SEC Enforcement Staff Takes Aim at the BDC Space in Two Recent Actions

by Dechert LLP

Dechert LLP

In December 2018, the SEC announced two enforcement actions involving business development companies (BDCs) – one against Fifth Street Management, LLC, the former external registered investment adviser to two BDCs, and the other against KCAP Financial, Inc., an internally managed BDC.1 While the two actions involve wholly separate issues, they do demonstrate the SEC Division of Enforcement staff’s continuing focus on the ever-growing BDC industry and provide some helpful takeaways for BDCs and their advisers. We discuss these two actions and the related takeaways below.

Fifth Street Management, LLC Enforcement Action

This action stems from (i) the improper allocation of expenses by Fifth Street Management to the BDCs then managed by it—Fifth Street Finance Corp. and Fifth Street Senior Floating Rate Corp. (together, the “Fifth Street BDCs”)2 and (ii) failures surrounding Fifth Street Management’s policies and procedures relating to (a) expense allocation; (b) the valuation of two investments held by one of the Fifth Street BDCs; and (c) the misuse of nonpublic information about the Fifth Street BDCs’ portfolio companies.

A. Improper Allocation of Expenses

According to the SEC’s order with Fifth Street Management, Fifth Street Management allocated rent and other overhead expenses relating to its investment professionals and other employees to the Fifth Street BDCs even though the investment advisory agreements with those BDCs provided that Fifth Street Management was responsible for paying “the compensation and routine overhead expenses” of its personnel when and to the extent they were engaged in providing investment advisory services to the Fifth Street BDCs. While Fifth Street Management allocated compensation expenses for only 8 or 9 of its 50+ employees to the Fifth Street BDCs, the order states that Fifth Street Management allocated essentially all the rent and other overhead expenses associated with its employees to the Fifth Street BDCs. In addition, the order notes that Fifth Street Management improperly allocated to the Fifth Street BDCs compensation expenses of two of its employees who assisted in the preparation of the Form S-1 registration statement for the initial public offering of its parent holding company (Fifth Street Asset Management Inc.).

The SEC order repeatedly states that Fifth Street Management had not adopted written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 (the “Advisers Act”) concerning expense allocation at the time of the infractions. Specifically, Section 206(4) of the Advisers Act and Rule 206(4)-7(a) thereunder require investment advisers registered with the SEC to “[a]dopt and implement written policies and procedures reasonably designed to prevent violation” of the Advisers Act and its rules by advisers and their supervised persons.

B. Failure to Implement Certain Procedures in Valuation Process

The order states that two portfolio company investments made by one of the Fifth Street BDCs were overvalued due to repeated failures by certain of Fifth Street Management’s investment professionals to upload the most recently available information about the portfolio companies (including financial reporting packages, budget projections, lender updates and board presentations) to the shared network drive used by the valuation team responsible for preparing the valuation models. In particular, the order cites Section 206(4) of the Advisers Act and Rule 206(4)-7(a) thereunder and finds that Fifth Street Management “failed to adopt and implement written policies and procedures” addressing the duties and responsibilities of Fifth Street Management’s investment professionals in connection with the valuation process. It also states that Fifth Street Management should have provided training to its investment professionals with respect to their duties and responsibilities in the valuation process (including ensuring that the valuation team had the most recent information about each of the portfolio companies) and emphasizes the importance of such duties and responsibilities in the context of the valuation process.

C. Misuse of Nonpublic Information

Finally, the SEC order states that Fifth Street Management’s marketing materials for a hedge fund that it managed indicated that Fifth Street Management would “leverage private company information flow generated through [its] work for . . . other clients” (i.e., the Fifth Street BDCs) in connection with making investment decisions for the hedge fund. The order notes that Section 204A of the Advisers Act requires investment advisers to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material, nonpublic information by the investment adviser or its associated persons, including “using one client’s material, nonpublic information for the benefit of another client.” Although Fifth Street Management had adopted and maintained a written policy on insider trading, the SEC order states that the policy did not address the misuse of material, non-public information that the Advisers Act was designed to prevent.

D. SEC-Imposed Sanctions

The SEC ordered that Fifth Street Management cease and desist from committing or causing any violations and any future violations of the federal securities laws highlighted in the order, censured Fifth Street Management, and required it to pay disgorgement of approximately US$2 million, prejudgment interest of approximately US$335,000, and a civil money penalty of US$1.65 million. 

KCAP Financial, Inc.3 Enforcement Action 

This action partially relates to KCAP’s noncompliance with the requirements of Section 19(a) of the Investment Company Act of 1940 (the “1940 Act”) and Rule 19a-1 thereunder in connection with distributions paid to stockholders from a source other than KCAP’s net income. 

A. Compliance with Section 19(a) of the 1940 Act 

Section 19(a) of the 1940 Act generally prohibits a BDC from paying a dividend from any source other than its current-year or accumulated net income unless the payment is contemporaneously accompanied by a written statement to stockholders that adequately discloses the source or sources of the payment. Rule 19a-1 under the 1940 Act specifies the information required to be disclosed in such written statement, including that such information be presented on a per share basis. The SEC order notes that KCAP “did not send contemporaneous written statements to its shareholders because it mistakenly believed, based at least in part on the advice of counsel, that it could comply with Section 19(a) of the Investment Company Act at year end in connection with the preparation of its tax returns when it was able to determine its taxable income for the full year” and do so through tax Forms 1099 issued to its stockholders via its transfer agent in January of each year. The SEC rejected that approach and emphasized that “KCAP failed to adopt and implement policies and procedures that were reasonably designed to prevent violation of the federal securities laws” in connection with “the way it recorded distributions that it received from” its wholly owned portfolio companies. 

B. SEC-Imposed Sanctions

The SEC did not exact any financial penalty but ordered that KCAP cease and desist from committing or causing any violations and any future violations of the federal securities laws highlighted in the order, including Section 19(a) of the 1940 Act. 

Takeaways for BDCs and Their Advisers

  • A BDC and its adviser may need to devote significant time and resources to ensure compliance with complex and sometimes confusing statutory, regulatory and accounting requirements.
  • The SEC enforcement, examination and disclosure staffs continue to focus on the perennial hot topic items in the BDC space, including valuation of Level 3 investments (within the meaning of Financial Accounting Standards Board Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures) and allocation of expenses by advisers to their BDC clients. The Fifth Street Management enforcement action indicates a renewed focus on whether advisers’ expense allocation practices are consistent with contractual language and public disclosures, particularly where an adviser might inappropriately shift expenses to BDCs.
  • BDCs and their advisers need to provide adequate training to ensure that their employees understand their duties and responsibilities in complying with applicable federal securities laws.
  • In view of the breadth of Section 206(4) of the Advisers Act and Rule 206(4)-7(a) thereunder and Rule 38a-1 under the 1940 Act, any significant aspect of a BDC’s business and/or its adviser’s oversight of such business may need to be included in written policies and procedures.
  • Section 19(a) of the 1940 Act requires a notice to be sent to stockholders if any portion of a distribution is from a source other than net income.
  • Providing stockholders with tax Forms 1099 does not satisfy the contemporaneous disclosure requirement mandated by Section 19(a) of the 1940 Act. Consequently, a BDC needs to make a good-faith effort to determine whether a distribution is from a source other than its current-year or accumulated net income.4 If so, the BDC must comply with Section 19(a) of the 1940 Act and Rule 19a-1 thereunder by contemporaneously sending a written notice to its stockholders disclosing the portion of the distribution from such other source.
  • Because Section 19(a) notices are sent only to stockholders and may be issued prior to any public disclosure with respect thereto, a BDC should take appropriate action to ensure compliance with the requirements of Regulation FD relating to the selective disclosure of material, non-public information.
  • BDCs and asset managers should be aware that the Fifth Street Management and KCAP enforcement actions may indicate a trend towards increased enforcement actions against BDCs and registered investment advisers. In this regard, a report recently released by NYU Pollack Center for Law & Business and Cornerstone Research, Inc. highlights the following trends in SEC Enforcement actions which unfortunately may portend more activity to come in this area for BDCs and the asset management industry in general:
  • For the SEC’s 2018 fiscal year, which ended September 30, 2018, the SEC filed a total of 71 new enforcement actions against public companies, compared to 65 in the 2017 fiscal year; and
  • Approximately 45% of these actions involved broker dealer or investment adviser/investment company allegations.5


1) See Fifth Street Management settlement order and KCAP settlement order.

2) In October 2017, Fifth Street Management effectively sold the rights to become the investment adviser of Fifth Street Finance Corp. and Fifth Street Senior Floating Rate Corp. to Oaktree Capital Management, L.P. for $320 million in cash. Subsequent to the closing of the sale transaction, Fifth Street Finance Corp. changed its name to Oaktree Specialty Lending Corporation and Fifth Street Senior Floating Rate Corp. changed its name to Oaktree Strategic Income Corporation. 

3) On December 17, 2018, KCAP announced that it would seek to convert to an externally managed BDC and be advised by BC Partners.   

4) Rule 19a-1(e) states that “the source or sources from which a dividend is paid shall be determined (or reasonably estimated) to the close of the period.” The SEC allows a BDC to determine the sources of a distribution for purposes of Section 19(a) of the 1940 Act using either GAAP (book) or tax accounting. However, once the BDC selects an accounting methodology in making such determination, it should apply that methodology consistently.

5) See Cornerstone Research & NYU Pollack Center for Law & Business, SEC Enforcement Activity: Public Companies and Subsidiaries - Fiscal Year 2018 Update (2018), available here.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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