In May 2019, the SEC proposed amendments1 to the rules that require BDCs to include (i) certain financial information pertaining to their majority-owned or controlled portfolio companies and (ii) historical and pro forma financial information relating to funds acquired or to be acquired in their SEC filings. The proposed revisions are intended to reduce the complexity and costs for BDC registrants associated with preparing financial disclosure concerning third parties and, accordingly, to facilitate access to capital for BDCs. Importantly, the proposed amendments continue the progress that the SEC has made in recent years in simplifying and updating its disclosure requirements, including financial disclosure requirements contained in Regulation S-X.
Current Rules Relating to Provision of Certain Financial Information for Majority-Owned or Controlled Portfolio Companies
Rules 3-09 and 4-08(g) of Regulation S-X require BDCs to include certain financial information pertaining to their majority-owned or controlled2 portfolio companies in their SEC filings.3 Specifically, Rule 3-09 addresses whether separate financial statements for a BDC’s majority-owned portfolio company should be included in the BDC’s SEC filings, while Rule 4-08(g) describes when summarized annual balance sheet and income statement information must be included in the notes to a BDC’s financial statements for its controlled portfolio companies. Both rules look to the three significance tests set forth in Rule 1-02(w) of Regulation S-X (i.e., the investment test, asset test and income test) to determine whether such financial information is required to be included in a BDC’s SEC filings, except that a 20% threshold trigger applies to Rule 3-09 and a 10% threshold trigger applies to Rule 4-08(g).
Current Rules Relating to the Provision of Historical and Pro Forma Financial Information for Funds Acquired or to Be Acquired
When a BDC acquires a significant business, Rule 3-05 of Regulation S-X requires disclosure of separate audited annual and unaudited interim pre-acquisition financial statements of that business if it is significant to the BDC. Similar to Rules 3-09 and 4-08(g), significance is determined by applying the investment, asset and income tests set forth in Rule 1-02(w) of Regulation S-X.
Article 11 of Regulation S-X provides that BDCs required to file Rule 3-05 historical financial statements of an acquired or to-be-acquired fund in connection with an acquisition transaction are additionally required to file unaudited pro forma financial information relating to such transaction. This pro forma financial information typically includes a pro forma balance sheet and pro forma income statement for the most recently completed fiscal year and the most recently completed stub period based on the historical financial statements of the BDC and the acquired or to-be-acquired fund. The pro forma financial information includes adjustments that are intended to show how the acquisition would have affected the BDC’s financial condition and results of operations during its most recent reporting periods.
Proposed Rule Revisions
The SEC proposes to add new Rule 1-02(w)(2) of Regulation S-X to create a separate set of significance tests applicable to BDCs and other 1940 Act funds (as opposed to the current set of significance tests which are more suitable for operating companies). In particular, new Rule 1-02(w)(2) would eliminate the asset test, given that it is not meaningful for investment companies, and revise the income and investment tests as follows:
- Investment Test: New Rule 1-02(w)(2) would compare whether the value4 of the BDC and its subsidiaries’ investment in and advances to the tested entity exceeds 10%5 of the value of the total investments of the BDC and its consolidated subsidiaries as of the end of the most recently completed fiscal year. The proposed Investment Test is similar to the existing Investment Test but is modified so that the test would compare the fair value of the BDC’s total investments rather than its total assets. The SEC believes that the total investments measure, as proposed, “would be more appropriate for [BDCs and other 1940 Act funds] and more relevant than existing tests, because it would focus the significance determination on the impact to the BDC’s investment portfolio as opposed to other non-investment assets that may be held.”6
- Income Test: New Rule 1-02(w)(2) would compare whether the absolute value of the combined investment income from dividends, interest and other income, net realized gains and losses on investments, and net change in unrealized gains and losses on investments for the tested entity for the most recently completed fiscal year exceeds:
- 80% of the absolute value of the change in net assets resulting from operations of the BDC and its consolidated subsidiaries for the most recently completed fiscal year (“New Income Test”); or
- 10% of the absolute value of the change in net assets resulting from operations of the BDC and its consolidated subsidiaries for the most recently completed fiscal year and the Investment Test proposed under new Rule 1-02(w)(2) exceeds 5% (“Alternate Income Test” and collectively, with the New Income Test, “Proposed Income Tests”). The Proposed Income Tests would use income elements that are actually reported by BDCs and other 1940 Act funds in the statement of operations required by Rule 6-07 of Regulation S-X. In particular, the SEC stated that “including changes in realized and unrealized gains/losses can better reflect the impact of the tested [entity] on an investment portfolio rather than investment income alone, especially if volatility in the value of the investment portfolio is significantly greater than investment income or if there are significant holdings of securities that do not produce investment income.”7 According to the SEC, the proposed threshold changes reflected in the Proposed Income Tests “would reduce the need to produce additional financial information in situations where a registrant’s change in net asset resulting from operations is relatively small and better identify situations of significance in which additional disclosure is warranted.”8 To further mitigate the potential adverse effects of the Proposed Income Tests on BDCs and other 1940 Act funds that have insignificant changes in net assets resulting from operations for the most recently completed fiscal year, the proposed rule would include an instruction that permits BDCs and other 1940 Act funds to compute the Proposed Income Tests using the average of the absolute value of the changes in net assets for the past five fiscal years.
Provision of Historical and Pro Forma Financial Information for Funds Acquired or to Be Acquired
The SEC proposes to adopt new Rule 6-11 of Regulation S-X. This rule would be used by BDCs and other 1940 Act funds in lieu of Rule 3-05 to address financial statements of funds acquired or to be acquired. Proposed Rule 6-11 would apply only to the acquisitions of a fund, including any 1940 Act regulated investment company, Section 3(c)(1) or 3(c)(7) private fund or any private account managed by an investment adviser. To determine whether financial statements of a fund acquired or to be acquired must be provided under proposed Rule 6-11, the conditions specified in the significance test under new Rule 1-02(w)(2) would be applied, using the Investment Test and the Alternate Income Test for BDCs and other 1940 Act funds and substituting 20% for 10% in each place where it appears therein. The New Income Test with the 80% condition would not be used for purposes of proposed Rule 6-11 because the SEC “believe[s], in the acquisition context, significance matters principally with respect to portfolio investments and the amount of assets being acquired, since investment income and realized and unrealized gains/losses from investments acquired will be immediately reflected in the daily net asset value of the registrant.”9
The proposed rule amendment would require only one year of audited financial statements for fund acquisitions, as opposed to the existing Rule 3-05 requirements of between one and three years of audited financial statements. Under new Rule 6-11, any requirement to file financial statements of an acquired fund would cease once an audited balance sheet is filed by the BDC for a date after the date the acquisition was consummated.
New Rule 6-11 would also allow BDCs and other 1940 Act funds to provide financial statements for private funds that were prepared in accordance with U.S. GAAP, as opposed to the current requirement that the financial statements be prepared in accordance with SEC rules. The one exception would be a continuing requirement that BDC and other investment company registrants file schedules for acquired funds that comply with Article 12 of Regulation S-X, which requires each investment to be listed separately.
In addition, the proposed amendments would eliminate the requirement to provide pro forma information for BDCs and other 1940 Act funds in connection with fund acquisitions and replace such information with more relevant disclosures. Specifically, new Rule 6-11(d) of Regulation S-X would require BDCs and other 1940 Act funds to include the following supplemental financial information about the newly combined entity in lieu of the current pro forma financial information requirements:
- A pro forma fee table, setting forth the post-transaction fee structure of the combined entity;
- If the transaction would result in a material change in the acquired fund’s investment portfolio due to investment restrictions, a schedule of investments of the acquired fund modified to show the effects of such change and accompanied by narrative disclosure describing such change; and
- Narrative disclosure about material differences in accounting policies of the acquired fund when compared to the newly combined entity.
The supplemental financial information would be required only in connection with fund acquisitions that trigger the one of the significance tests contained in new Rule 1-02(w) at the 20% level.
The SEC also proposes to amend Form N-14 so that its disclosure requirements are consistent with the disclosures required in new Rule 6-11 of Regulation S-X, including new Rule 6-11(d).
The Proposing Release contains more than 25 questions that solicit comment relating to the BDC and other 1940 Act fund-related amendments. In light of this, we encourage interested parties to express their views of the proposed changes.