The requirement of the Securities and Exchange Commission (the “SEC”) for registered open-end funds to disclose “acquired fund fees and expenses” (“AFFE”) of other funds they invest in, including business development companies (“BDCs”), is useful to revisit at this time in light of the recent release of the U.S. Department of Labor’s final fiduciary rule (the “DOL final rule”). The DOL final rule, among other things, prohibits a fiduciary providing investment advice to a plan subject to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), from causing the fiduciary or any of its affiliates to receive commission or transaction-based compensation unless there is an available exemption. Investments in BDCs are not a restricted asset class under the DOL final rule, and one available exemption is the “best interest contract exemption” (“BICE”). However, the requirements of the BICE limit its practical benefit for investments in BDCs and will likely result in ERISA plans avoiding such investments, whether directly or indirectly through an index. This in turn will further reduce the level of institutional ownership in BDCs. The decline of institutional ownership in BDCs, which has contributed to the volatility of BDC stocks, can be traced to the establishment of the AFFE requirement (which we describe in more detail below) and was further exacerbated by the removal of BDCs from the Russell 2000 Index in March 2014.

AFFE Requirement -

In June 2006, the SEC adopted amendments to Form N-1A to require any registered open-end fund investing in shares of another fund, including BDCs, to include in its prospectus fee table an additional line item titled “Acquired Fund Fees and Expenses.” Under amended Item 3 of Form N-1A, an acquiring fund must aggregate the amount of total annual fund operating expenses of acquired funds (which are indirectly paid by the acquiring fund) and transaction fees (which are directly paid by the acquiring fund over the past year) and express the total amount as a percentage of average net assets of the acquiring fund. The acquiring fund must determine the average invested balance and number of actual days invested in each acquired fund. The acquiring fund also must include in the expense calculation any transaction fee the acquiring fund paid to acquire or dispose of shares of an acquired fund during the past fiscal year (even if it no longer holds shares of the acquired fund).