In a Guidance Update published on June 30, 2014 by the SEC’s Division of Investment Management, the staff closed a loophole that allowed business development companies (BDCs) with wholly owned Small Business Investment Company (SBIC) subsidiaries to avoid meeting asset coverage requirements when the SBIC subsidiaries issue debt that is not guaranteed by the Small Business Administration (SBA).
Sections 18(a) and 61(a) of the Investment Company Act of 1940 (1940 Act) generally require BDCs to meet asset coverage requirements when they issue “senior securities,” including debt instruments. A BDC may be deemed an indirect issuer of any class of “senior security” issued by its direct or indirect wholly owned SBIC subsidiaries.
The SEC has regularly granted BDCs limited exemptive relief from these asset coverage requirements. The relief allows the BDCs to treat certain indebtedness issued by their wholly owned SBIC subsidiaries as indebtedness not represented by senior securities for purposes of determining the BDC’s consolidated asset coverage. The SEC exemptive orders are, in part, based upon the representation that SBIC subsidiaries are subject to the SBA’s regulation of leverage.
The staff said that it learned that some BDCs have sought to rely on this limited relief in connection with SBICs that have not issued indebtedness that is held or guaranteed by the SBA.
Although in most cases the representations and condition in the orders have not explicitly required that an SBIC subsidiary have issued indebtedness held or guaranteed by the SBA, the staff said that this requirement is implicit in the rationale for the relief because the SBA’s independent oversight of SBIC debt makes the protections of the 1940 Act unnecessary. The staff said that when an SBIC subsidiary issues debt that is not backed by the SBA, the subsidiary is not subject to the full oversight of the SBA, and thus the protections of Section 18(a) are required.
Going forward, the staff will require that BDC applications for relief from the Section 18 asset coverage requirements include a condition providing that:
[A]ny senior securities representing indebtedness of an SBIC Subsidiary will not be considered senior securities and, for purposes of the definition of “asset coverage” in section 18(h), will be treated as indebtedness not represented by senior securities but only if that SBIC Subsidiary has issued indebtedness that is held or guaranteed by the SBA.
We expect that as BDCs grow in popularity and assets, the staff will issue more regulatory guidance for BDCs.