Document ID: SEC-2006-1407-0001
Agency: sec
Document Type: Rule
Title: Definition of Eligible Portfolio Company Under the Investment Company Act of 1940
Posted Date: 2006-10-31T05:00Z

[Federal Register: October 31, 2006 (Volume 71, Number 210)]
[Rules and Regulations]               
[Page 64085-64092]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr31oc06-17]                         

[[Page 64085]]

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Part VII

Securities and Exchange Commission

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17 CFR Part 270

 Definition of Eligible Portfolio Company Under the Investment Company 
Act of 1940; Final Rule and Proposed Rule

[[Page 64086]]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 270

[Release No. IC-27538; 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: Final rule.

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SUMMARY: The Commission is adopting two new rules under the Investment 
Company Act of 1940 (``Investment Company Act'' or ``Act''). The new 
rules more closely align the definition of eligible portfolio company, 
and the investment activities of business development companies 
(``BDCs''), with the purpose that Congress intended. The rules expand 
the definition of eligible portfolio company in a manner that promotes 
the flow of capital to certain small, developing and financially 
troubled companies.

DATES: Effective Date: November 30, 2006.

FOR FURTHER INFORMATION CONTACT: Rochelle Kauffman Plesset, Senior 
Counsel, or Elizabeth G. Osterman, Assistant Chief Counsel, Office of 
Chief Counsel, (202) 551-6825, Division of Investment Management, 
Securities and Exchange Commission, 100 F Street, NE., Washington, DC 
20549-5030.

SUPPLEMENTARY INFORMATION: The Commission today is adopting new Rule 
2a-46 [17 CFR 270.2a-46] and new Rule 55a-1 [17 CFR 270.55a-1], both 
under the Investment Company Act [15 U.S.C. 80a et seq.].\1\
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    \1\ Rules 2a-46 and 55a-1 were proposed in Definition of 
Eligible Portfolio Company under the Investment Company Act of 1940, 
Investment Company Act Release No. 26647 (Nov. 1, 2004) [69 FR 64815 
(Nov. 8, 2004)] (``2004 Proposing Release''). The Commission today 
also issued a release reproposing Rule 2a-46(b). Definition of 
Eligible Portfolio Company under the Investment Company Act of 1940, 
Investment Company Act Release No. 27539 (Oct. 25, 2006).
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Table of Contents

I. Background
II. Discussion
    A. Rule 2a-46
    B. Rule 55a-1
III. Cost-Benefit Analysis
    A. Benefits
    B. Costs
IV. Consideration of Promotion of Efficiency, Competition and 
Capital Formation
V. Paperwork Reduction Act
VI. Final Regulatory Flexibility Analysis
    A. Reasons and Objectives of the New Rules
    B. Significant Issues Raised by Public Comment
    C. Small Entities Subject to the Rule
    D. Reporting, Recordkeeping, and Other Compliance Requirements
    E. Commission Action To Minimize Adverse Impact on Small 
Entities
VII. Statutory Authority

I. Background

    In 1980, Congress enacted the Small Business Investment Incentive 
Act (``SBIIA''), which, among other things, established BDCs as a means 
of making capital more readily available to small, developing and 
financially troubled companies that do not have ready access to the 
public capital markets or other forms of conventional financing.\2\ 
Consistent with this purpose, Section 55(a) of the Investment Company 
Act generally prohibits a BDC from acquiring any assets unless, at the 
time of acquisition, at least 70 percent of its total assets are 
invested in securities of certain specified types of companies (``70 
percent basket'').\3\ Among other things, the 70 percent basket may 
include securities of eligible portfolio companies purchased in 
transactions not involving any public offering,\4\ securities of 
eligible portfolio companies already controlled by the BDC without 
regard to the nature of the offering,\5\ and securities of certain 
financially distressed companies that do not meet the definition of 
eligible portfolio company and that are purchased in transactions not 
involving any public offering.\6\
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    \2\ Pub. L. 96-477, 94th Stat. 2274 (1980) (codified at 
scattered sections of the United States Code). See generally H.R. 
Rep. No. 1341, 96th Cong., 2d Sess. 21 (1980) (``House Report'').
    \3\ Section 55(a) of the Investment Company Act [15 U.S.C. 80a-
54(a)]. See House Report at 23 (``The restrictions are designed to 
assure that companies electing special treatment as [BDCs] are in 
fact those that [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, well-established businesses.'').
    Congress did not specifically regulate how a BDC should invest 
the remainder of its assets (``30% basket''). See id. at 31, 38-40. 
Congress clarified, however, that a BDC would be required to invest 
its 30% basket in a manner consistent with the overall purpose of 
SBIIA. Id. 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.'').
    \4\ See Section 55(a)(1) of the Investment Company Act. See also 
Section 2(a)(46) of the Investment Company Act [15 U.S.C. 80a-
2(a)(46)] (statutory definition of eligible portfolio company).
    \5\ See Section 55(a)(2) of the Investment Company Act, 
referring to companies with respect to which the BDC satisfies the 
requirements of Section 2(a)(46)(C)(ii) of the Act. Section 
2(a)(46)(C)(ii) provides that a company that meets the initial 
requirements set forth in Sections 2(a)(46)(A) and (B) is an 
eligible portfolio company if ``it is controlled by a [BDC], either 
alone, or as part of a group acting together, and such [BDC] in fact 
exercises a controlling influence over the management or policies of 
such eligible portfolio company and, as a result of such control, 
has an affiliated person who is a director of such eligible 
portfolio company.''
    \6\ See Section 55(a)(3) of the Investment Company Act 
(includes, among others, companies that have filed for bankruptcy). 
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 (1) through (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.
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    The definition of eligible portfolio company is central to the 
restrictions of section 55(a) and the purpose of SBIIA. Section 
2(a)(46) first generally defines eligible portfolio company to include 
only domestic companies that are not investment companies under the 
Investment Company Act (``domestic operating companies'').\7\ Section 
2(a)(46)(C) further defines eligible portfolio company under three 
categories. Many BDCs invest in companies that historically met the 
criteria of section 2(a)(46)(C)(i).\8\ Under section 2(a)(46)(C)(i), an 
eligible portfolio company includes any company that does not have any 
class of securities with respect to which a member of a national 
securities exchange, broker or dealer may extend or maintain margin 
credit pursuant to the rules or regulations adopted by the Federal 
Reserve Board under section 7 of the Securities Exchange Act of 1934 
(``Exchange Act''). At the time that

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section 2(a)(46) was adopted, Congress generally perceived the Federal 
Reserve Board's definition of ``margin security'' to be a ``rational 
and objective test'' that could be used to determine whether a company 
has ready access to the public capital markets or other sources of 
financing.\9\ Nevertheless, Congress recognized that 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.\10\
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    \7\ See House Report at 29. Sections 2(a)(46)(A) of the 
Investment Company Act defines eligible portfolio company to include 
(among other things) companies organized under the laws of, and with 
their principal business in, one or more states of the United 
States. Section 2(a)(46)(B) of the Investment Company Act generally 
excludes from the definition of eligible portfolio company any 
company that meets the definition of investment company under 
section 3 of the Investment Company Act, or that is excluded from 
the definition of investment company by Section 3(c) of the Act, but 
includes as an eligible portfolio company any small BDC that is 
licensed by the Small Business Administration and that is a wholly-
owned subsidiary of a BDC.
    \8\ In addition to section 2(a)(46)(C)(i), discussed infra, 
section 2(a)(46)(C)(ii) includes in the definition of eligible 
portfolio company any issuer in which the BDC or certain affiliates 
own a controlling interest, see supra note 5, and section 
2(a)(46)(C)(iii), enacted in 1996, includes in the definition any 
issuer that has total assets of not more than $4 million, and 
capital and surplus (shareholder equity minus retained earnings) of 
not less than $2 million.
    \9\ See House Report at 30-31.
    \10\ House Report at 31. Under 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 specific standards.''). The legislative 
history also makes clear that the intent of this provision ``is to 
enable the Commission through the administrative process to broaden, 
if appropriate, the category of eligible portfolio company.'' While 
stating that BDCs ``already have substantial freedom of action to 
purchase securities of companies which are not eligible portfolio 
companies,'' referring to the 30% basket, Congress also noted its 
expectation that ``the Commission would institute [rulemaking] 
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.''). See House Report at 31.
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    Since 1980, the Federal Reserve Board has periodically amended its 
definition of margin security to increase the types of securities that 
would fall within that definition under its rules. In 1998, for reasons 
unrelated to small business capital formation, the Federal Reserve 
Board adopted amendments to those rules that had the unintended 
consequence of reducing the number of companies that meet the 
definition of eligible portfolio company by expanding the definition of 
margin security to include all publicly traded equity securities and 
most debt securities.\11\
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    \11\ See 2004 Proposing Release, supra note 1 at nn. 19-23 and 
accompanying text.
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    On November 1, 2004, we proposed for comment Rules 2a-46 and 55a-1 
under the Investment Company Act.\12\ The proposed rules were designed 
to address the impact of the Federal Reserve Board's 1998 amendments on 
the definition of eligible portfolio company by realigning that 
definition, and the investment activities of BDCs, with the purpose of 
SBIIA.
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    \12\ Id.
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    Generally, proposed Rule 2a-46 would have defined eligible 
portfolio company in one of two ways. Proposed Rule 2a-46(a) would have 
defined eligible portfolio company to include any domestic operating 
company \13\ that does not have any class of securities listed on a 
national securities exchange (``Exchange'').\14\ Proposed Rule 2a-46(b) 
would have defined eligible portfolio company to include any domestic 
operating company that has a class of securities listed on an Exchange 
but (1) has received notice that its securities will be delisted and 
(2) is not eligible to list its securities on any Exchange. Proposed 
Rule 55a-1 would have conditionally permitted a BDC to include in its 
70 percent basket follow-on investments in any company that was an 
eligible portfolio company as defined by proposed Rule 2a-46 at the 
time of the BDC's initial investment(s) in it, but no longer met that 
definition.
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    \13\ The proposed rule incorporated the provisions of section 
2(a)(46)(A) and (B). See supra note 7.
    \14\ The rule as proposed also would have defined eligible 
portfolio company to include any domestic operating company that 
does not have any class of securities listed on an automated 
interdealer quotation system of a national securities association 
(i.e., The NASDAQ Stock Market LLC (``Nasdaq'')). On August 1, 2006, 
Nasdaq began operating as a national securities exchange registered 
under section 6(a) of the Exchange Act.
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II. Discussion

    We received thirty-six comment letters that addressed the proposed 
rules.\15\ Commenters generally agreed that Commission rulemaking is 
appropriate at this time. Virtually all commenters supported proposed 
Rule 55a-1, and most commenters agreed with the definition of eligible 
portfolio company set forth in proposed Rule 2a-46(a). Some commenters, 
however, were concerned that proposed Rule 2a-46(b) would not include 
many of the small public companies whose securities are listed on an 
Exchange that historically would have met the definition of eligible 
portfolio company before the margin rule amendments. In addition, some 
commenters argued that some small companies that list their securities 
on an Exchange may not fall within the definition set forth in proposed 
Rule 2a-46(b), but nevertheless may have difficulties accessing 
conventional sources of capital and raising capital on the public 
capital markets. These commenters argued that these companies should 
qualify as eligible portfolio companies under the rule.\16\ Commenters 
also generally stated that proposed Rule 2a-46(b) was unworkable.\17\
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    \15\ Commenters included members of Congress, BDCs, law firms, 
trade associations and small businesses that had received financing 
from a BDC. The comment letters are available for inspection in the 
Commission's Public Reference Room at 100 F Street, NE., Washington, 
DC 20549 (File No. S7-37-04). They also may be viewed at http://www.sec.gov/rules/proposed/ic-26647.htm
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    \16\ See, e.g., comments of UTEK (Jan. 7, 2005); comments of 
Gladstone Capital (Jan. 6, 2005); comments of Thompson & Knight 
(Jan. 4, 2005). But see comments of the Committee on Federal 
Regulation of Securities of the Business Law Section of the American 
Bar Association (Jan. 5, 2005) (supporting proposal in full); 
comments of the Investment Company Institute (Jan. 6, 2005) 
(supporting proposal in full). A few commenters also argued that the 
proposed rule may harm BDC shareholders because it would increase 
the risk profile of a BDC. See, e.g., comments of Allied Capital 
(Jan. 7, 2005). We discuss this comment below. See infra notes 24-25 
and accompanying text.
    \17\ See, e.g., comments of Sherman & Sterling LLP (Jan. 7, 
2005).
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    After considering the comments received, the Commission today is 
adopting Rule 2a-46, initially proposed as Rule 2a-46(a), to define 
``eligible portfolio company'' to include all private companies and all 
public companies whose securities are not listed on an Exchange. We 
estimate that, based on June 2006 data, 61.4 percent (6,041/9,845) of 
all public domestic operating companies qualify as eligible portfolio 
companies under Rule 2a-46.
    We are not, however, adopting proposed paragraph (b). We are 
sensitive to some commenters' concerns that the proposed rule was too 
narrow. Accordingly, we are seeking comment on reproposed Rule 2a-46(b) 
in a separate release.\18\
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    \18\ See supra note 1.
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    We also are adopting Rule 55a-1 today.\19\ That rule conditionally 
allows BDCs to make follow-on investments in companies that met the 
definition of eligible portfolio company under Rule 2a-46 at the time 
of a BDC's initial investment(s) in them, but that do not meet that 
definition at the time of the BDC's follow-on investment.
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    \19\ Rule 55a-1 as adopted has been modified from the proposed 
rule merely to refer to Rule 2a-46 as adopted, rather than reciting 
the definition of eligible portfolio company set forth in Rule 2a-
46.
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    We discuss the rules that we are adopting today in greater detail 
below.

A. Rule 2a-46

    Rule 2a-46 defines eligible portfolio company to include all 
private domestic operating companies \20\ and those public domestic 
operating companies whose securities are not listed on an

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Exchange.\21\ Public domestic operating companies whose securities are 
quoted on the over-the-counter bulletin board (``OTCBB'') and through 
Pink Sheets LLC (``Pink Sheets'') are not listed on an Exchange, and 
therefore are eligible portfolio companies under this provision.
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    \20\ Like Section 2(a)(46) and the proposed rule, Rule 2a-46 
defines eligible portfolio company to include only domestic 
operating companies. See supra notes 7 and 13 and accompanying text.
    \21\ Under this provision, an issuer would be an eligible 
portfolio company if it does not have a class of securities listed 
on a national securities exchange registered under Section 6(a) of 
the Exchange Act, [15 U.S.C. 78f(a)] such as the New York Stock 
Exchange (``NYSE''), the American Stock Exchange (``Amex''), and 
Nasdaq. See supra note 14.
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    Rule 2a-46 in our view provides a workable and appropriate test for 
determining whether a company is an eligible portfolio company. The 
rule more closely aligns the definition of eligible portfolio company 
with the purpose of SBIIA by including many of the types of companies 
that Congress originally intended to benefit from BDC financing that 
may have lost their eligible portfolio company status because of the 
change in the margin rules. Rule 2a-46 is consistent with the public 
interest, the protection of investors and the purposes fairly intended 
by the policy and provisions of the Investment Company Act.\22\
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    \22\ See supra note 10.
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    Most commenters supported proposed Rule 2a-46(a), and agreed that 
this approach would establish a clear, workable standard that 
correlates to whether a company has access to publicly raised 
capital.\23\ A few commenters, however, raised a concern that this 
provision, when coupled with the definition set forth in proposed 
paragraph (b), would cause BDCs to focus their investment activities on 
companies that are in financial distress because of their view that 
most public companies that are quoted on the OTCBB or through Pink 
Sheets are financially troubled.\24\
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    \23\ See, e.g., comments of American Capital Strategies Ltd. 
(Jan. 7, 2004); comments of Sherman & Sterling LLP (Jan. 7, 2005). 
We note that the House of Representatives has passed legislation 
that in part defines eligible portfolio company in a manner similar 
to the definition that we are adopting today. See H.R. 436, 109th 
Cong., 1st Sess. (2005) (an eligible portfolio company includes any 
company that ``does not have any class of equity securities listed 
for trading on a national securities exchange or traded through the 
facilities of a national securities association as described in 
Section 15A of the Securities Exchange Act of 1934''). S. 1396, 
which is identical to H.R. 436, was introduced in the Senate on July 
14, 2005. S. 1396, 109th Cong., 1st Sess. (2005). Both H.R. 436 and 
S. 1396 are currently pending before the Senate Committee on 
Banking, Housing and Urban Affairs.
    \24\ Comments of UTEK (Jan. 7, 2005); comments of Allied Capital 
(Jan. 7, 2005). Some commenters also raised the concern that the 
proposed rule would harm BDC shareholders by raising BDCs' risk 
profiles. Rule 2a-46, however, is intended to address the 
inadvertent reduction in the number of companies that qualify under 
Section 2(a)(46) by the amendment to the margin rules. The rule does 
not alter the statutory mandate or requires a BDC to invest in any 
particular company. Further, Congress addressed investor protection 
concerns with respect to BDC shareholders in 1980. See House Report 
at 22 (explaining that SBIIA ``is intended to preserve to the 
fullest possible extent * * * [investor] protections, while at the 
same time reducing unnecessary regulatory burdens.''). In this 
regard, the federal securities laws require, among other things, 
BDCs to disclose to their shareholders the risks associated with 
investment and to manage their business consistent with their 
fiduciary obligations.
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    Rule 2a-46 does not require BDCs to focus their investment 
activities in financially troubled companies whose securities are 
traded on the OTCBB or through Pink Sheets. Although some companies 
have their shares traded on the OTCBB or though Pink Sheets because of 
financial circumstances, this is not true for all companies whose 
securities are traded on these quotation mediums. Rather, OTCBB and 
Pink Sheets companies also include small public companies that do not 
meet the minimum listing standards of one of the Exchanges, and 
companies that wish to become more developed before applying to list 
their securities on an Exchange even though they may already be 
eligible to do so.\25\ In other words, although companies whose 
securities are traded on the OTCBB and through Pink Sheets include 
financially troubled companies, they also include small, developing, 
financially stable public companies. Thus, we believe that including 
companies that are traded on the OTCBB or through Pink Sheets as 
eligible portfolio companies under Rule 2a-46 will not require BDCs to 
change their investment strategies to focus on financially troubled 
companies. Instead, the rule is designed to more closely align the 
definition with the purpose of SBIIA.
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    \25\ See ``A Little About The Pink Sheets'' at 
http://www.PennyMarkets.com. See also Testimony of James A. Connolly III 

representing the CEO Council before the Subcommittee of Oversight 
and Investigations of the House Committee on Financial Services 
(Sept. 23, 2004) (the OTCBB and Pink Sheet companies are `` `engines 
of economic growth, job creation and innovation.' Our market space 
of 7000 companies includes hundreds of millions of dollars in market 
capitalization, tens of thousands of employees, and likely hundreds 
of thousands of stockholders.'').
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    We note that OTCBB and Pink Sheets companies also include a few 
large companies that do not list their securities on an Exchange even 
though they may meet applicable listing requirements. With this in 
mind, we had asked in the Proposing Release whether we should exclude 
from the definition of eligible portfolio company any company that 
would meet the lowest initial quantitative listing standard of any 
Exchange, regardless of whether the company enters into a listing 
agreement with the Exchange. Commenters, however, argued that a company 
that may meet the lowest initial quantitative listing of any Exchange 
may nevertheless not have access to the public capital markets.\26\ 
These comments have persuaded us not to adopt this approach.
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    \26\ See comments of Thompson & Knight (Jan. 4, 2005); comments 
of American Capital Strategies (Jan. 7, 2006).
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B. Rule 55a-1

    Proposed Rule 55a-1, which virtually all commenters supported, is 
adopted.\27\ As adopted, Rule 55a-1 permits a BDC to include in its 70 
percent basket follow-on investments in a company that met the 
definition of eligible portfolio company under Rule 2a-46 at the time 
of the BDC's initial investment(s) in the company, but subsequently 
would not meet the definition of eligible portfolio company because the 
company no longer meets the requirements of that rule (i.e., following 
the BDC's initial investment(s) in the company, the company listed its 
securities on an Exchange), subject to certain conditions. These 
conditions permit a BDC to make a follow-on investment only if the BDC, 
at the time of the follow-on investment: (1) Owns at least 50 percent 
of (a) the greatest number of equity securities of such company, 
including securities convertible into or exchangeable for such 
securities, and (b) the greatest amount of certain debt securities of 
such company held by the BDC at any time during the period when such 
company was an eligible portfolio company; and (2) is one of the twenty 
largest holders of record of the company's outstanding voting 
securities.\28\ Rule 55a-1 is appropriate in the public interest and 
consistent with the protection of investors and the purposes and 
policies fairly intended by the policy and provisions of the Act.
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    \27\ See supra note 19.
    \28\ The rule incorporates the conditions set forth in Section 
55(a)(1)(B), the section that permits a BDC to make follow-on 
investments in a company that was an eligible portfolio company at 
the time of the BDC's initial investment(s), but that subsequently 
lost its status as an eligible portfolio company because it issued 
margin securities.
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III. Cost-Benefit Analysis

    We are sensitive to the costs and benefits that result from our 
rules. In the Proposing Release we requested public comment and 
specific data regarding the costs and benefits of the proposed rules. 
Several commenters suggested that proposed Rule 2a-46(a) would benefit 
BDCs by addressing the impact caused

[[Page 64089]]

by changes in the margin rules.\29\ Another commenter argued that the 
Commission calculated incorrectly the number of companies that the 
proposed rule would benefit and wrote that the proposal would benefit 
even fewer companies than the Commission estimated.\30\ We received no 
comments on the costs and benefits of proposed Rule 55a-1.
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    \29\ See, e.g., comment of American Capital Strategies (Jan. 7, 
2005); comments of the Committee on Federal Regulation of Securities 
of the Business Law Section of the American Bar Association (Jan. 5, 
2005).
    \30\ Comments of Williams & Jensen (Jan. 7, 2005). In addition, 
most commenters urged the Commission to modify the proposed rule to 
capture more small companies whose securities are listed on an 
Exchange. The Commission is reproposing Rule 2a-46(b) to address 
this concern. See supra note 1.
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A. Benefits

    Rules 2a-46 and 55a-1 would more closely align the definition of 
eligible portfolio company with the purpose that Congress intended when 
it established BDCs as a source of financing for certain types of 
companies. These companies often need capital for continued development 
and growth, but may be unable to borrow money through conventional 
sources or may not have ready access to the public capital markets. 
Rules 2a-46 and 55a-1 would also benefit BDCs by recapturing companies 
that Congress originally intended to make eligible for BDC investment 
as part of a BDC's 70 percent basket.
    A number of companies may have lost their eligible portfolio 
company status as a result of amendments to the Federal Reserve Board's 
margin rules. BDCs may be currently required to include in their 30 
percent basket--rather than in their 70 percent basket--any investment 
in these companies, notwithstanding the fact that they may be the type 
of companies that Congress intended to benefit from BDC financing.
    Rule 2a-46 defines an eligible portfolio company to include all 
private companies and those public companies whose securities are not 
listed on an Exchange. The Commission's Office of Economic Analysis 
(``OEA'') estimates that, as of June 2006, there were a total number of 
6,041 domestic operating companies with securities that were traded on 
the OTCBB and through Pink Sheets, and therefore would qualify as 
eligible portfolio companies under the rule. OEA reached this 
conclusion by first calculating the number of companies whose 
securities are trading on the OTCBB (3,295 companies) and through Pink 
Sheets (4,794 companies), and then removing from these figures 
estimates of all foreign companies, investment companies and companies 
that are excluded from the definition of investment company by Section 
3(c) of the Investment Company Act (e.g., REITS, banks, insurance 
companies) because both Section 2(a)(46) of the Investment Company Act 
and Rule 2a-46 exclude these types of companies from the definition of 
eligible portfolio company (a deduction of 776 companies from OTCBB and 
1,273 companies from Pink Sheets). OEA thus concluded that, as of June 
2006, there were a total of 6,041 domestic operating companies (2,519 
OTCBB companies and 3,522 Pink Sheets companies) that would qualify as 
eligible portfolio companies. OEA estimates that these 6,041 companies 
represent approximately 61.4 percent (6,041/9,845) \31\ of all public 
domestic operating companies that could qualify as eligible portfolio 
companies under Rule 2a-46.
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    \31\ OEA concluded that, as of June 2006, there were 9,845 
public domestic operating companies by calculating the number of 
companies whose securities are listed on Nasdaq, NYSE and Amex, in 
addition to those companies whose securities are trading on the 
OTCBB and through Pink Sheets, corrected for cases where individual 
companies had multiple classes of securities listed (60 companies), 
and then removing from this number foreign companies, investment 
companies, and companies that are excluded from the definition of 
investment company by Section 3(c). See Sections 2(a)(46)(A) and 
(B), supra note 7.
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    In the Proposing Release, we explained that OEA estimated that 60 
percent of public domestic operating companies do not have securities 
that trade on an Exchange, and thus would meet the definition of 
eligible portfolio company under proposed Rule 2a-46(a). We further 
explained that even more public companies should qualify as eligible 
portfolio companies by virtue of meeting the requirements of proposed 
paragraph (b) of that rule (which, as noted previously, is being 
reproposed).\32\
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    \32\ See 2004 Proposing Release, supra note 1 at n.49 and 
accompanying text.
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    We note that one commenter argued that the Commission calculated 
incorrectly the number of companies that the proposed rule would 
benefit and wrote that the proposal would benefit even fewer companies 
than the Commission estimated. The commenter argued that proposed Rule 
2a-46(a) (which we are adopting today as Rule 2a-46) would capture only 
52.4 percent of public companies.\33\
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    \33\ Comments of Williams & Jensen (Jan. 7, 2005).
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    The commenter's figure is lower than the figure calculated by OEA. 
It appears that the commenter did not remove from its data foreign 
companies, investment companies and companies that are excluded from 
the definition of investment company by Section 3(c). As discussed 
previously, because Section 2(a)(46) excludes these companies from the 
definition of eligible portfolio company, we believe that they should 
be excluded from the total number of companies trading on U.S. markets 
when quantifying the benefits of the rule.
    Rule 55a-1 provides additional benefits to certain companies that 
met the definition of eligible portfolio company under Rule 2a-46 at 
the time of the BDC's initial investment(s) in them but that 
subsequently lost their eligible portfolio company status under Rule 
2a-46, by allowing BDCs to make follow-on investments in such companies 
under certain conditions.
    Finally, we note that both Rule 2a-46 and Rule 55a-1 would benefit 
BDCs by expanding the universe of investments that may be included in 
their 70 percent baskets. It also benefits BDCs by addressing the 
uncertainty caused by changes in the margin rules in the operation of 
BDCs. As one commenter noted, a ``technical flaw'' in the definition of 
eligible portfolio company arose as a result of changes to the margin 
rules which imposed substantial constraints on BDC investments. The 
commenter expressed its view that proposed Rule 2a-46(a) had corrected 
this flaw.\34\
---------------------------------------------------------------------------

    \34\ See, e.g., comment of American Capital Strategies (Jan. 7, 
2005). See also comments of Capital Southwest Corp. (Dec. 28, 2004).
---------------------------------------------------------------------------

B. Costs

    While Rules 2a-46 and 55a-1 might impose certain administrative 
compliance costs on BDCs, we expect such costs to be minimal and 
commenters provided no data as requested in the 2004 Proposing Release. 
Under Rule 2a-46, a BDC would need to determine, prior to investing in 
a company, whether the company has a class of securities listed on an 
Exchange. Such information is easily obtainable through reliable third-
party sources. Furthermore, Section 55 of the Investment Company Act 
generally requires a BDC to invest in eligible portfolio companies 
through privately negotiated transactions. Thus, this information would 
also be readily available to a BDC from the company during the course 
of these negotiations.
    We also expect that a BDC's costs relating to the requirements of 
Rule 55a-1 will be minimal. Rule 55a-1 permits a BDC to include in its 
70 percent basket follow-on investments in a company that met the 
definition of eligible portfolio company under Rule 2a-46 when the BDC 
made its initial

[[Page 64090]]

investment(s), but that does not meet that definition at the time of 
the follow-on investment. A BDC generally may make follow-on 
investments under the rule only if, at the time of the follow-on 
investment, the BDC owns at least 50 percent of (1) the greatest number 
of equity securities of such company, including securities convertible 
into or exchangeable for such securities and (2) the greatest amount of 
certain debt securities of such company held by the BDC at any time 
during the period when such company was an eligible portfolio company. 
In addition, the rule requires a BDC that makes such a follow-on 
investment to be one of the twenty largest holders of record of the 
company's outstanding voting securities at the time of that investment.
    These requirements mirror the 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 percent basket certain follow-on investments 
in companies 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 a company that had lost their eligible 
portfolio company status because they had issued marginable securities. 
We anticipate that the rule will impose only minimal, if any, costs on 
companies.

IV. 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, to consider, in addition to the protection of investors, 
whether the action will promote efficiency, competition and capital 
formation.\35\ In the Proposing Release, we requested comment on our 
analysis of the impact of the proposed rules on efficiency, competition 
and capital formation. Although we did not receive any comments that 
specifically addressed proposed Rule 2a-46(a), which is the provision 
that we are adopting today, we did receive comments about the entire 
rule.
---------------------------------------------------------------------------

    \35\ 15 U.S.C. 80a-2(c).
---------------------------------------------------------------------------

    Specifically, some commenters argued that proposed Rule 2a-46 was 
too narrow and did not capture all of the very small public companies 
that could benefit from BDC financing.\36\ We interpreted this comment 
to suggest that capital formation may have been limited under the 
proposed rule. We are sensitive to this concern and therefore are 
seeking comment on reproposed Rule 2a-46(b) in a separate release.\37\
---------------------------------------------------------------------------

    \36\ See supra note 16 and accompanying text.
    \37\ See supra note 1.
---------------------------------------------------------------------------

    Some commenters also expressed a concern that proposed Rule 2a-
46(a), when coupled with the definition set forth in proposed paragraph 
(b), would cause BDCs to focus their investment activities on companies 
that are in financial distress because of their view that most public 
companies that are quoted on the OTCBB or through Pink Sheets are 
financially troubled.\38\ We interpret this comment to suggest that the 
rule does not promote efficiency and would impede capital formation. 
Rule 2a-46 as adopted, however, does not require BDCs to focus their 
investment activities in financially troubled companies. Rather, Rule 
2a-46 allows BDCs to invest in all companies whose securities are 
traded on the OTCBB and through Pink Sheets, including small, 
developing, financially stable public companies, which are among the 
types of companies that Congress intended to benefit from BDC 
financing.\39\
---------------------------------------------------------------------------

    \38\ See supra note 24 and accompanying text.
    \39\ See supra note 25 and accompanying text.
---------------------------------------------------------------------------

    As discussed, the new rules more closely align the definition of 
eligible portfolio company, and the investment activities of BDCs, with 
the purpose that Congress intended. Rule 2a-46 defines eligible 
portfolio company to include all private companies and approximately 
61.4 percent of public domestic operating companies. Rule 55a-1 permits 
a BDC to include in its 70 percent basket follow-on investments in a 
company that met the definition of eligible portfolio company under 
Rule 2a-46 when the BDC made its initial investment(s), but that does 
not meet that definition at the time of the follow-on investment. Both 
rules will promote efficiency, competition and capital formation.
    Specifically, both rules promote efficiency by more closely 
aligning the definition of eligible portfolio company with the purpose 
of SBIIA. To the extent that BDC investments represent additional 
capital to certain small companies, these rules enhance efficiency. 
Efficiency will be enhanced because the rules address the unintended 
adverse impact that the amendments to the margin rules have had on the 
ability of BDCs to provide financing to these companies. Rule 2a-46 in 
our view also promotes efficiency by providing a workable and 
appropriate test for determining whether a company is an eligible 
portfolio company. Rule 55a-1 will further enhance efficiency by making 
it easier for BDCs to make follow-on investments in companies that no 
longer meet the definition of eligible portfolio company under Rule 2a-
46.
    We also anticipate that these rules will promote competition. The 
market for private equity and debt investments can be highly 
competitive. Since their establishment, BDCs have competed with various 
sources of capital, including private equity funds, hedge funds, 
investment banks and other BDCs, to provide financing to certain small 
businesses. We expect that the rules will encourage competition by 
addressing the impact and uncertainty caused by changes in the margin 
rules on BDC investment. Under the rules, BDCs will be able to compete 
with other entities that provide capital to small, developing and 
financially troubled companies in a manner that is consistent with the 
statutory requirement that at least 70 percent of a BDC's assets must 
be invested in those businesses at the time of any new investment. We 
further note that shareholders of companies that had lost their status 
as eligible portfolio companies will benefit under the rules because 
such companies may now more readily consider BDCs as a source of 
financing.
    Finally, we anticipate that the new rules will promote capital 
formation. As mentioned above, eligible portfolio company is broadly 
defined to include all private companies and a significant portion of 
public domestic operating companies. The definition, however, is 
designed to ensure that the investment activities of BDCs remain 
focused primarily on the types of companies that Congress intended BDCs 
to assist.

V. 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.].

VI. Final Regulatory Flexibility Analysis

    This Final Regulatory Flexibility Analysis has been prepared in 
accordance with 5 U.S.C. 604, which relates to new Rules 2a-46 and 55a-
1 under the Investment Company Act. An Initial Regulatory Flexibility 
Analysis (``IRFA'') was prepared in accordance

[[Page 64091]]

with 5 U.S.C. 603 and was published in the Proposing Release.\40\
---------------------------------------------------------------------------

    \40\ 2004 Proposing Release, supra note 1 at Section VII.
---------------------------------------------------------------------------

A. Reasons and Objectives of the New Rules

    As described more fully in Sections I. and II. of this Release, the 
objectives of the new rules are to more closely align 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. The rules are designed to 
recapture in the definition of eligible portfolio company companies 
that Congress originally intended to include within the definition, but 
that may have lost their eligible portfolio company status as a result 
of the 1998 amendment to the Federal Reserve Board's margin rules.

B. Significant Issues Raised by Public Comment

    When the Commission proposed the rules that are being adopted 
today, comment was requested on the proposal and the accompanying IRFA. 
We received thirty-six comment letters that addressed the proposed 
rules. As discussed, some commenters believed that proposed Rule 2a-46 
was too narrow and did not include some small public companies that can 
benefit from BDC financing. In a separate release, we are seeking 
comment on reproposed Rule 2a-46(b), which would address this concern. 
None of the comment letters, however, specifically addressed the IRFA.

C. Small Entities Subject to the Rule

    Rules 2a-46 and 55a-1 affect both BDCs and companies 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.\41\ As of December 2005, there were 87 BDCs, 
of which 66 were small entities. A company 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.\42\ We estimate that there are approximately 2,500 
companies, other than investment companies, that may be considered 
small entities under the Regulatory Flexibility Act.
---------------------------------------------------------------------------

    \41\ 17 CFR 270.0-10.
    \42\ 17 CFR 230.157; 17 CFR 240.0-10.
---------------------------------------------------------------------------

    As discussed in this Release, the rules are intended to more 
closely align the definition of eligible portfolio company with the 
purpose that Congress intended when it established BDCs as a source of 
financing for certain small companies. These companies often need 
capital for continued development and growth, but may be unable to 
borrow money through conventional sources or may not have ready access 
to the public capital markets. The rules would also benefit BDCs, 
including those that are small entities, by recapturing the types of 
companies that Congress originally intended to make eligible for BDC 
investment as part of a BDC's 70 percent basket. We have no reason to 
expect that those BDCs and companies that are small entities for 
purposes of the Regulatory Flexibility Act will be disproportionately 
affected by the rules.

D. Reporting, Recordkeeping and Other Compliance Requirements

    The rules do not impose any new reporting or recordkeeping 
requirements on BDCs or on companies. The rules also do not impose any 
compliance requirements on companies. They do, however, impose minimal 
compliance requirements on all BDCs, including small entities. Under 
Rule 2a-46, a BDC, prior to investing in a company, would need to 
determine whether the company has a class of securities listed on an 
Exchange. This information is readily available, and we believe that 
all BDCs, including those that are small entities, already evaluate 
similar types of information when considering whether to invest in a 
company.
    Rule 55a-1 permits a BDC to include in its 70 percent basket 
follow-on investments in a company that met the definition of eligible 
portfolio company under Rule 2a-46 when the BDC made its initial 
investment(s), but that does not meet that definition at the time of 
the follow-on investment. A BDC generally may make follow-on 
investments under the rule only if, at the time of the follow-on 
investment, the BDC owns at least 50 percent of (1) the greatest number 
of equity securities of such company, including securities convertible 
into or exchangeable for such securities and (2) the greatest amount of 
certain debt securities of such company held by the BDC at any time 
during the period when such company was an eligible portfolio company. 
In addition, the rule requires a BDC that makes such a follow-on 
investment to be one of the twenty largest holders of record of the 
company's outstanding voting securities at the time of investment. 
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 percent basket certain follow-on investments 
in companies 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 companies that had lost their eligible portfolio company status 
because they had issued marginable securities.

E. Commission Action to Minimize Adverse Impact on Small Entities

    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 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 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 rules 
do not impose any reporting requirements on BDCs or on companies. In 
addition, the rules do not impose any compliance requirements on 
companies. Both Rules 2a-46 and 55a-1, however, do impose some 
compliance requirements on BDCs that are intended to ensure that BDCs 
invest primarily in those companies that Congress intended them to 
invest in when it established BDCs in 1980. These requirements should, 
however, impose minimum burdens on BDCs. We note that Rule 2a-46 as 
adopted does not include proposed paragraph (b) in part because of 
commenters' concerns that the conditions of that provision are 
unworkable and burdensome.
    We also believe that clarifying, consolidating, or simplifying the 
compliance requirements under the rules for small entities is 
inappropriate. As discussed above, neither rule imposes any compliance 
requirements on companies. Although the rules do impose some compliance 
requirements on BDCs, as discussed above, these requirements, which we 
believe will

[[Page 64092]]

impose minimal burdens on BDCs, are designed to insure that BDCs invest 
primarily in those companies that Congress intended them to invest in 
when it established BDCs in 1980.
    We believe that the use of performance rather than design standards 
would add unnecessary complexity. The rules are intended to address the 
impact and the uncertainty as a result of the 1998 amendment to the 
Federal Reserve Board's margin rules by providing a clear, bright-line, 
workable test for determining whether a company is an eligible 
portfolio company. A standard based on performance could be unduly 
complicated and cause further uncertainty to BDCs, including those that 
are small entities, when determining whether a company is an eligible 
portfolio company. Likewise, the use of a performance standard would 
bring uncertainty to companies, including those that are small 
entities, in determining whether they meet the definition of eligible 
portfolio company.
    Finally, we believe that it would be inappropriate to exempt small 
entities from the coverage of the rules. The rules are intended to 
benefit BDCs and certain companies that qualify as eligible portfolio 
companies, including those BDCs and other companies that are small 
entities. These eligible portfolio companies often need capital for 
continued development and growth. Exempting small entities from all or 
part of the rules would be contradictory to the purpose of the rules.

VII. Statutory Authority

    We are adopting Rules 2a-46 and 55a-1 pursuant to our rulemaking 
authority under Sections 2(a)(46)(C)(iv), 6(c) and 38(a) of the 
Investment Company Act.

List of Subjects in 17 CFR Part 270

    Investment companies, Reporting and recordkeeping requirements, 
Securities.

Text of Rules

0
For reasons set forth in the preamble, Title 17, Chapter II of the Code 
of Federal Regulations is amended as follows:

PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940

0
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.
* * * * *

0
2. Section 270.2a-46 is added to read as follows:

Sec.  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 does 
not have any class of securities listed on a national securities 
exchange.

0
3. Section 270.55a-1 is added to read as follows:

Sec.  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 sections 2(a)(46)(A) and (B) of the Act (15 
U.S.C. 80a-2(a)(46)(A) and (B)), but the issuer is not an eligible 
portfolio company because it does not meet the requirements of Sec.  
270.2a-46, and the business development company 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: October 25, 2006.

    By the Commission.
Nancy M. Morris,
Secretary.
[FR Doc. E6-18255 Filed 10-30-06; 8:45 am]

BILLING CODE 8011-01-P