,
neither of the alternatives would impose any compliance requirements on
portfolio companies. Both Alternative One and Alternative Two of
reproposed Rule 2a-46(b) would, however, impose some compliance
requirements on BDCs that are intended to ensure that BDCs invest
primarily in certain types of companies. These requirements should,
however, impose only minimal burdens on BDCs.
We believe that clarifying, consolidating or simplifying the
compliance requirements for small entities under either alternative
would be inappropriate. As discussed above, neither Alternative One nor
Alternative Two would impose any compliance requirements on portfolio
companies. Although both alternatives of reproposed Rule 2a-46(b) would
impose some compliance requirements on BDCs, as discussed above, these
requirements, which we believe would impose minimal burdens on BDCs,
are designed to ensure that BDCs would invest in companies in
accordance with the proposed rule.
We believe that using performance rather than design standards
would add unnecessary complexity. Both Alternative One and Alternative
Two of reproposed Rule 2a-46(b) provide a clear, bright-line, workable
test for determining whether a company is an eligible portfolio
company. A standard
[[Page 64102]]
based on performance could be unduly complicated and cause further
uncertainty to BDCs, including those that are small entities, when
determining whether a company is an eligible portfolio company.
Likewise, the use of a performance standard would bring uncertainty to
companies in determining whether they meet the definition of eligible
portfolio company.
Finally, we believe that it would be inappropriate to exempt BDCs
that are small entities from the coverage of the reproposed Rule 2a-
46(b). Both Alternative One and Alternative Two of reproposed Rule 2a-
46(b) should benefit BDCs and companies, including those that are small
entities, by expanding the definition of eligible portfolio company to
include certain companies whose securities are listed on an Exchange.
Exempting BDCs and companies that are small entities from all or part
of either proposed alternative would be contradictory to the purpose of
this rulemaking.
G. Solicitation of Comments
We encourage the submission of comments with respect to any aspect
of this IRFA. Comment is specifically requested on the number of small
entities that would be affected by Alternative One and each version of
Alternative Two and the likely impact on Alternative One and
Alternative Two (both versions) on small entities. Commenters are asked
to describe the nature of any impact and provide empirical data
supporting the extent of the impact. These comments will be considered
in connection with the adoption of reproposed Rule 2a-46(b) and will be
reflected in the Final Regulatory Flexibility Analysis.
VIII. Statutory Authority
We are proposing to amend Rule 2a-46 and reproposing Rule 2a-46(b)
pursuant to our rulemaking authority under Sections 2(a)(46)(C)(iv) and
38(a) of the Investment Company Act.
List of Subjects in 17 CFR Part 270
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Proposed Rules
For reasons set forth in the preamble, Title 17, Chapter II of the
Code of Federal Regulations is proposed to be amended as follows:
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
1. The authority citation for Part 270 continues to read in part as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, and 80a-
39, unless otherwise noted.
* * * * *
2. Revise Sec. 270.2a-46 to read as follows:
Sec. 270.2a-46 Certain issuers as eligible portfolio companies.
The term eligible portfolio company shall include any issuer that
meets the requirements set forth in paragraphs (A) and (B) of section
2(a)(46) of the Act (15 U.S.C. 80a-2(a)(46)(A) and (B)) and that:
(a) Does not have any class of securities listed on a national
securities exchange; or
(b) Has a class of securities listed on a national securities
exchange, but has an aggregate market value of outstanding voting and
non-voting common equity [held by non-affiliates of less than $75
million] [of less than $150 million] [of less than $250 million]. For
purposes of this paragraph:
(1) The aggregate market value of an issuer's outstanding voting
and non-voting common equity shall be computed by use of the price at
which the common equity was last sold, or the average of the bid and
asked prices of such common equity, in the principal market for such
common equity as of a date within 60 days prior to the date of
acquisition of its securities by a business development company; and
(2) Common equity [has] [and affiliate have] the same meaning[s] as
in 17 CFR 230.405.
Dated: October 25, 2006.
By the Commission.
Nancy M. Morris,
Secretary.
[FR Doc. E6-18257 Filed 10-30-06; 8:45 am]
BILLING CODE 8011-01-P