64816 Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 

1Pub. L. 96–477, 94 Stat. 2275 (1980) (codified 

at scattered sections of the United States Code).

2See H.R. Rep. No. 1341, 96th Cong., 2d Sess. 21 

(1980) (‘‘House Report’’). An issuer generally may 

qualify for BDC status if it: (1) Is a closed-end 

investment company (i.e., it does not offer for sale 

or have outstanding redeemable securities) that is 

organized and operated in the United States; (2) is 

operated for purposes of investing in securities 

described in paragraphs (1) through (3) of Section 

55(a) of the Investment Company Act [15 U.S.C. 

80a–54(a)]; (3) makes available significant 

managerial assistance to most of its portfolio 

companies; and (4) registers a class of its equity 

securities under Section 12 of the Securities 

Exchange Act of 1934 [15 U.S.C. 78l] (‘‘Securities 

Exchange Act’’). See Section 2(a)(48) of the 

Investment Company Act [15 U.S.C. 80a–2(a)(48)] 

(defining ‘‘business development company’’) and 

Section 54 of the Investment Company Act [15 

U.S.C. 80a–53] (setting forth the requirements for 

election as a BDC). The SBIIA also amended the 

Investment Advisers Act of 1940, the Securities Act 

of 1933, and the Trust Indenture Act of 1939 in 

such a manner as to promote small business capital 

formation.

3House Report at 23.

4For example, unlike with respect to traditional 

closed-end investment companies, the Investment 

Company Act does not prohibit persons that a BDC 

controls or of which the BDC holds at least five 

percent of the outstanding securities (so-called 

downstream affiliates) from engaging in 

transactions with the BDC. See House Report at 48. 

The BDC Amendments also provide some relief 

from the Investment Company Act’s general 

prohibitions against affiliated transactions set forth 

in Section 17 of the Act [15 U.S.C. 80a–17] with 

certain non-controlling affiliates of BDCs. See

Section 57(f) of the Investment Company Act 

[15.U.S.C. 80a–56(f)]. See also House Report at 24 

and 47. In addition, BDCs have greater ability to 

invest in securities and issue debt securities 

because their asset coverage limit for debt is 200% 

(rather than 300%, as required for traditional 

closed-end investment companies); BDCs may offer 

other forms of executive compensation (such as 

stock options, warrants, and rights) in order to 

recruit experienced management; and BDCs have 

greater access to the capital markets because they 

may sell their stock at less than current net asset 

value. See Sections 57(j)(1), 61(a)(1) and (3), and 

63(2) of the Investment Company Act [15 U.S.C. 

80a–56(j)(1), –60(a)(1), –60(a)(3) and –62(2)]. See 

also Reginald L. Thomas and Paul F. Roye, 

Regulation of Business Development Companies 

under the Investment Company Act, 55 S. Cal. L. 

Rev. 895 (1982) (discussing the 1980 amendments 

to the Investment Company Act and regulatory 

issues affecting BDCs). 5House Report at 22.

6These assets include, for example, office 

furniture and equipment, deferred organization and 

operating expenses and notes of indebtedness of 

corporate insiders relating to certain executive 

compensation plans. See Section 55(a)(7) of the 

Investment Company Act. 7Section 55(a) of the Investment Company Act. 

See House Report at 23 (‘‘The restrictions are 

designed to assure that companies electing special 

treatment as [BDCs] are in fact those that [the 

SBIIA] is intended to aid—companies providing 

capital and assistance to small, developing or 

financially troubled businesses that are seeking to 

expand, not passive investors in large, wellestablished businesses.’’).

SECURITIES AND EXCHANGE 

COMMISSION 

17 CFR Part 270 

[Release No. IC–26647; File No. S7–37–04] 

RIN 3235–AJ31 

Definition of Eligible Portfolio 

Company Under the Investment 

Company Act of 1940

AGENCY: Securities and Exchange 

Commission (the ‘‘Commission’’).

ACTION: Proposed rule.

SUMMARY: The Commission is proposing 

for comments two new rules under the 

Investment Company Act of 1940 

(‘‘Investment Company Act’’ or ‘‘Act’’). 

The proposed new rules are designed to 

realign the definition of eligible 

portfolio company set forth under the 

Investment Company Act, and the 

investment activities of business 

development companies (‘‘BDCs’’), with 

the purpose of the Small Business 

Investment Incentive Act of 1980 

(‘‘SBIIA’’). These rules are intended to 

expand the definition of eligible 

portfolio company in a manner that 

would promote the flow of capital to 

small, developing and financially 

troubled companies.

DATES: Comments should be received on 

or before January 7, 2005.

ADDRESSES: Comments may be 

submitted by any of the following 

methods: 

Electronic Comments 

• Use the Commission’s Internet 

comment form (http://www.sec.gov/

rules/proposed); or 

• Send an e-mail to rulecomments@sec.gov. Please include File 

Number S7–37–04 on the subject line; 

or 

• Use the Federal eRulemaking Portal 

(http://www.regulations.gov). Follow the 

instructions for submitting comments. 

Paper Comments 

• Send paper comments in triplicate 

to Jonathan G. Katz, Secretary, 

Securities and Exchange Commission, 

450 Fifth Street, NW., Washington, DC 

20549–0609. 

All submissions should refer to File 

Number S7–37–04. This file number 

should be included on the subject line 

if e-mail is used. To help us process and 

review your comments more efficiently, 

please use only one method. The 

Commission will post all comments on 

the Commission’s Internet Web site 

(http://www.sec.gov/rules/proposed). 

Comments are also available for public 

inspection and copying in the 

Commission’s Public Reference Room, 

450 Fifth Street, NW., Washington, DC 

20549. All comments received will be 

posted without change; we do not edit 

personal identifying information from 

submissions. You should submit only 

information that you wish to make 

available publicly.

FOR FURTHER INFORMATION CONTACT:

Rochelle Kauffman Plesset, Senior 

Counsel, or Elizabeth G. Osterman, 

Assistant Chief Counsel, Office of Chief 

Counsel, (202) 942–0660, Division of 

Investment Management, Securities and 

Exchange Commission, 450 Fifth Street, 

NW., Washington, DC 20549–0506.

SUPPLEMENTARY INFORMATION: The 

Commission today is requesting public 

comment on proposed new Rule 2a–46 

[17 CFR 270.2a–46] and proposed new 

Rule 55a–1 [17 CFR 270.55a–1], both 

under the Investment Company Act [15 

U.S.C. 80a].

Table of Contents 

I. Background 

II. Discussion 

A. Proposed Rule 2a–46 

1. No Securities Listed on an Exchange or 

on NASDAQ 

2. Financially Troubled Companies 

B. Proposed Rule 55a–1 

III. General Request for Comment 

IV. Cost-Benefit Analysis 

V. Consideration of Promotion of Efficiency, 

Competition, and Capital Formation 

VI. Paperwork Reduction Act 

VII. Initial Regulatory Flexibility Analysis 

VIII. Statutory Authority

I. Background 

In 1980, Congress enacted the SBIIA,1

which, among other things, amended 

the Investment Company Act to 

establish BDCs as a new type of closedend investment company.2 Importantly, 

Congress emphasized that the primary 

purpose of the amendments to the 

Investment Company Act (the ‘‘BDC 

Amendments’’) was to make capital 

more readily available to small 

developing and financially troubled 

businesses.3 To accomplish this 

purpose, the BDC Amendments relieved 

BDCs from the application of some of 

the restrictions applicable to registered 

closed-end investment companies under 

the Investment Company Act, while also 

retaining important investor 

protections.4

In amending the Investment Company 

Act, Congress underscored that the new 

provisions would apply only to BDCs 

that are operated for the purpose of 

investing in the securities of certain 

issuers and that make available 

significant managerial assistance to 

those issuers.5 Accordingly, Section 

55(a) of the Investment Company Act 

generally prohibits a BDC from making 

any investment unless, at the time of the 

investment, at least 70 percent of its 

total assets (other than certain specified 

non-investment assets 6) are invested in 

securities of certain specified issuers 

(‘‘70% basket’’).7 Among other things, 

Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 64817

8Section 55(a)(1) of the Investment Company Act.

9See Section 55(a)(2) of the Investment Company 

Act, referring to Section 2(a)(46)(C)(ii) of the Act [15 

U.S.C. 80a–2(a)(46)(C)(ii)], which generally includes 

in the definition of eligible portfolio company an 

issuer of which the BDC (either alone, or as part of 

a group acting together) owns a controlling interest.

10Section 55(a)(3) of the Investment Company 

Act. In addition, a BDC generally may purchase the 

securities of an eligible portfolio company from any 

person in a non-public offering if there is no ready 

market for the securities and, immediately before 

the purchase, the BDC owns at least 60% of the 

issuer’s outstanding equity securities. Section 

55(a)(4) of the Investment Company Act. BDCs may 

also invest in securities received in exchange for, 

or distributed on or with respect to, the securities 

described in paragraphs (a)(1) through (a)(4) of 

Section 55(a) or pursuant to the exercise of options, 

warrants or other rights relating to these securities 

and in cash and certain short-term securities. 

Sections 55(a)(5) and (6) of the Investment 

Company Act.

11House Report at 39–40 (‘‘One such purpose 

would be to allow an investment * * * in a 

publicly-held company whose success may be 

stimulated or revived by the infusion of new capital 

or managerial assistance * * *. A second purpose 

might be to recognize the need for [BDCs] * * * to 

have a source of cash flow to fund current 

operations or to meet contingencies which may 

arise.’’).

12Section 3 of the Investment Company Act [15 

U.S.C. 80a–3].

13Sections 2(a)(46)(A) and 2(a)(46)(B) of the 

Investment Company Act. Section 2(a)(46)(B) also 

includes as an eligible portfolio company a small 

BDC which is licensed by the Small Business 

Administration and which is a wholly-owned 

subsidiary of a BDC.

14See House Report at 29.

15Section 2(a)(46)(C)(i) of the Investment 

Company Act. Section 2(a)(46)(C)(ii) includes in the 

definition of eligible portfolio company an issuer in 

which the BDC or certain affiliates own a 

controlling interest. See supra note 9. In addition, 

in 1996, Congress expanded the definition of 

eligible portfolio company to include issuers that 

have total assets of not more than $4 million, and 

capital and surplus (shareholder equity minus 

retained earnings) of no less than $2 million. 

Section 2(a)(46)(C)(iii) of the Investment Company 

Act. A BDC is not required to make available 

significant managerial assistance to any issuer that 

meets the requirements of Section 2(a)(46)(C)(iii). 

Section 2(a)(48)(B) of the Investment Company Act.

16House Report at 30.

17See House Report at 30–31 (Section 

2(a)(46)(C)(i) was ‘‘intended to include companies 

which are unable to borrow money through 

conventional sources or which do not have ready 

access to the public capital markets.’’).

18Under Section 2(a)(46)(C)(iv), the term eligible 

portfolio company includes any issuer that, in 

addition to meeting the requirements of Sections 

2(a)(46)(A) and (B), ‘‘meets such other criteria as the 

Commission may, by rule, establish as consistent 

with the public interest, the protection of investors, 

and the purposes fairly intended by the policy and 

provisions of the [Act].’’ See House Report at 23

(‘‘* * * the Commission is given rulemaking 

authority to expand the class of eligible portfolio 

companies, following certain specified standards’’). 

See also House Report at 31 (discussing the 

expectation that ‘‘the Commission would institute 

proceedings to consider whether the definition of 

eligible portfolio company can be expanded, 

consistent with the purpose of the legislation, to 

increase the flow of capital to small, developing 

businesses or financially troubled businesses. 

Among the objective factors which the Commission 

may consider in such proceedings are the size of 

such companies, the extent of their public 

ownership, and their operating history as going 

concerns and public companies.’’). In addition, 

Section 38(a) of the Investment Company Act [15 

U.S.C. 80a–37(a)] authorizes the Commission to, 

among other things, adopt such rules as are 

necessary to define technical terms used in the 

Investment Company Act.

19Securities Credit Transactions; Borrowing By 

Brokers and Dealers, 63 FR 2805 (1998) (adopting 

final rule amendment).

20 12 CFR 220.2 (definition of margin security). 

Before the 1998 amendment, certain securities that 

were listed on NASDAQ’s SmallCap Market were 

not considered to be margin securities. As such, the 

issuers of such securities could be treated as eligible 

portfolio companies for purposes of BDC 

investment.

21Section 3(a)(11) of the Securities Exchange Act 

[15 U.S.C. 78c(a)(11)]. That section defines an 

‘‘equity security’’ as any stock or similar security; 

or any security future on any such security; or any 

security convertible, with or without consideration, 

into such a security, or carrying any warrant or right 

to subscribe to or purchase such a security; or any 

such warrant or right; or any other security which 

the Commission shall deem to be of similar nature 

and consider necessary or appropriate, by such 

rules and regulations as it may prescribe in the 

public interest or for the protection of investors, to 

treat as an equity security.

the 70% basket may include securities 

of eligible portfolio companies, as 

defined in Section 2(a)(46) of the 

Investment Company Act, purchased in 

transactions not involving any public 

offering,8 securities of eligible portfolio 

companies, as defined in Section 

2(a)(46)(C)(ii), without regard to the 

nature of the offering,9 and securities of 

financially troubled issuers purchased 

in transactions not involving any public 

offering.10 At the same time, Congress 

allowed BDCs to invest in certain other 

assets that would not count toward the 

70% basket (‘‘30% basket’’). Congress 

clarified, however, that a BDC would be 

required to invest its 30% basket 

consistent with the overall purpose of 

the SBIIA.11

Eligible portfolio company is defined 

in Section 2(a)(46) of the Investment 

Company Act to include any issuer that 

(1) is organized under the laws of, and 

has its principal business in, the United 

States and (2) generally does not meet 

the definition of an investment 

company under Section 3 of the 

Investment Company Act 12 or is 

excluded from the definition of 

investment company by Section 3(c) of 

that Act.13 These provisions are 

intended to ensure that BDCs will invest 

most of their assets in domestic 

operating issuers.14 In addition to these 

requirements, an eligible portfolio 

company must meet one of the criteria 

set forth in Section 2(a)(46)(C). Many 

BDCs invest in issuers that historically 

met the criteria set forth in Section 

2(a)(46)(C)(i).15

Under Section 2(a)(46)(C)(i), an 

eligible portfolio company includes any 

issuer that does not have any class of 

securities with respect to which a 

member of a national securities 

exchange, broker, or dealer may extend 

margin credit pursuant to the rules or 

regulations adopted by the Federal 

Reserve Board under Section 7 of the 

Securities Exchange Act. This provision 

generally reflects Congress’s view in 

1980 that the issuers of margin 

securities ‘‘generally are reasonably 

mature, at least from the standpoint that 

they generally have access to 

conventional public capital markets,’’ 16

and that the Federal Reserve Board’s 

definition of ‘‘margin security’’ would 

serve ‘‘as a rational and objective test for 

determining whether a issuer has ready 

access to the securities markets.’’ 17

Nevertheless, Congress recognized that 

the definition of eligible portfolio 

company as adopted, and, in particular, 

the definition’s reliance on the Federal 

Reserve Board’s margin rules, might 

need to be adjusted in the future. 

Accordingly, Congress specifically gave 

the Commission rulemaking authority 

under Section 2(a)(46)(C)(iv) of the 

Investment Company Act to expand the 

definition of eligible portfolio 

company.18

Since 1980, the Federal Reserve Board 

has periodically amended its definition 

of margin security under Regulation T, 

the regulation governing the securities 

credit activities of broker-dealers, for 

reasons unrelated to small business 

capital formation. In 1998, the Federal 

Reserve Board amended the definition 

of margin security to reduce regulatory 

distinctions between broker-dealers and 

other lenders.19 This amendment had 

the unintended consequence of limiting 

the investment opportunities of BDCs by 

expanding the definition of margin 

security to include all securities that 

trade on a national securities exchange 

(‘‘Exchange’’) or are listed on the 

NASDAQ Stock Market (both 

NASDAQ’s National Market System and 

the NASDAQ’s SmallCap Market).20

More significantly, however, the 1998 

amendment also expanded the 

definition of margin security to include 

any security, regardless of whether it is 

publicly or privately offered, that is not 

an ‘‘equity security’’ within the meaning 

of Section 3(a)(11) of the Securities 

Exchange Act.21 Thus, because the 

definition of eligible portfolio company 

is linked, in part, to the Federal Reserve 

Board’s margin rules, the 1998 

amendment appears to have had the 

effect of precluding most issuers that 

have issued debt securities from 

qualifying as an eligible portfolio 

64818 Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 

22Convertible debt falls within the definition of 

margin security if the security received upon the 

conversion is marginable. See id.

23 It is difficult to quantify how many issuers may 

no longer meet the definition of eligible portfolio 

company as a result of the changes to the margin 

rules, as minimal information is available regarding 

which issuers have privately issued debt securities. 

Some industry participants, however, have 

informed us that, subsequent to the 1998 

amendment, investments that previously were 

counted as part of a BDC’s 70% basket were more 

likely to be required to be counted as part of the 

30% basket.

24See supra note 18.

25See supra notes 12–14 and accompanying text.

26See proposed Rule 2a–46(a).

27See proposed Rule 2a–46(b).

28Under this provision, an issuer would be an 

eligible portfolio company if it does not have a class 

of securities listed on any of the New York Stock 

Exchange (‘‘NYSE’’), the American Stock Exchange 

(‘‘Amex’’), the NASDAQ National Market System or 

the NASDAQ SmallCap Market.

29See supra note 17.

30An issuer is eligible to list its securities on an 

Exchange or on NASDAQ if it, among other things, 

complies with initial quantitative listing standards. 

These include minimum financial requirements 

relating to, among other things, the issuer’s total 

revenues, distribution, market capitalization and 

bid price. Listing standards serve to facilitate fair 

and orderly markets by screening issuers and 

providing listed status only to bona fide companies 

with sufficient float, investor base and trading 

interest. Once a security has been approved for 

initial listing, maintenance criteria allow an 

Exchange or NASDAQ to monitor the status and 

trading characteristics of that issue to ensure that 

it continues to meet the Exchange’s or NASDAQ’s 

standards for market depth and liquidity. Securities 

Act Release No. 7494 (Jan. 13, 1998) [63 FR 3032 

(Jan. 21, 1998)]. Listing on an Exchange or on 

NASDAQ generally provides an issuer with 

visibility, marketability, third party established 

valuations and liquidity, all of which aid in capital 

formation.

31For example, issuers with securities traded 

solely through these quotation mediums do not 

have the same visibility and marketability benefits 

as issuers with securities listed on an Exchange or 

on NASDAQ. Few analysts cover these issuers and 

many databases do not include price and quotation 

data for their securities, making it difficult for 

investors to obtain information about them. Further, 

as a general matter, many of the securities trading 

on these markets are penny stocks, which are 

subject to heightened sales practice requirements. 

Section 3(a)(51) of the Securities Exchange Act [15 

U.S.C. 78c(a)(51)] and Rule 3a51–1 thereunder [17 

CFR 240.3a51–1] generally define ‘‘penny stocks’’

as equity securities that are not: (a) Reported 

securities as defined in Rule 11Aa3–1(a) under the 

Securities Exchange Act [17 CFR 240.11Aa3–1(a)]; 

(b) securities issued by an investment company 

registered under the Investment Company Act; (c) 

put or call options issued by the Options Clearing 

Corporation; (d) securities that have a price of five 

dollars or more; (e) securities that are registered or 

approved for registration upon notice of issuance on 

company.22 As a result, issuers that 

would have been considered eligible 

portfolio companies in 1980 may no 

longer meet that definition.23 Rules 

adopted and amended by the Federal 

Reserve Board for reasons unrelated to 

small business development therefore 

have resulted in reducing the number of 

businesses eligible for BDC investment. 

Congress clearly intended us to exercise 

our rulemaking authority under Section 

2(a)(46)(C)(iv) when necessary to 

accomplish the purposes and policies of 

the SBIIA.24 Thus, we are today 

proposing two rules that will realign the 

definition of eligible portfolio company, 

and the investment activities of BDCs, 

with the purpose intended by Congress 

when it enacted the SBIIA.

II. Discussion

The new rules that we propose today 

address the effect that the amendment to 

the margin rules had on the definition 

of eligible portfolio company under the 

Investment Company Act. The new 

rules are intended to realign the 

definition of eligible portfolio company 

with the purpose of the SBIIA by (1) 

defining eligible portfolio company with 

reference to whether an issuer has any 

class of securities listed on an Exchange 

or on an automated interdealer 

quotation system of a national securities 

association (‘‘NASDAQ’’) and (2) 

permitting BDCs to make certain 

additional (‘‘follow-on’’) investments in 

those issuers even after they list their 

securities on an Exchange or on 

NASDAQ. 

Proposed Rule 2a–46 would 

modernize the definition of eligible 

portfolio company by creating a new, 

objective standard. The proposed rule is 

intended to recapture the type of issuers 

that Congress originally intended to 

make eligible for BDC investment as 

part of a BDC’s 70% basket, i.e., those 

issuers that do not have ready access to 

the public capital markets, but that may 

have lost their status as eligible portfolio 

companies because they have issued 

marginable securities. The proposed 

rule also would include certain 

financially troubled issuers that would 

not have been eligible portfolio 

companies before the 1998 amendment 

to the margin rules because they likely 

had a class of marginable securities 

outstanding. 

Proposed Rule 55a–1 conditionally 

would permit a BDC to include in its 

70% basket follow-on investments in an 

issuer that met the definition of eligible 

portfolio company under proposed Rule 

2a–46 at the time of the BDC’s initial 

investment(s) in it, but that 

subsequently lost its eligible portfolio 

company status because it listed a class 

of securities on an Exchange or on 

NASDAQ. The proposed rule 

incorporates the conditions set forth in 

Section 55(a)(1)(B), which permit a BDC 

to make follow-on investments in an 

issuer that was an eligible portfolio 

company at the time of the BDC’s initial 

investment(s), but that subsequently lost 

its eligible portfolio company status 

because it issued marginable securities. 

The proposed rules and their 

provisions are discussed in more detail 

below. 

A. Proposed Rule 2a–46 

Proposed Rule 2a–46 incorporates the 

requirements set forth in Sections 

2(a)(46)(A) and (B) of the Investment 

Company Act. The proposed rule thus 

requires an eligible portfolio company, 

as defined under the rule, to be 

organized under the laws of, and have 

its principal business in, the United 

States. It also generally excludes from 

the definition any issuer that meets the 

definition of an investment company 

under Section 3(a) of the Investment 

Company Act or that is excluded from 

the definition of investment company 

by Section 3(c) of that Act. These 

requirements are intended to ensure that 

BDCs relying on the proposed rule will 

continue to invest most of their assets in 

domestic operating issuers.25

The proposed rule would further 

define eligible portfolio company to 

include either (1) any issuer that does 

not have any class of securities listed on 

an Exchange or on NASDAQ 26 or (2) 

any issuer that has a class of securities 

listed on an Exchange or on NASDAQ, 

but (a) that has received notice from the 

Exchange or NASDAQ that it does not 

meet the quantitative continued listing 

standards of the Exchange or NASDAQ 

and (b) does not satisfy the initial 

quantitative requirements for listing a 

class of its securities on any Exchange 

or NASDAQ.27

These provisions are further 

discussed below.

1. No Securities Listed on an Exchange 

or on NASDAQ 

Paragraph (a) of proposed Rule 2a–46 

links the definition of eligible portfolio 

company to whether an issuer has a 

class of securities listed on an Exchange 

or on NASDAQ.28 As noted previously, 

Congress intended eligible portfolio 

companies to include those issuers that 

‘‘are unable to borrow through 

conventional sources or which do not 

have ready access to the public capital 

markets.’’ 29 We generally believe that 

most issuers that are able to list their 

securities on an Exchange or on 

NASDAQ have access to the public 

capital markets.30

In contrast, quotation mediums, such 

as the over-the-counter bulletin board 

(‘‘OTCBB’’) and Pink Sheets LLC (‘‘Pink 

Sheets’’), do not provide the capital 

formation benefits that an Exchange or 

NASDAQ offers to its members,31 but 

Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 64819

an Exchange; (f) securities that are authorized or 

approved for authorization upon notice of issuance 

on NASDAQ; or (g) securities issued by companies 

that have net tangible assets or average annual 

revenues exceeding certain specified minimums. 

Solicited sales of penny stocks are subject to, among 

other things, enhanced suitability and disclosure 

obligations. See Rules 15g–1 through 15g–9 under 

the Securities Exchange Act [17 CFR 240.15g–1—

240.15g–9], collectively known as the ‘‘Penny Stock 

Rule.’’

32 In order for a security to be eligible for 

quotation on the OTCBB, however, its issuer must 

either make current filings with the Commission 

pursuant to Sections 13 and 15(d) of the Securities 

Exchange Act [15 U.S.C. 78m, 78o(d)], be a 

depository institution that is exempt from 

Securities Exchange Act filing requirements but file 

publicly available reports with the appropriate 

regulatory agency, be a registered closed-end 

investment company or be an insurance company 

that is exempt from registration under Section 

12(g)(2)(G) of the Securities Exchange Act [15 

U.S.C. 78l(g)(12)G)]. There are no such 

requirements with respect to issuers of securities 

quoted on the Pink Sheets.

33We recognize that, although many of the 

securities that are traded on the OTCBB or the Pink 

Sheets are small or financially troubled companies, 

there are a few, large, financially sound companies 

that have chosen not be listed on an Exchange or 

on NASDAQ, even though they may meet 

applicable listing requirements.

34H.R. 3170, 108th Cong. 1st Sess. (2003) (passed 

in the House of Representatives, Apr. 28, 2004) 

embodies such an approach.

35For example, for purposes of its compliance 

with the Regulatory Flexibility Act [5 U.S.C. 601 et 

seq.], and the Securities Exchange Act, the 

Commission has classified a securities issuer (other 

than an investment company) as a small business 

if it has total assets of $5 million or less. See Rule 

0.0–10(a) under the Securities Exchange Act [17 

CFR 240.0–10a]. Regulation S–B under the 

Securities Act of 1933 and the Securities Exchange 

Act defines a ‘‘small business issuer’’ as, among 

other things, an issuer that has revenues of less than 

$25 million, but would not include an issuer that 

has public float of $25 million or more. Rule 10 of 

Regulation S–B [17 CFR 228.10].

36See supra note 4.

37Certain investment companies make 

investments similar to those of BDCs in that they 

also purchase privately offered securities of small 

issuers. It is possible that defining eligible portfolio 

company using a market capitalization standard 

would result in investment companies deciding to 

elect BDC status based on the level of regulation 

under the Investment Company Act, instead of 

based on their investment objectives and the best 

interests of their shareholders.

serve as mediums for the over-thecounter securities market by collecting 

and distributing market maker quotes to 

subscribers. These quotation mediums 

do not maintain or impose listing 

standards or enter into listing 

agreements with issuers whose 

securities are quoted through them.32

Moreover, most issuers that rely on 

these mediums for the trading of their 

securities do not meet the listing 

requirements of an Exchange or 

NASDAQ.33 Thus, we believe that the 

proposed rule, which essentially 

includes in the definition of eligible 

portfolio company issuers that do not 

list their securities on an Exchange or 

on NASDAQ, is a rational, objective and 

workable test for determining whether 

an issuer is an eligible portfolio 

company, consistent with Congress’s 

intent when it enacted the SBIIA.

We considered a variety of alternative 

approaches in proposing a standard that 

would capture the type of issuers that 

Congress intended to benefit from the 

SBIIA (i.e., small, developing businesses 

or financially troubled businesses). In 

particular, we considered an approach 

based on market capitalization.34

It is unclear, however, what level of 

market capitalization would be 

appropriate to set as a measure of small, 

developing or financially troubled 

businesses. ‘‘Small business’’ is used to 

mean different things in different 

contexts.35 Further, issuers that are near 

a specified cutoff level may be able to 

adjust their capital structure so that they 

fall below the specified level. In 

addition, given that an issuer’s market 

capitalization fluctuates depending on 

various market and economic 

conditions, issuers near the cutoff may 

find their eligibility changing frequently 

over time. Finally, it is possible that 

defining eligible portfolio company 

using a market capitalization standard 

could result in some registered 

investment companies electing BDC 

status to take advantage of the less 

restrictive provisions of the Investment 

Company Act generally applicable to 

BDCs.36 Although we would not 

necessarily object to such a result, we 

would need to engage in additional 

study before we could conclude that 

such regulatory arbitrage would be 

appropriate.37

We request comment on our proposal 

to link the definition of eligible portfolio 

company to whether an issuer has a 

class of securities listed on an Exchange 

or on NASDAQ and, in particular, the 

following issues:

• Does our approach adequately 

describe issuers that meet the purpose 

of the SBIIA, i.e., small, developing or 

financially troubled businesses that do 

not have ready access to the public 

capital markets? Is there an alternative 

approach that would (1) better describe 

those issuers and (2) be more objective 

and workable than our proposal? For 

example, would linking the definition of 

eligible portfolio company to whether 

an issuer has market capitalization 

equal to the lowest initial quantitative 

listing standard of any Exchange or 

NASDAQ, regardless of whether it lists 

its securities on an Exchange or on 

NASDAQ, more appropriately describe 

the category of issuers that Congress 

intended to capture in 1980? Is there 

enough public information available so 

that BDCs may readily ascertain 

whether an issuer is an eligible portfolio 

company under such an alternative 

approach? Please include in your 

response a detailed description of any 

alternative approach that you may 

propose and an explanation of its 

benefits compared with our proposal. 

• What is the likelihood that 

registered investment companies would 

determine to elect BDC status if the 

definition of eligible portfolio company 

was linked to an issuer’s market 

capitalization? Are there investment 

companies that could easily reorganize 

themselves as BDCs to take advantage of 

a rule that defines eligible portfolio 

company based on market 

capitalization? Among other things, 

please provide information about the 

composition of the portfolios of 

registered investment companies that 

might determine to elect BDC status if 

we adopted a market capitalization test 

(e.g., what percentage of such 

companies’ portfolios consists of issuers 

that would meet the proposed rule’s 

definition of eligible portfolio company) 

and whether those investment 

companies would be in a position to 

make significant managerial experience 

available to issuers. 

• We recognize that, before the 1998 

amendment to the margin rules, Section 

2(a)(46)(C)(i) would have included in 

the definition of eligible portfolio 

company certain large, financially 

healthy issuers that had ready access to 

capital, but that did not have any class 

of marginable securities outstanding. 

Our proposed rules similarly would 

permit BDCs to invest in certain large, 

financially healthy issuers that choose 

not to list their securities on an 

Exchange or on NASDAQ. Please 

comment on whether we should modify 

proposed Rule 2a–46 to exclude from 

the definition of eligible portfolio 

company any issuer that would meet the 

initial listing standards (quantitative 

and qualitative) of an Exchange or 

NASDAQ, regardless of whether the 

issuer enters a listing agreement with 

the Exchange or NASDAQ. 

2. Financially Troubled Companies 

Paragraph (b) of the proposed rule 

would include in the definition of 

eligible portfolio company any issuer 

that has a class of securities listed on an 

Exchange or on NASDAQ subject to two 

conditions discussed below. In 

comparison to proposed paragraph (a), 

which includes as an eligible portfolio 

company only issuers that either have 

never had, or no longer have, a class of 

securities listed on an Exchange or on 

NASDAQ, proposed paragraph (b) is 

intended to include certain issuers that 

exhibit financial distress while their 

64820 Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 

38Absent this provision, a BDC could invest in 

such issuers, but that investment would be counted 

as part of the BDC’s 30% basket. See supra notes 

5–11 and accompanying text.

39Section 55(a)(3) permits a BDC to count in its 

70% basket securities of an issuer purchased from 

the issuer or certain affiliates of the issuer in 

specific situations demonstrating financial distress, 

including bankruptcy proceedings.

40The Exchanges and NASDAQ all have 

quantitative continued listing requirements with 

which an issuer must comply in order for its 

securities to remain listed. The quantitative 

continued listing requirements are lower than the 

quantitative initial listing requirements. Although 

actual procedures differ among the Exchanges and 

NASDAQ, as a general matter, all send a deficiency 

notice to a listed issuer upon detecting 

noncompliance with quantitative listing 

requirements, and the issuer typically is given a 

grace period—the amount dependent on the 

requirement in noncompliance—to rectify the 

situation before delisting proceedings begin. 

The Exchanges and NASDAQ also have 

qualitative standards that an issuer must meet to list 

its securities. These standards include certain 

corporate governance and shareholder voting 

requirements, and require that the issuer’s 

securities be registered with the Commission under 

Section 12(g) of the Securities Exchange Act. An 

issuer that is subject to delisting because the issuer 

did not comply with these standards would not be 

treated as an eligible portfolio company under the 

proposed rule. But see infra text accompanying note 

44.

41While we cannot quantify how many additional 

companies would be treated as eligible portfolio 

companies by virtue of meeting the requirements of 

proposed paragraph (b)(i), we note that the 

percentage of issuers that ultimately were delisted 

as of December 31, 2003, after trading while 

noncompliant with their markets’ quantitative 

standard at any time during calendar year 2003 was 

as follows: Amex—43% (40/94); NYSE—59% (40/

68) and NASDAQ—31% (191/617). According to 

NASDAQ, 486 of the 617 noncompliant issuers 

(79%) were noncompliant with standards related to 

bid price. GAO Report: Securities Markets—

Opportunities Exist to Enhance Investor Confidence 

and Improve Listing Program Oversight (April 

2004), available at www.gao.gov/cgi-bin/

getrpt?GAO–04–75 at 19.

42Economic studies have shown that companies 

whose shares are delisted face potentially higher 

costs of capital and operating costs and greater 

difficulty in obtaining financing due to the loss of 

suppliers, customers, employees, analyst coverage, 

institutional investor interest and business 

development opportunities. Shareholders suffer 

because the value of their securities typically 

declines and they may face significantly higher 

trading costs. See, e.g., Ventagesh Panchapagesan 

and Ingrid M. Werner, From Pink Slips to Pink 

Sheets: Market Quality Around Delisting From 

NASDAQ, available at http://papers.ssrn.com/sol3/

papers.cfm?abstract_id=565325, at pp. 3, 9, and 23.

43See, e.g., Section 802.02 of the NYSE Listed 

Company Manual, and Section 1009 of Amex 

Company Guide, which provide up to 18 months 

for an issuer to regain compliance with continued 

listing standards if the Exchange accepts the 

issuer’s plan for regaining compliance.

securities are listed on an Exchange or 

on NASDAQ.

Paragraph (b) of the proposed rule is 

consistent with Congress’s intent of 

providing financially troubled issuers 

with a more readily available source of 

capital.38 Although Section 55(a)(3) of 

the Investment Company Act generally 

permits BDCs to invest in certain issuers 

that are experiencing financial 

difficulties, those issuers generally must 

be in dire financial straits before BDC 

capital will be readily available to 

them.39 Paragraph (b) of the proposed 

rule addresses the need of other 

financially troubled issuers to access 

BDC capital more readily by including 

in the definition of eligible portfolio 

company certain issuers that are in 

danger of losing their listing status.

Paragraph (b) of the proposed rule is 

subject to two conditions. These 

conditions are designed to ensure that 

only an issuer that is at risk of having 

its securities delisted from the Exchange 

or NASDAQ, and that cannot list its 

securities on any other Exchange or on 

NASDAQ because of its inability to 

meet initial quantitative listing 

standards, falls within the definition of 

eligible portfolio company. 

Paragraph (b)(1) of the proposed rule 

provides that an issuer that has 

securities listed on an Exchange or on 

NASDAQ will meet the definition of 

eligible portfolio company if the issuer 

has received a notice from the Exchange 

or NASDAQ that it does not satisfy a 

rule or standard setting forth 

quantitative requirements for continued 

listing 40 on that Exchange or on 

NASDAQ. We have determined that an 

issuer’s receipt of such a notice is an 

early indication that an issuer is 

experiencing some degree of financial 

distress. Every year issuers are forced to 

delist their securities because they can 

no longer satisfy the minimum 

quantitative requirements for the 

continued listing of their securities.41

Delisting is highly detrimental to an 

issuer and its shareholders.42 We have 

therefore designed the proposed rule to 

permit BDCs to provide capital to 

issuers at risk of losing their listing 

status as evidenced by the issuer’s 

receipt of a notice from an Exchange or 

NASDAQ stating that the issuer does 

not meet relevant continued 

quantitative listing requirements on that 

Exchange or NASDAQ.

Paragraph (b)(2) of the proposed rule 

would exclude from the definition of 

eligible portfolio company an issuer that 

otherwise meets the conditions of 

paragraph (b)(1) of the proposed rule if 

that issuer meets the initial quantitative 

listing requirements of any Exchange or 

NASDAQ. An issuer that is able to meet 

the initial quantitative listing 

requirements of an Exchange or 

NASDAQ, which generally are higher 

than the continued listing requirements, 

is not the type of issuer that Congress 

intended to aid through the 

establishment of BDCs. Thus, proposed 

paragraph (b)(2) is designed to preclude 

an issuer from qualifying as an eligible 

portfolio company if it is able to list its 

securities on one of those markets, even 

though its securities are delisted from 

another. 

We request comment on our proposal 

to define as an eligible portfolio 

company an issuer whose securities are 

listed on an Exchange or on NASDAQ 

but that (1) has received a notice from 

the Exchange or NASDAQ that it does 

not satisfy the continued quantitative 

listing requirements of that Exchange or 

NASDAQ and (2) does not meet the 

initial quantitative listing standards on 

any Exchange or NASDAQ. In 

particular, we request comment on the 

following issues:

• Does the proposal capture those 

financially troubled issuers that could 

benefit from BDC financing? If not, 

please provide an alternative approach 

that would better capture these issuers 

but yet ensure that financially healthy 

issuers are not included. 

• We recognize that an issuer may 

continue to have a class of securities 

listed on an Exchange or on NASDAQ 

long after receiving a notice that it does 

not satisfy a rule or standard setting 

forth quantitative requirements for 

continued listing on an Exchange or on 

NASDAQ.43 Should the proposed rule 

be modified so that an issuer would be 

an eligible portfolio company for only a 

specified period of time after it has 

received such notice? If so, what would 

be the appropriate time period (e.g., 12 

months following the receipt of the 

notice)? Please include in your response 

a detailed description of any alternative 

that you may propose and an 

explanation of its benefits compared 

with our proposal.

• Rule 2a–46(b)(1) requires that an 

issuer that has a class of securities listed 

on an Exchange or on NASDAQ must 

have received a notice from the 

Exchange or NASDAQ that the issuer 

does not satisfy a quantitative listing 

standard of such Exchange or NASDAQ 

before it qualifies as an eligible portfolio 

company. Is there another objective 

factor that would serve as a clearer 

indicator that an issuer listed on an 

Exchange or NASDAQ is beginning to 

experience financial distress? In your 

response, please discuss whether you 

believe using that factor as a different or 

alternate condition under the rule 

would more accurately identify 

financially troubled issuers that are 

likely to lose their ability to access the 

public capital markets. Please also 

discuss the benefits and burdens of 

using such a factor as a condition. 

• Proposed Rule 2a–46(b)(2) excludes 

any issuer from the definition of eligible 

Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 64821

44See supra note 40.

45House Report at 23.

46Section 55(a)(1)(B)(i) requires BDCs making 

follow-on investments in an issuer that no longer 

meets the definition of eligible portfolio company 

because it issued marginable securities to own, at 

the time of the follow-on investment, at least 50% 

of (1) the greatest number of equity securities of 

such issuer, including securities convertible into or 

exchangeable for such securities and (2) the greatest 

amount of certain debt securities of such issuer held 

by the BDC at any time during the period when 

such issuer was an eligible portfolio company. 

Section 55(a)(1)(B)(ii) requires a BDC that makes 

such a follow-on investment to be one of the twenty 

largest holders of record of the issuer’s outstanding 

voting securities.

47Proposed Rule 55a–1 incorporates by reference 

the conditions set forth in Section 55(a)(1)(B). See 

supra note 46.

portfolio company if it meets the initial 

quantitative listing requirements of any 

Exchange or NASDAQ. How 

burdensome would it be for BDCs to 

determine whether an issuer meets such 

requirements? What public information 

is available that would enable BDCs to 

make this determination? Can we be 

confident that an issuer will make 

publicly available information that will 

enable BDCs to readily ascertain that the 

issuer is not an eligible portfolio 

company? If you believe that another 

alternative may better address the 

purpose of this provision, please 

describe that alternative in detail and 

explain what public information is 

available that would allow BDCs to 

readily ascertain that an issuer meets 

your proposal. 

• We considered, but did not tie 

paragraph 2a–46(b) of the proposed rule 

to, whether an issuer may lose its listing 

because of its failure to comply with 

qualitative listing standards,44 generally 

based on our belief that such standards 

generally are directly under the control 

of the issuer, and are not necessarily 

indicative of the issuer’s ability to 

access the public markets in the future. 

Should the proposal include an issuer’s 

failure to meet qualitative listing 

standards, as well as quantitative listing 

standards, as a measure of whether that 

issuer is financially troubled? If you 

believe that it should, please provide 

your analysis of why such standards 

objectively help to measure an issuer’s 

financial stability.

• In light of the purpose of paragraph 

2a–46(b) of the proposed rule, would it 

be more appropriate for this provision to 

be set forth as a separate exemption to 

Section 55(a) rather than as part of a 

definitional rule? 

B. Proposed Rule 55a–1 

In enacting the SBIIA, Congress took 

note of BDCs’ interest in providing 

additional capital to issuers that had 

prospered after receiving BDC capital.45

As a result, Section 55(a)(1)(B) permits 

a BDC to include in its 70% basket 

certain follow-on investments in issuers 

that were eligible portfolio companies at 

the time of the BDC’s initial 

investment(s), but that subsequently lost 

that status because they issued 

marginable securities. Section 

55(a)(1)(B) requires such investments to 

be acquired in private transactions from 

the issuer or certain of the issuer’s 

affiliates. In addition, the section is 

conditioned on the BDC having at the 

time of the follow-on investment, and 

subsequently maintaining, a significant 

investment presence in the issuer.46

Proposed Rule 55a–1 would mirror 

the approach established in Section 

55(a)(1)(B). It would conditionally 

permit a BDC to make follow-on 

investments in certain issuers that met 

the definition of eligible portfolio 

company under proposed Rule 2a–46 

when the BDC made its initial 

investment(s) in the issuer, but that do 

not meet that definition at the time of 

the follow-on investment because the 

issuer subsequently listed a class of 

securities on an Exchange or on 

NASDAQ.47 As in follow-on 

investments under Section 55(a)(1)(B), 

the proposed rule would permit BDCs to 

purchase the securities only in nonpublic offerings from the issuer or 

certain of its affiliates.

We request comment on our proposal 

to permit a BDC to include in its 70% 

basket certain follow-on investments in 

an issuer that no longer meets the 

definition of eligible portfolio company 

because it has a class of securities listed 

on an Exchange or on NASDAQ and, in 

particular, on the following issues:

• We have not proposed any time 

restriction on follow-on investments 

under the proposed rule. Should we 

modify the proposed rule to apply a 

time restriction to such follow-on 

investments (e.g., 12 months following 

the date of the issuer’s receipt of the 

notice referred to in Rule 2a–46(b)(1))? 

Please address whether any such a 

restriction would interfere with a BDC’s 

ability to manage its investments in the 

best interests of shareholders and 

consistent with the purposes and 

policies of the Act. Would such a 

restriction provide necessary discipline 

to the markets by providing an incentive 

to issuers to delist their securities 

promptly? 

• If you believe that restricting some 

follow-on investments is appropriate, 

please provide us with a description of 

those restrictions, including your 

analysis of the benefit that such 

restrictions would provide, and to 

whom those benefits would inure. 

III. General Request for Comment 

We request comment on the rules 

proposed in this Release and on other 

matters that might have an effect on our 

proposals. For purposes of the Small 

Business Regulatory Enforcement 

Fairness Act of 1996, we also request 

information regarding the potential 

impact of the proposed rules on the 

economy on an annual basis. 

Commenters should provide empirical 

data to support their views. 

IV. Cost-Benefit Analysis 

We are sensitive to the costs and 

benefits that result from our rules. 

Proposed Rules 2a–46 and 55a–1 seek to 

realign the definition of eligible 

portfolio company under the Investment 

Company Act, and investment activities 

of BDCs, with the original purpose of 

the SBIIA. Proposed Rule 2a–46(a) 

would define eligible portfolio company 

with reference to whether an issuer has 

securities that are listed on an Exchange 

or on NASDAQ. Proposed Rule 2a–46(b) 

would also include in the definition of 

eligible portfolio company certain 

financially troubled issuers that are 

listed on an Exchange or on NASDAQ 

but are in danger of losing their listing 

status. Proposed Rule 55a–1 would 

permit BDCs to make follow-on 

investments in issuers that meet the 

new definition, subject to certain 

conditions. 

We have identified certain costs and 

benefits that may result from the 

proposed rules. We encourage 

commenters to identify, discuss, 

analyze, and supply relevant data 

regarding these or any additional costs 

and benefits. 

A. Benefits 

The proposed rules would benefit 

small, developing and financially 

troubled companies by making them 

more accessible to BDC financing. These 

companies often need capital for 

continued development and growth but 

are unable to borrow money through 

conventional sources or do not have 

ready access to the capital markets. 

As discussed previously, Congress 

established BDCs in 1980 in order to 

promote the flow of capital and provide 

assistance to these small, developing or 

financially troubled companies. A 

significant number of such issuers, 

however, may have lost their eligible 

portfolio company status because, as a 

result of a 1998 amendment to the 

Federal Reserve Board’s margin rules, 

they have a class of securities 

outstanding that are now considered to 

64822 Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 

48See Section I of this Release.

49But see supra note 41. 50 15 U.S.C. 80a–2(c).

be marginable. Accordingly, BDCs are 

currently required to include in their 

30% basket—rather than in their 70% 

basket—any investment in these issuers 

notwithstanding the fact that they are 

the type of issuers that Congress 

intended to benefit from BDC 

financing.48 Proposed Rule 2a–46 is 

intended to recapture the type of issuers 

that Congress originally intended to 

make eligible for BDC investment as 

part of a BDC’s 70% basket. The 

proposed rule would also benefit certain 

financially troubled issuers that would 

not have been eligible portfolio 

companies before the 1998 amendment 

to the margin rules because they likely 

had a class of marginable securities 

outstanding. Proposed Rule 55a–1 

would provide additional benefits to 

certain issuers that meet the definition 

of eligible portfolio company under 

proposed Rule 2a–46 by allowing BDCs 

to make follow-on investments in such 

companies under certain conditions, 

notwithstanding the fact that they no 

longer meet the definition of eligible 

portfolio company because the issuer 

subsequently listed a class of securities 

on an Exchange or on NASDAQ.

Although it is difficult to quantify 

how many issuers would benefit under 

the proposed rules, the Office of 

Economic Analysis has estimated that 

60% of public issuers currently do not 

have securities that trade on an 

Exchange or on NASDAQ, and thus 

would meet the definition of eligible 

portfolio company in proposed Rule 2a–

46(a). Even more public issuers should 

qualify as eligible portfolio companies 

by virtue of meeting the requirements of 

proposed paragraph (b) of that rule, 

although we cannot quantify how many 

additional issuers this would be.49

The proposed rules would benefit 

BDCs by expanding the universe of 

investments that may be included in 

their 70% basket. Industry participants 

have informed us that the 1998 

amendment to the margin rules has 

substantially reduced the number of 

issuers which BDCs may include in 

their 70% basket and accordingly has 

adversely affected their business 

operations.

B. Costs 

The proposed rules might impose 

certain administrative compliance costs 

on BDCs. Under Proposed Rule 2a–46, 

a BDC would need to determine, prior 

to investing in an issuer, whether the 

issuer has a class of securities listed on 

an Exchange or on NASDAQ. If the 

issuer has a class of securities listed on 

an Exchange or on NASDAQ, a BDC 

could invest in the issuer only if the 

BDC determines that the issuer (1) has 

received a notice from the Exchange or 

NASDAQ that it does not satisfy a rule 

or standard setting forth quantitative 

requirements for continued listing on 

that Exchange or on NASDAQ and (2) 

does not meet the initial quantitative 

listing requirements of any Exchange or 

NASDAQ. We expect the costs involved 

in a BDC complying with these 

requirements to be minimal. 

Furthermore, it is our understanding 

that these costs are similar to the types 

of compliance costs that a BDC 

currently undertakes when it invests in 

an issuer. We do not anticipate that the 

proposed rule would impose any costs 

on issuers. 

We also expect that the costs involved 

in a BDC complying with the 

requirements of Proposed Rule 55a–1 to 

be minimal. Proposed Rule 55a–1 would 

permit a BDC to include in its 70% 

basket follow-on investments in an 

issuer that met the definition of eligible 

portfolio company under Proposed Rule 

2a–46 when the BDC made its initial 

investment(s), but that does not meet 

that definition at the time of the followon investment because the issuer 

subsequently listed a class of securities 

on an Exchange or on NASDAQ. A BDC 

generally may make follow-on 

investments under the proposal only if, 

at the time of the follow-on investment, 

the BDC owns at least 50% of (1) the 

greatest number of equity securities of 

such issuer, including securities 

convertible into or exchangeable for 

such securities and (2) the greatest 

amount of certain debt securities of such 

issuer held by the BDC at any time 

during the period when such issuer was 

an eligible portfolio company. In 

addition, the proposal would require a 

BDC that makes such a follow-on 

investment to be one of the twenty 

largest holders of record of the issuer’s 

outstanding voting securities. These 

requirements are the same requirements 

set forth in Section 55(a)(1)(B) of the 

Investment Company Act, the provision 

that permits a BDC to include in its 70% 

basket certain follow-on investments in 

issuers that were eligible portfolio 

companies at the time of the BDC’s 

initial investment(s), but that 

subsequently lost that status because 

they issued marginable securities. 

Accordingly, BDCs already make similar 

types of determinations when 

considering whether to make follow-on 

investments in issuers that had lost their 

eligible portfolio company status 

because they had issued marginable 

securities. We also do not anticipate that 

the proposed rule would impose any 

costs on issuers. 

C. Request for Comments 

We request comment on the potential 

costs and benefits identified in the 

proposal and any other costs and 

benefits that may result from the 

proposed rules. For purposes of the 

Small Business Regulatory Enforcement 

Fairness Act of 1996, the Commission 

also requests information regarding the 

impact of the proposed rules on the 

economy on an annual basis. 

Commenters are requested to provide 

data to support their views. 

V. Consideration of Promotion of 

Efficiency, Competition, and Capital 

Formation 

Section 2(c) of the Investment 

Company Act mandates that the 

Commission, when engaging in 

rulemaking that requires it to consider 

or determine whether an action is 

necessary or appropriate in the public 

interest, consider, in addition to the 

protection of investors, whether the 

action will promote efficiency, 

competition and capital formation.50

As discussed above, the two proposed 

rules would expand the definition of 

eligible portfolio company set forth in 

Section (2)(a)(46) of the Investment 

Company Act and provide for certain 

follow-on investments in issuers 

meeting the expanded definition. We 

intend for these new rules to promote 

efficiency by realigning the definition of 

eligible portfolio company with the 

purpose of the SBIIA. 

We do not anticipate that these 

proposed rules would harm 

competition. The proposed rules are 

designed to recapture within the 

definition of eligible portfolio company 

those issuers originally intended to be 

funded by BDCs under the SBIIA. BDCs 

would be able to take advantage of the 

new rules equally. Moreover, the 

proposed rules would not affect 

investment opportunities generally 

available to other investors, including 

registered investment companies. The 

proposed rules also could foster greater 

competition among small, developing or 

financially troubled issuers for BDCs’

initial and follow-on investments of 

capital and provision of managerial 

assistance. Thus, the proposed rules are 

designed to enhance competition. 

We anticipate that the proposed new 

rules would promote capital formation 

by increasing the flow of capital from 

BDCs to small, developing businesses or 

financially troubled businesses. Thus, 

Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 64823

51 17 CFR 270.0–10.

52 17 CFR 230.157; 17 CFR 240.0–10.

we anticipate that the proposed new 

rules would promote capital formation. 

We request comment on whether the 

proposed new rules will affect 

efficiency, competition and capital 

formation. Comments will be 

considered by the Commission in 

satisfying its responsibilities under 

Section 2(c) of the Investment Company 

Act. Commenters are requested to 

provide empirical data and other factual 

support for their views to the extent 

possible. 

VI. Paperwork Reduction Act 

The Commission has determined that 

these rules do not involve a collection 

of information pursuant to the 

provisions of the Paperwork Reduction 

Act [44 U.S.C. 3501 et seq.]. 

VII. Initial Regulatory Flexibility 

Analysis 

This Initial Regulatory Flexibility 

Analysis (‘‘IRFA’’) has been prepared in 

accordance with 5 U.S.C. 603. It relates 

to proposed new Rules 2a–46 and 55a–

1, both under the Investment Company 

Act, which would modernize the 

definition of eligible portfolio company 

set forth under that Act. 

A. Reasons for the Proposed Action 

As described more fully in Section I 

of this Release, the proposed rules are 

designed to recapture the type of issuers 

that Congress originally intended to 

include as eligible portfolio companies 

when it established BDCs in 1980, but 

may have lost their eligible portfolio 

company status as a result of the 1998 

amendment to the Federal Reserve 

Board’s margin rules.

B. Objectives of the Proposed Action 

As described more fully in Section II 

of this Release, the objectives of the 

proposed rules are to realign the 

definition of eligible portfolio company 

set forth under the Investment Company 

Act, and the investment activities of 

BDCs, with the purpose intended by 

Congress when it established BDCs in 

1980. 

C. Legal Basis 

Rule 2a–46 is being proposed 

pursuant to the authority set forth in 

Section 2(a)(46)(C)(iv) [15 U.S.C. 80a–

2(a)(46)(c)(iv)] of the Investment 

Company Act. Rule 55a–1 is being 

proposed pursuant to the authority set 

forth in Section 6(c) [15 U.S.C. 80a–6(c)] 

of the Investment Company Act and 

Section 55(a)(1) [15 U.S.C. 80a–54(a)(1)] 

of the Investment Company Act. Both 

rules are also being proposed pursuant 

to the authority set forth in Section 38(a) 

[15 U.S.C. 80a–37(a)] of the Investment 

Company Act. 

D. Small Entities Subject to the Rule 

The proposed rules affect both BDCs 

and issuers that qualify as small entities 

under the Regulatory Flexibility Act. 

For purposes of the Regulatory 

Flexibility Act, a BDC is a small entity 

if it, together with other investment 

companies in the same group of related 

investment companies, has net assets of 

$50 million or less as of the end of its 

most recent fiscal year.51 There are 64 

BDCs, of which 46 are small entities. An 

issuer other than an investment 

company is a small entity under the 

Regulatory Flexibility Act if it had total 

assets of $5 million or less on the last 

day of its most recent fiscal year.52 We 

estimate that there are approximately 

2,500 issuers, other than investment 

companies, that may be considered 

small entities.

As discussed in this Release, the 

proposed rules are intended to benefit 

small, developing and financially 

troubled companies by making BDC 

capital more accessible to them. The 

proposed rules would also benefit BDCs, 

including those that are small entities, 

by expanding their universe of 

investment opportunities. We have no 

reason to expect that those BDCs and 

issuers that are small entities for 

purposes of the Regulatory Flexibility 

Act would be disproportionately 

affected by the proposed rules. We 

request comment on the effects and 

costs of the proposed rules on small 

entities. 

E. Reporting, Recordkeeping and Other 

Compliance Requirements 

The proposed rules do not include 

any new reporting or recordkeeping 

requirements on BDCs or on issuers. 

While the proposed rules would not 

impose any compliance requirements on 

issuers, they would impose minimal 

compliance requirements on all BDCs, 

including small entities. Under 

Proposed Rule 2a–46, a BDC, prior to 

investing in an issuer, must determine 

whether that issuer has listed a class of 

its securities on an Exchange or on 

NASDAQ. In the event that the issuer 

does have securities listed on an 

Exchange or on NASDAQ, the BDC may 

only invest in the issuer if the BDC 

determines that the issuer (1) has 

received notice that it does not meet the 

quantitative continued listing 

requirements of the Exchange or 

NASDAQ and (2) does not satisfy the 

initial quantitative requirements for 

listing a class of its securities on any 

Exchange or on NASDAQ. We believe 

that all BDCs, including those that are 

small entities, already make similar 

types of determinations when 

considering whether to invest in an 

issuer. 

Proposed Rule 55a–1 would permit a 

BDC to include in its 70% basket 

follow-on investments in an issuer that 

met the definition of eligible portfolio 

company under Proposed Rule 2a–46 

when the BDC made its initial 

investment(s), but that does not meet 

that definition at the time of the followon investment because the issuer 

subsequently listed a class of securities 

on an Exchange or on NASDAQ. A BDC 

generally may make follow-on 

investments under the proposal only if, 

at the time of the follow-on investment, 

the BDC owns at least 50% of (1) the 

greatest number of equity securities of 

such issuer, including securities 

convertible into or exchangeable for 

such securities and (2) the greatest 

amount of certain debt securities of such 

issuer held by the BDC at any time 

during the period when such issuer was 

an eligible portfolio company. In 

addition, the proposal would require a 

BDC that makes such a follow-on 

investment to be one of the twenty 

largest holders of record of the issuer’s 

outstanding voting securities. These 

requirements are the same requirements 

set forth in Section 55(a)(1)(B) of the 

Investment Company Act, the provision 

that permits a BDC to include in its 70% 

basket certain follow-on investments in 

issuers that were eligible portfolio 

companies at the time of the BDC’s 

initial investment(s), but that 

subsequently lost that status because 

they issued marginable securities. 

Accordingly, BDCs, including those that 

are small entities, already make similar 

types of determinations when 

considering whether to make follow-on 

investments in issuers that had lost their 

eligible portfolio company status 

because they had issued marginable 

securities. 

F. Duplicative, Overlapping, or 

Conflicting Federal Rules 

There are no rules that duplicate, 

overlap, or conflict with the proposed 

rules.

G. Significant Alternatives 

The Regulatory Flexibility Act directs 

us to consider significant alternatives 

that would accomplish our stated 

objectives, while minimizing any 

significant adverse impact on small 

entities. Alternatives in this category 

would include: (1) Establishing different 

compliance or reporting standards that 

64824 Federal Register / Vol. 69, No. 215 / Monday, November 8, 2004 / Proposed Rules 

53Comments on the IRFA will be placed in the 

same public file that contains comments on the 

proposed rules themselves.

take into account the resources available 

to small entities; (2) clarifying, 

consolidating, or simplifying the 

compliance requirements under the 

proposed rules for small entities; (3) the 

use of performance rather than design 

standards; and (4) an exemption from 

coverage of the proposed rules, or any 

part thereof, for small entities. 

Establishing different compliance or 

reporting requirements for small entities 

would not be appropriate. As discussed 

above, the proposed rules do not impose 

any reporting requirements on BDCs or 

on issuers. In addition, the proposed 

rules do not impose any compliance 

requirements on issuers. While the 

proposed rules do impose some 

compliance requirements on BDCs, 

these requirements are designed to 

insure that BDCs invest primarily in 

those issuers that Congress intended 

them to invest in when it established 

BDCs in 1980. We believe at this time 

that these requirements impose minimal 

burdens on BDCs. Furthermore, we 

believe that to comply with these 

requirements, a BDC would be required 

to engage in the types of activities that 

they already undertake before making 

most investments. 

We also believe that clarifying, 

consolidating, or simplifying the 

compliance requirements under the 

proposed rules for small entities is 

inappropriate. As discussed above, the 

proposed rules do not impose any 

compliance requirements on issuers. 

Although the proposed rules do impose 

some compliance requirements on 

BDCs, as discussed above, these 

requirements, which we believe impose 

minimal burdens on BDCs, are designed 

to insure that BDCs invest primarily in 

those issuers that Congress intended 

them to invest in when it established 

BDCs in 1980. 

We do not believe that the use of 

performance rather than design 

standards is feasible. The proposed 

rules are designed to recapture the type 

of issuers that Congress originally 

intended to include as eligible portfolio 

companies when it established BDCs in 

1980—small developing or financially 

troubled companies that do not have 

access to capital—but may have lost 

their eligible portfolio company status 

as a result of the 1998 amendment to the 

Federal Reserve Board’s margin rules. 

They are also intended to ensure that 

BDCs do not invest primarily in those 

large, established companies that 

Congress did not intend to receive the 

benefits of BDC investment. 

Finally, it would be inappropriate to 

exempt small entities from coverage of 

the proposed rules. The proposed rules 

are intended to benefit BDCs, including 

those that are small entities, by 

expanding the universe of their 

investment opportunities. The proposed 

rules are also intended to benefit small, 

developing and financially troubled 

issuers, including those that are small 

entities, by making BDC capital more 

readily available to them. Exempting 

small entities from all or part of the 

proposed rules would be contradictory 

to the purpose of the proposed rules. 

H. Solicitation of Comments 

We encourage the submission of 

comments with respect to any aspect of 

this IRFA. Comment is specifically 

requested on the number of small 

entities that would be affected by the 

proposed rules, and the likely impact of 

the proposals on small entities. 

Commenters are asked to describe the 

nature of any impact and provide 

empirical data supporting the extent of 

the impact. These comments will be 

considered in connection with the 

adoption of the proposed rules and will 

be reflected in the Final Regulatory 

Flexibility Analysis.53

VIII. Statutory Authority 

We are proposing Rule 2a–46 

pursuant to our rulemaking authority 

under Sections 2(a)(46)(C)(iv) and 38(a) 

of the Investment Company Act. We are 

proposing Rule 55a–1 pursuant to our 

exemptive authority under Section 6(c) 

and our rulemaking authority under 

Sections 38(a) and 55(a)(1) of the 

Investment Company Act.

List of Subjects in 17 CFR Part 270 

Investment companies, Reporting and 

recordkeeping requirements, Securities.

Text of Proposed Rules 

For reasons set forth in the preamble, 

Title 17, Chapter II of the Code of 

Federal Regulations is proposed to be 

amended as follows:

PART 270—RULES AND 

REGULATIONS, INVESTMENT 

COMPANY ACT OF 1940 

1. The authority citation for Part 270 

continues to read in part as follows:

Authority: 15 U.S.C. 80a–1 et seq., 80a–

34(d), 80a–37, and 80a–39, unless otherwise 

noted.

* * * * *

2. Section 270.2a–46 is added to read 

as follows:

§ 270.2a–46 Certain issuers as eligible 

portfolio companies. 

The term eligible portfolio company 

shall include any issuer that meets the 

requirements set forth in paragraphs (A) 

and (B) of section 2(a)(46) of the Act (15 

U.S.C. 80a–2(a)(46)(a) and (B)) and that: 

(a) Does not have any class of 

securities listed on a national securities 

exchange or on an automated 

interdealer quotation system of a 

national securities association; or 

(b) Has a class of securities listed on 

a national securities exchange or on an 

automated interdealer quotation system 

of a national securities association, but 

that: 

(1) Has received a notice from the 

national securities exchange or national 

securities association (or facility thereof) 

that it does not satisfy a rule or standard 

setting forth quantitative requirements 

for continued listing on the exchange or 

association; and 

(2) Does not satisfy the initial 

quantitative requirements for listing any 

class of its securities on any national 

securities exchange or on an automated 

interdealer quotation system of a 

national securities association. 

3. Section 270.55a–1 is added to read 

as follows:

§ 270.55a–1 Investment activities of 

business development companies. 

Notwithstanding section 55(a) of the 

Act (15 U.S.C. 80a–54(a)), a business 

development company may acquire 

securities purchased in transactions not 

involving any public offering from an 

issuer, or from any person who is an 

officer or employee of the issuer, if the 

issuer meets the requirements of section 

2(a)(46)(A) and (B) of the Act (15 U.S.C. 

80a–2(a)(46)(A) and (B)), but is not an 

eligible portfolio company because it 

has a class of securities that is listed on 

a national securities exchange or on an 

automated interdealer quotation system 

of a national securities association, and 

the BDC meets the requirements of 

paragraphs (i) and (ii) of Section 

55(a)(1)(B) of the Act (15 U.S.C. 80a–

54(a)(1)(B)(i) and (ii)).

Dated: November 1, 2004.

By the Commission. 

Jill M. Peterson, 

Assistant Secretary.

[FR Doc. 04–24788 Filed 11–5–04; 8:45 am] 

BILLING CODE 8010–01–P