SEC Revises BDC Financial Disclosure Rules Related to Acquisitions and Dispositions

Nelson Mullins Riley & Scarborough LLP

Overview

Currently, registered investment companies and business development companies, or BDCs, are required to comply with Rule 3-05 of Regulation S-X in connection with acquisitions of other investment companies and private funds. Rule 3-05 generally requires the acquiror to provide separate audited annual and unaudited interim financial statements of the acquired fund, if the acquisition is significant to the acquiror from an accounting perspective. The number of years of financial information that must be provided depends on the level of significance, as measured by the Rule 1-02(w) significance tests.

On May 20, 2020, the SEC adopted, effective January 1, 2021, amendments to the rules that govern financial disclosures regarding acquisitions and dispositions by investment companies and BDCs. The amendments include, among other changes, an update to the “significant subsidiary” test in Regulation S-X Rule 1-02(w) and a new Regulation S-X Rule 6-11 covering financial reporting for fund acquisitions by investment companies and BDCs. The 267-page adopting release can be found here. While this Securities Alert focuses on the changes most relevant to investment companies and BDCs, the final rule also contains more generally applicable provisions relevant to acquisitions of businesses or real estate operations by all registrants. Our prior Securities Alert on the entire adopting release can be found here. The rule amendments are intended to improve the information investors receive regarding acquired or disposed businesses, reduce complexity and costs of preparing the required disclosures, and facilitate timely access to capital.

Revised “Significant Subsidiary” Definition

When an investment company or BDC registers securities to offer to the security holders of a target fund (such as on a Form N-14 registration statement), Rule 3-05 generally requires financial statements of the to-be-acquired fund without regard to the significance of the acquisition.  In other scenarios, registered investment companies and BDCs are required to use the Rule 1-02(w) significant subsidiary tests when applying Rule 3-05 to determine disclosure obligations. The Rule 1-02(w) tests, however, are not tailored to the operations and accounting of investment companies or BDCs, and they are based on financial measures not commonly reported by these companies. In addition, the Rule 1-02(w) significance tests differ from the definition of “significant subsidiary” provided in Rule 8b-2 under the Investment Company Act of 1940, or the 1940 Act.

To rectify these issues, the amendments add a separate definition of “significant subsidiary” for investment companies and BDCs in Rule 1-02(w)(2) and make changes to Rule 8b-2 to incorporate the new definition. The new definition eliminates the asset test for investment companies and BDCs, and makes them subject to investment company-specific versions of the investment test and income test:

  • Investment Test. A subsidiary is significant if the value of investments in and advances to the business being acquired or disposed of exceeds 10% of the value of the registrant’s total consolidated investments as of the end of the most recently completed fiscal year.
  • Income Test. A subsidiary is significant if the absolute value of the sum of (a) investment company income from dividends, interest and other income, (b) net realized gains and losses on investments and (c) net change in unrealized gains and losses on investments from the business to be acquired or disposed of in the most recently completed fiscal year exceeds:
    • 80% of the absolute value of the change in net assets resulting from operations of the registrant and its consolidated subsidiaries for the most recently completed fiscal year (referred to as Income Test A); or
    • 10% of the absolute value of the change in net assets resulting from operations of the registrant and its consolidated subsidiaries for the most recently completed fiscal year and the investment test described above is satisfied at the 5% level (instead of 10%) (referred to as Income Test B);
      provided that, if the absolute value of the change in net assets resulting from operations of the registrant and its consolidated subsidiaries for the most recently completed fiscal year is at least 10% lower than the average of the absolute value of such amounts for each of its last five fiscal years, the registrant may compute both Income Test A and Income Test B using the average of the absolute value of such amounts for the registrant and its consolidated subsidiaries for each of its last five fiscal years.

The new investment test is similar to the existing investment test but uses a comparison of the value of the registrant’s total investments rather than total assets to focus the significance determination on the impact to the registrant’s investment portfolio. The new income tests seek to better reflect the impact of the acquisition or disposition on an investment portfolio by including net realized gains and losses and the net change in unrealized gains and losses, in addition to investment income.

New Regulation S-X Rule 6-11 – Acquisition Financial Statements for Fund Acquisitions

The amendments also introduce new Regulation S-X Rule 6-11 to specifically cover financial reporting in the event of a fund acquisition. Investment companies and BDCs must use Rule 6-11 instead of Rule 3-05 when a fund acquisition occurs or is probable to occur.[1] The determination of whether a fund has been acquired or will be acquired is evaluated in light of the facts and circumstances involved, including whether an action will result in the acquisition by the registrant of all or substantially all of the portfolio investments held by another fund.

Rule 6-11 requires only a single year of audited financial statements, aligning with the financial reporting obligations under Regulation S-X Rule 3-18, which allows investment companies to file only one year of audited financial statements in registration statements. Investment companies and BDCs are required to file separate financial statements for acquired funds as follows:

  • If neither the Investment Test nor Income Test B is satisfied at the 20% level, financial statements and supplemental information are not required.
  • If either the Investment Test or Income Test B is satisfied at the 20% level, financial statements for the most recent fiscal year and the most recent interim period must be filed, as well as certain supplemental financial information.
  • If the aggregate impact to an investment company or BDC of acquired funds and probable acquisitions causes either significance test to be satisfied at the 50% level, financial statements for the most recent fiscal year and the most recent interim period must be filed for each such fund, as well as certain supplemental financial information.

Separate financial statements of the acquired funds are no longer required once the portfolio investments of the acquired fund have been reflected in the acquiring investment company or BDC’s most recent audited balance sheet.

New Rule 6-11 also allows investment companies and BDCs to provide financial statements for private funds that were prepared in accordance with U.S. GAAP, rather than in accordance with SEC rules (as currently required, and as required for non-private funds). Note, however, that even for private funds the current requirement that the acquiror file Regulation S-X Article 12-compliant schedules for acquired funds continues, requiring each investment to be listed separately.

Pro Forma and Supplemental Financial Information

The amendments remove the requirement for investment companies and BDCs to provide pro forma information in connection with fund acquisitions, and instead new Rule 6-11(d) requires supplemental financial information about the newly combined entity:

  • A pro forma fee table, showing (i) the pre-transaction fee structures of the acquiror and the acquired fund and (ii) 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 reflect such change and accompanied by narrative disclosure describing the change; and
  • Narrative disclosure about material differences in accounting policies of the acquired fund when compared to the acquiror.

This supplemental financial information will be required only in connection with a fund acquisition that triggers the Investment Test or Income Test B at the 20% level.

Form N-14

In addition, the amendments revise Form N-14 so that its disclosure requirements are consistent with the disclosures required by new Rule 6-11.

Effective Date and Transition Provisions

As noted above, the amendments are effective January 1, 2021 and are required to be applied at the beginning of a registrant’s fiscal year beginning after December 31, 2020. Voluntary early compliance is permitted, so long as registrants comply with the amendments in full.

The above is only a summary of some of the changes in the amendments.


[1] The term “fund” includes any investment company as defined in Section 3(a) of the 1940 Act including a BDC, or any company that would be an investment company but for the exclusions provided by Sections 3(c)(1) or 3(c)(7) of the 1940 Act, or any private account managed by an investment adviser.

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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