Non-traded business development companies (BDCs) have long sought the ability to offer and sell multiple classes of shares with different pricing and expense structures. A multi-class structure facilitates the distribution of shares and provides greater investor optionality. Historically, only mutual funds and, with exemptive relief, non-traded continuously offered registered closed-end funds (CEFs) have been able to take advantage of a multi-class structure.
However, for the first time, on February 25, 2020, the Securities and Exchange Commission (the SEC) granted an exemptive order (the Order) to permit a non-traded BDC1 to offer investors multiple classes of shares.
We believe the Order should provide precedent for other non-traded BDCs to seek similar relief. Such relief would put non-traded BDCs on par with competing structures like CEFs, including interval funds, that offer multiple classes of shares.
Why Relief is Necessary
Section 18 of the Investment Company Act of 1940,2 as modified by Section 61(a), prohibits BDCs from issuing multiple classes of equity. For this purpose, a share of stock of a fund is considered to be of a separate “class” if it receives different allocations of fees and expenses or has unequal voting rights compared to other shares of stock of such fund.
Whereas mutual funds are able to rely on the exemption under Rule 18f-3, a CEF that periodically offers to repurchase its shares on a mandatory or discretionary basis must apply for its own exemptive relief to offer multiple classes of shares. In such requests for relief, each CEF argues, among other things, that it is similar to mutual funds in its manner of operations and in the distribution of its shares and would comply with Rule 18f-3 as if it were a mutual fund.
While there is ample precedent for multi-class relief granted to CEFs, until now, the SEC has not granted exemptive relief to non-traded BDCs despite a number of BDCs having applied for such relief over the years.
The key takeaways from the exemptive application include:
- The Applicants requested relief for any current or future continuously offered non-traded BDC for which the Adviser or any entity controlling, controlled by, or under common control with the Adviser acts as an investment adviser and that periodically offers to repurchase its shares pursuant to Rule 13e-4 under the Securities and Exchange Act of 1934 and Section 23(c)(2). The Applicants argued that, by periodically offering to repurchase its shares, any non-traded BDC relying on the Order would provide a degree of liquidity to shareholders like CEFs and similar to, although not as expansive as, mutual funds.
- Similar to prior exemptive orders granted to CEFs, each BDC relying on the Order would comply with Rule 18f-3 as if it were a mutual fund. The Applicants argued that the factors that led the SEC to adopt Rule 18f-3 for mutual funds and grant orders to CEFs are equally applicable to non-traded BDCs. Like mutual funds, non-traded BDCs could offer their shares on a continuous basis through multiple distribution channels and use different fee structures to cover costs of selling shares and to accommodate the particular features of each such distribution channel. Allowing multiple share classes, rather than requiring separate single-class funds, could benefit investors by, among other things, (i) allowing a multiple-class fund to spread expenses over a larger asset base, and (ii) providing greater investor optionality to choose a class of shares that is most beneficial given the amount of his or her purchase, the length of time the investor expects to hold his or her shares and other relevant circumstances.
- Pursuant to the Order, classes of the non-traded BDC can charge distinct front-end sales load, contingent deferred sales charge, early withdrawal charge, and/or an annual asset-based service fee and/or distribution fee, subject to the following:
- If a non-traded BDC relying on the Order charges a distribution fee, such BDC would be required to comply with Rule 12b-1, which includes the adoption of a distribution plan, as if it were a mutual fund. A Rule 12b-1 distribution plan must be approved by a majority of the applicable BDC’s board of directors, including a majority of the directors who are not “interested persons” (as defined in Section 2(a)(9)) of such BDC and who have no direct or indirect financial interest in the operation of such distribution plan or in any agreements related to such distribution plan.
- Unlike mutual funds and CEFs that are required to comply with FINRA Rule 2341, non-traded BDCs are required to comply with FINRA Rule 2310 because non-traded BDCs are considered to be “direct participation programs” by FINRA. FINRA Rule 2310 caps the amount of (i) organization and offering expenses at 15% of gross proceeds, and (ii) all items of compensation from whatever source payable to underwriters, broker-dealers and affiliates thereof at 10.0% of gross proceeds. Therefore, a share that is subject to asset-based service or distribution fees must convert to a class with no asset-based or distribution fees upon such share reaching the applicable sales charge cap determined accordance with FINRA Rule 2310.
We believe that the Order should provide precedent for other non-traded BDCs to seek similar relief. Such exemptive relief would provide non-traded BDCs with the flexibility to create classes with different pricing and expense structures and would provide investors with enhanced investment options. Non-traded BDCs should review their charters to consider if an amendment is necessary to issue multiple classes of shares.