Business Development Companies Examined
Venture capital funds have traditionally been available only to institutions and wealthy individuals through private placements. Concerns about the possible applicability of the Investment Company Act of 1940 (the 1940 Act) were avoided by limiting participation to 100 or fewer investors or extremely wealthy “qualified purchasers.”
Increasingly, however, venture capitalists have displayed an interest in attracting public investors. Companies that wish to avoid the 1940 Act but seek venture capital dollars from the public generally rely on either of the following:
- The exclusion from investment company status under Rule 3a-1 of the Act, which generally provides that a company will not be considered an investment company if no more than 45% of the value of its assets consists of “investment securities” and no more than 45% of its after-tax net income is derived from such securities
- An exemptive order from the Securities and Exchange Commission (SEC) pursuant to Section 3(b)(2) of the 1940 Act declaring the applicant to be primarily engaged in a non-investment company business and therefore not subject to the 1940 Act
Companies relying on either Rule 3a-1 or an SEC exemptive order are not subject to the provisions of the 1940 Act. However, depending on the exemption on which they rely, such companies remain subject to either the strict numerical limitations of Rule 3a-1 or the conditions upon which their exemptive orders were granted.
An alternative to relying on either Rule 3a-1 or an exemptive order is when a venture capital company that is seeking to access the public market elects to be regulated under the 1940 Act as a business development company (BDC).
Regulating Business Development Companies
The specific provisions of the 1940 Act regulating BDCs fall into two distinct categories. The first category includes those provisions that directly or indirectly promote investment in developing businesses. Examples of these provisions include lower asset coverage requirements for borrowing, mandatory investment in small businesses (as a percentage of the company’s total assets), and relaxed restrictions on affiliated transactions. The second category includes those provisions designed to compensate employees of BDCs in a manner consistent with compensation practices in the venture capital industry. Examples of such provisions include permitting the company to issue certain types of equity-based compensation to employees and permitting the company to make loans to employees of the company to enable them to purchase the company’s securities. Collectively, these provisions were designed to achieve Congress’ goal of promoting capital investment in small businesses by encouraging venture capitalists previously unwilling to submit to 1940 Act regulation to establish public funds for private investment.
Generally, to be eligible to elect BDC status, a company must engage in the business of furnishing capital and offering significant managerial assistance to companies that do not have ready access to capital through conventional financial channels. More specifically, in order to qualify as a BDC, a company must:
- Be a domestic company
- Have registered a class of its securities or have filed a registration statement with the SEC pursuant to Section 12 of the Exchange Act
- Operate for the purpose of investing in the securities of certain types of eligible portfolio companies, namely less seasoned or emerging companies and businesses suffering or just recovering from financial distress
- Offer to extend significant managerial assistance to such eligible portfolio companies
- File (or, under certain circumstances, intend to file) a proper notice of election with the SEC
The 1940 Act also imposes, among others, the following regulations on BDCs:
- The issuance of senior equities and debt securities by a BDC is subject to certain limitations.
- The issuance of warrants and options by a BDC is subject to certain limitations.
- A BDC may not engage in certain transactions with affiliates without obtaining exemptive relief from the SEC.
- A BDC may not change the nature of its business or fundamental investment policies without the prior approval of the stockholders.
- A BDC must carry its portfolio investments at market value, or at fair value if there is no market value readily available.
- It imposes a new regulatory structure.
Election And 1934 Act Registration
A BDC is subject to Sections 54 through 65 of the 1940 Act, which relate specifically to BDCs (the BDC provisions). To qualify for the exemption, a closed-end investment company must elect to be treated as a BDC and file a notice on Form N-54A to that effect with the SEC. Significantly, to make the BDC election, a company must also have a class of its equity securities registered under the Securities Exchange Act of 1934 (the 1934 Act). As a result, shares of BDCs, like those of closed-end funds, typically are listed for trading on public exchanges or on a Nasdaq market. However, unlike closed-end funds, which are not required to register under the 1934 Act, BDCs must file with the SEC periodic reports (i.e., Forms 10-Q and 10-K) and other reports (e.g., Form 8-K), like those filed by publicly traded operating companies. Management personnel also must report their trading in the company’s stock and are restricted from obtaining short swing profits from trading in such securities within a six-month period. Like other 1934 Act registrants, BDCs are also subject to the proxy solicitation requirements of Section 14 of the 1934 Act.
A BDC is, in effect, required by Section 55(a) to have at least 70% of its investments in eligible assets. Eligible assets, for purposes of Section 55(a), include, among other things:
- Securities of an “eligible portfolio company” that are purchased from that company in a private transaction
- Securities received by the BDC in connection with its ownership of securities of an “eligible portfolio company”
- Cash, cash items, government securities or high-quality debt securities maturing one year or less from the time of investment
An eligible portfolio company is defined as any issuer that is organized and has its principal place of business in the United States; is not an investment company other than a small business investment company wholly-owned by the BDC; and does not have any class of publicly traded securities with respect to which a broker may extend credit.
BDCs are required to make available significant managerial assistance to their portfolio companies. Significant managerial assistance refers to any arrangement whereby a BDC provides significant guidance and counsel concerning the management, operations, or business objectives and policies of a portfolio company. Examples of such activities include arranging financing, managing relationships with financing sources, recruiting management personnel, and evaluating acquisition and divestiture opportunities.
Unlike other investment companies, BDCs are able to issue options, warrants and rights to convert to voting securities to their officers, employees and board members.
Any issuance of derivative securities requires the approval of the company’s board of directors and authorization by the company’s shareholders. The company also may not issue derivative securities to its nonemployee directors unless it first obtains an exemptive order from the SEC.
In general, the amount of voting securities that would result from the exercise of all derivative securities of a BDC at the time of issuance is not permitted to exceed 25% of the outstanding voting securities of the BDC. However, if the outstanding derivative securities issued to management personnel as a component of their compensation represents 15% of the BDC’s outstanding shares, then the total amount of derivative securities that the BDC may issue, as a percentage of its total outstanding shares, is 20%.
A BDC may operate a profit-sharing plan for its employees, subject to certain restrictions. A BDC cannot, however, maintain such a plan if it maintains a stock option plan for management or is externally managed by a registered investment adviser.
BDCs are less restricted than closed-end funds as to the amount of debt they can have outstanding. Generally, a BDC may not issue any class of senior security representing an indebtedness unless, immediately after such issuance or sale, it will have at least double the asset coverage. For example, if a BDC has $1 million in assets, then it can borrow up to $1 million, which would result in assets of $2 million and debt of $1 million. Other investment companies must have triple the asset coverage.
As with any other company subject to the 1940 Act, a BDC must adhere to certain substantive regulatory requirements with respect to its operations.
Composition Of Board of Directors
A majority of the directors of a BDC must be persons who are not “interested persons” of the BDC. The 1940 Act defines interested persons to include, among others:
Officers, directors and employees – however, no person is deemed to be interested solely by reason of being a member of the board of directors
A 5% or more voting shareholder of the company
A person who is a member of the immediate family of an affiliate of the company
Legal counsel for the company
Any natural person whom the SEC determines to have had a material business relationship in the past two completed fiscal years with the company or its CEO
A BDC is prohibited from protecting any director or officer from any liability to the company – or its security holders – arising from willful misfeasance, bad faith, gross negligence or reckless disregard of the duties involved in the conduct of such person’s office. This prohibition also applies to the company’s investment adviser, if it is externally managed.
The board of directors of a BDC is required to value portfolio assets on a quarterly basis in connection with filing certain required periodic reports. Assets must be valued on the basis of market value, if available; in the absence of a readily ascertainable market value for an asset, the board must in good faith determine the “fair value.”
Transactions With Related Persons
Transactions involving a BDC and certain persons related to it, including, among others, officers, directors, employees, members of an advisory board, the investment adviser, the principal underwriter, and persons controlling or under common control with the BDC, are generally prohibited, absent an SEC exemptive order. Transactions involving a BDC and companies that it controls (i.e., those in which it owns more than 25% of the voting securities) generally are not subject to this limitation.
Code Of Ethics
Officers and directors of a BDC and its external investment adviser (if any) are subject to general fiduciary duties with respect to the conduct of their duties as they impact the BDC. A BDC (and its investment adviser) must adopt a code of ethics and institute procedures reasonably necessary to ensure that its employees and certain affiliates adhere to the code.
A BDC must provide and maintain a bond issued by a reputable fidelity insurance company to protect the company against larceny and embezzlement. The bond must cover each officer and employee with access to securities and funds of the company with the required coverage tied to the amount of the company’s assets.
A BDC may elect to be taxed either as a C corporation (like typical operating companies) or as a regulated investment company under Subchapter M of the Internal Revenue Code of 1986. As a regulated investment company (RIC), a BDC can avoid taxation at the company level on that portion of income and capital gains distributed to shareholders. To qualify for RIC treatment, in general, at least 90% of the BDC’s income must consist of interest, dividends, gains from sales of securities, and similar types of income and gains, and the BDC must distribute to its stockholders for each taxable year at least 90% of its investment company taxable income (consisting generally of net investment income from interest and dividends and net short-term capital gains). The RIC provisions also require a BDC to comply with certain requirements with respect to its portfolio diversification.
Providing Valuable Business Development Company Guidance
For further guidance on BDCs and related regulations, contact Anthony L.G., PLLC, in West Palm Beach. Our experienced attorneys can provide valuable knowledge and guidance on the 1940 Act. Contact us today by calling 877-541-3263 or completing our online contact form to schedule a consultation.