How does that saying go? Everything old is new again. Or, to borrow a different clichι, when it come to securities laws there is nothing new under the sun. The framework of U.S. Securities regulation was crafted before World War II, and while it is being tweaked, constantly, the bones of the old house still stand.
The Securities Act of 1933 and the Securities and Exchange Act of 1934 represent the firmament of the public marketplace and provide the mechanisms for most securities offerings and brokerage transactions. And although the world has changed in immeasurable ways since FDR's first term, there has been no clamor for revolutionary change, no serious suggestion to dump antiquated codes and replace them with a new framework that responds to the modern marketplace and enables regulators to address current problems.
Perhaps it is because everyone involved brokers, issuers, regulators, legislators, attorneys and auditors are all too familiar and comfortable with the 1933 and 1934 legislation. Seventy years later, they have explored virtually every nuance of the rules.
Ironically, there exists another securities statute, enacted six years after the 1934 Act, which remains something of a mystery, even to industry professionals. The Investment Company Act of 1940 carved out a separate set of regulations for companies that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. And while the Investment Company Act requires these companies to disclose their financial condition and investment strategy to investors, the 1940 Act consists of esoteric rules that operate with its companion code, the 1933 Act, to permit qualified companies to sell shares that have not been registered with the SEC. Unlike the 1933 and 1934 Acts, which are utilized and invoked by securities experts and amateur investors with equal ease, for sixty four years the Investment Company Act of 1940 has remained the province of a handful of Wall Street professionals and securities attorneys.
Until now. A number of small, obscure public companies appear to have recognized the advantages of the 1940 Act, and the relatively low bar that it sets for companies that seek shelter under its umbrella. These businesses have sought to be classified as "Business Development Companies," which would allow them to take advantage of the esoteric provisions of the 1940 Act. As it turns out, the transformation to a Business Development Company (BDC) is not formidable.
Open Ended Investments for Closed End Companies
How does a company become a BDC? For starters, the entity must be a "closed end company." A closed end company can only issue its securities in exchange for cash or other securities not in consideration for services or other property. That would sound like a deterrent to any company that plans to issue shares for services a device that is frequently utilized by struggling companies short on funds.
In reality, this restriction should not provide much of an impediment to the creative minds that populate the investment industry. Although the 1940 Act appears to take a hard line, declaring that a closed end company may not sell its common stock for less than its "current net asset value," there are exceptions galore to that rule. Stock may be sold at below its "net asset value" in connection to an offering to current shareholders; with the consent of a majority of common shareholders; or by converting a convertible security (such as a debenture or preferred stock).
In other words, money is no object and no obstacle.
And there are other exceptions which would empower the company to place additional stock in the hands of a favored few. Shares of a closed end company can be issued as part of a dividend or distribution or in connection with a corporate reorganization.
In essence, becoming a closed end company, while reserving the ability to issue shares, does not pose a difficult task.
The closed end company can qualify for treatment as a BDC by complying with a handful of convoluted rules. In essence, these regulations require the company to be formed in the United States, maintain its principal office in the U.S., and operate for the purpose of making investments in eligible securities of portfolio companies.
In what sort of companies may a BDC invest? Under the Investment Company Act of 1940 an issuer may qualify as a portfolio company by several means including, perhaps most importantly, if it is controlled, managed and influenced by one or more business development companies. The BDC must provide "significant managerial assistance" to the issuer meaning it must offer guidance and exercise control. It also must provide at least one director to the portfolio company.
As a general proposition, the Investment Company Act limits the ability of certain individuals principally, officers, directors, employees, promoters and others who might control the BDC from selling securities to the BDC and buying securities from the BDC. There are exceptions to this arms-length arrangement which entitle such individuals to obtain warrants, options and participate in the BDC's profit sharing plan.
One more thing. At least 70% of the assets of the Business Development Company must consist of qualified securities of portfolio companies principally consisting of securities purchased directly from issuers and persons affiliated with those issuers - and cash.
A Choice of Value
The statutes are incredibly complex, but the process is surprisingly simple. That said, why would any entity choose to be treated as a BDC? Why, in 2004, have a number of tiny over-the-counter companies decided to transform themselves into business development companies and seek comfort within the esoteric provisions of the Investment Advisors Act? Skeptics might conclude that some of those companies seek to avoid scrutiny by disappearing into a morass of obscure securities rules that confound even experienced regulators.
But there are other reasons, and other advantages to life as a BDC including the opportunity to assign value to assets which may bear little relationship to the success or financial condition of the portfolio company.
Remember, the assets of a BDC consist principally at least 70% - of securities of other companies. How are those holdings valued? If there is a public market for securities of the portfolio company, the BDC is entitled to value those securities based upon their market value which may, or may not, reflect the intrinsic value of that company. If the market price of those securities is unduly high, or has been inflated by a rigorous promotional campaign, the balance sheet of the BDC will benefit.
At least there is an objective method for valuing securities of public companies one that investors can verify. When it comes to securities of private companies, valuation is far more subjective. The BDC's Board of Directors determines the "fair value" of those securities on a "good faith basis," except for assets acquired within the most recent quarter, which are valued at cost.
Issuing Shares With EEs
There are, of course, other reasons for a company to become a BDC - most notably, the ease with which it can issue unregistered securities.
Here is where the Securities Act of 1933 comes into play in conjunction with the Investment Company Act. The Securities Act establishes various methods for the registration and issuance of securities, as well as specific registration exemptions. Some methods of registration are far more familiar than others. Investors and securities industry professionals are well acquainted with Form SB-2 (used by small companies to register shares); Form S-1, and other members of the Form S family (employed by larger companies to register stock); and Form S-8 (used, and occasionally abused to register shares for employee benefit plans). And Regulation D provides a commonly known method for exempt offerings, generally as private placements of securities.
Business development companies can avail themselves of a more esoteric provision of the Securities Act Regulation E, which provides an exemption from registration for securities issued by BDCs. In short, under Regulation E, a BDC may issue up to $5 million worth of securities a year without registration. Also under Regulation E, an individual may offer to sell up to $100,000 of securities in a BDC each year.
The implications of this rule are considerable. Although the BDC is required to file a form (called Form 1-E) at least ten days before the offering notifying the SEC that securities are being issued, it does not have to wait for that document to be reviewed before shares can be sold. This stands in sharp contrast to the exhaustive process that precedes the sale of securities registered on Form SB and Form S Registration Statements. In each of those cases the SEC has an opportunity to review the Registration Statement in advance, offer comments, demand clarification and revision, and delay the sale of securities until the Company provides sufficient information.
Here, both the vetting process and the registration have been dispensed with. Instead, the BDC is required to provide investors with an Offering Circular that, among other things, identifies the company, describes its investment policies, details the risks of an investment in the BDC, identifies the directors, officers and individuals controlling the company, and describes the portfolio companies.
The Offering Circular also is required to include financial information about the BDC although seemingly less than that required for a Form SB or Form S offering. In particular, the BDC must provide a balance sheet that is no more than 90 days old and a profit and loss or income statement for the last two years. Only the most recent fiscal year's statement must be certified.
Investors may receive the required Offering Circular, but the general public is likely to remain in the dark about BDC offerings. Form 1-E can be filed with the SEC the old fashioned way, on paper; there is no requirement that it be filed electronically through the Edgar system. Consequently, only the most diligent investors - those who are willing to expend the time and incur any administrative costs are likely to read the notification. Others, who routinely review company filings online through Edgar, will learn that a Form 1-E has been filed, but not know its contents.
As a result, public investors are at a disadvantage. The first wave of investors, those who participate directly in the offering of up to $5 million in securities, receive Offering Circulars, but subsequent buyers do not. In many instances those initial purchasers will be sophisticated investors or company insiders those who are least in need of extensive disclosure documents. Later purchasers, on the other hand, are more likely to be small public customers.
Clearly, it can prove advantageous to operate as a BDC, provided the company is determined to hold 70% of its assets in appropriate investments. What would cause a company to choose this course? As this series continues we will look at companies that decided to go the BDC route and see what they might have in common.
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