The FAIR Act (Fair Access to Investment Research Act) of 2017 (the “FAIR Act”) has led the SEC to propose a new rule 139b under the Securities Act of 1933, or the “Securities Act”. It would allow broker-dealers, including investment bank underwriters, and broker-dealer distributors that receive fees for fund distribution, to publish (or distribute) research reports on certain unaffiliated investment funds, without them being deemed an offer for sale and therefore a potential violation under the Securities Act. In particular, the proposed rule 139b would apply to both registered investment companies, including registered closed-end funds and mutual funds as well as business development companies, or “BDCs”.
“This better aligns BDCs and registered funds with public companies in general, including in particular regulated funds that conduct traditional firm commitment underwritten offerings on a frequent basis, such as many publicly-traded BDCs,” says Schulte Roth & Zabel investment management partner John J. Mahon, who is based in the firm’s Washington, D.C. office and regularly assists clients in connection with the establishment and operation of BDCs and both open-ended and closed-ended registered funds.
“Certainly one impetus for the change is that BDCs and certain similar registered funds have become much more active in raising both debt and equity capital through public follow-on offerings over the past decade or so, which has led to investment banks running into the restrictions on the use of the safe harbor under the current rule 139 for offerings involving regulated funds much more frequently,” explains Mahon.
The biggest impact will likely be on BDCs that do firm commitment underwritten follow on offerings on a routine basis.
John J. Mahon, partner, Schulte Roth & Zabel
“The new rule will cover registered closed-end funds, BDCs, traditional mutual funds and ETFs, as well as certain commodity vehicles that are publicly offered, but not technically regulated under the 1940 Act as they do not own securities, including oil, natural gas and gold funds that own physical commodities, and some currency-based trusts,” says Mahon.
The SEC estimates that 11,924 funds could be covered, including 9,564 mutual funds, 1,629 ETFs and ETPs, 596 closed-end funds and 136 BDCs. They have a market capitalisation of $20 trillion, made up of $17 trillion for open-ended mutual funds, $3 trillion for ETFs and ETPs, $317 billion for closed-end funds, and just $27 billion through BDCs (though this figure is lower than other estimates of $60 billion for BDC market capitalisation and ignores private BDCs).
BDCs are the smallest of these groups according to the SEC’s data on number and assets, but also the group most likely to avail themselves of the new rule according to Mahon, who expects: “the biggest impact will likely be on BDCs that do firm commitment underwritten follow on offerings on a routine basis.” He elaborates: “Non-traded regulated funds which are continuously offered but only provide for monthly, quarterly or annual redemptions, could also see a significant growth in research coverage from a larger network of unaffiliated broker-dealers, which have historically be unable to rely on the safe harbor under the current rule 139 for similar research reports relating to regulated funds.”
Clear rules exist on defining research and distinguishing it from advertising, which is subject to highly prescriptive rules on performance presentation metrics, with standard disclaimer language and qualifications. Though these very scripted rules could be relaxed for research reports covered by the new rule, Mahon stresses that firms still need to pay careful attention to avoid anything that might be deemed misleading. He also doubts whether reports historically deemed to be advertising will in the future be classified as research and relieved of the need to file with FINRA.
As part of addressing the requirements under the FAIR Act, the SEC has also proposed conforming changes under the Investment Company Act of 1940, or the “1940 Act”. In particular, those proposed changes, set forth in proposed rule 24b-4 under the 1940 Act, would carve out research reports that meet the content standards of any SRO, such as FINRA, from the SEC filing requirements set forth in Section 24(b) under the 1940 Act. As a result, “satisfying the FINRA requirements for research reports can remove the need to file with the SEC, thus avoiding duplication of regulatory oversight,” says Mahon.
Research reports published by the investment fund itself or its affiliates, and its investment advisers or their affiliates, are not covered, in order to ensure some degree of independence and address some potential conflicts of interest.
On 6 October 2017, Congress gave the SEC a 270-day deadline to implement the FAIR Act: much faster than the multi-year periods taken to implement some other acts.
Vehicles with less than a year of reporting history are also excluded, as the SEC fears that sparse information about new funds could make them sensitive to a biased report. In 2016, some 600 newly launched funds would have been excluded.
Vehicles with a public float market capitalisation (or net asset value for open-ended companies) below 75 million USD are expected to be excluded, in line with the rules on small public operating companies, due to SEC fears that they may be susceptible to price manipulation. So, this rule will not help micro-cap and nano-cap closed-end funds and operating companies, some of which appear to be somewhat “orphaned” in public markets. The assets held by such funds are relatively small in that they represent less than 1 percent of covered investment funds. However, the numbers of such funds are highly significant: nearly one third of all covered investment funds, and over 40 percent of ETFs, ETPs, and BDCs, would be excluded from the safe harbour. It remains to be seen if Congress comes up with any different proposals to help foster research on smaller BDCs, which can play an important role in financing smaller companies. The SEC does in fact have latitude to set a threshold lower (but not higher) than 75 million USD for investment funds, but in this instance appears to be prioritising its “investor protection” mandate over its “capital formation” mandate.
On 6 Oct. 2017, Congress gave the SEC a 270-day deadline to implement the FAIR Act, which would be much faster than the multi-year periods taken to implement some other acts. “We sense that the SEC is moving expeditiously on the rules Congress has asked it to implement and expect this will continue. The SEC will do whatever it takes to get it done. Still, the SEC takes its role as a regulator extremely seriously and will fully vet the proposal from every angle, taking into account various interests and viewpoints,” says Mahon. To that end, the SEC has invited comments in line with its usual policy, on topics such as defining investment funds, defining research reports, defining affiliates, and whether brokers’ revenue-sharing agreements should preclude them from publishing reports, or be disclosed. Mahon expects some potential push back on any restrictions on so-called 12b-1 fees, which remain popular with certain fund distributors.
The SEC has a dual mandate: investor protection and promotion of capital formation. Mahon feels that the SEC is reinvigorating its focus on capital formation over the past year or so, through rule proposals such as rule 139b that help address long-standing discrepancies between how operating companies and regulated funds are treated in connection with capital raising efforts. While this may in part be due to recent legislative efforts, including the FAIR Act itself, the SEC appears to have a greater willingness to address existing regulatory burdens that offer only limited investor protection while having a demonstrable negative impact on capital formation efforts.
The SEC’s cost-benefit analysis is qualitative in this case, as it does not feel able to put hard numbers on costs and benefits. It argues that the new rule “will generally reduce broker-dealers” costs of publishing and distributing research about covered investment funds and increase the supply of research reports, because this can be done without the content, liability and filing requirements of various rules.
Incidentally, research from investment consultants, research firms such as Morningstar, universities, academic journals, foundations, think tanks and so on will continue as usual. They have not previously been restricted, as they do not have broker/dealer or investment banking arms. However, the SEC believes that broker-dealers have a comparative advantage in producing research reports.
The SEC further expects that more research reports will educate investors about funds’ “management, objectives, risk exposures, tracking error, volatility, tax efficiency, fees” and help investors to “evaluate relative fund performance”. The SEC also expects that “negative information about a covered fund, such as high fees, high risk exposure, or an inefficient portfolio strategy will be more likely to be publicized because of increased competition among information providers”. The SEC is concerned that revenue sharing agreements, which are greatly restricted by RDR rules in the EU, create potential conflicts of interest, but expects this to be mitigated by increased competition amongst information providers. The SEC further expects that the rule will increase efficiency in the allocation of capital and thereby promote capital formation.
The SEC also expects “marginal efficiency improvements from reductions in regulatory ambiguity,” implicitly acknowledging the complexity and overlaps amongst multiple rules.
The FAIR Act proposals dovetail well with other reforms to BDCs and with renewed investor confidence in the space. The attraction of BDC dividend yields has led a significant number to trade at premiums to NAV during up markets, which has unleashed a continuing wave of follow-on debt and equity offerings by many of the larger publicly-traded BDCs over the past several years.
Mahon helps asset managers weigh the pros and cons of multiple fund structures, from angles including liquidity, issuance and registration processes, share repurchase routes, taxation, leverage, investability by retail investors, attractions for onshore versus offshore investors, reporting obligations, filing routines, interaction with SROs such as FINRA, and other criteria.
Issuance can be accelerated with some structures. For instance, “larger publicly-traded BDCs and registered closed-end funds can take advantage of a shelf registration statement process that allows them to complete follow-on debt and equity offerings quickly – in some cases even overnight – without a lengthy regulatory review process,” explains Mahon.
Higher ceilings on leverage for some BDCs (thanks to the Small Business Credit Availability Act) mean that issuance has an amplified multiplier effect on gross assets and may increase the appetite among BDCs for more liquid, lower yielding credit.
The SEC expects that negative information about a covered fund, such as high fees, high risk exposure, or an inefficient portfolio strategy will be more likely to be publicized because of increased competition among information providers.
While BDCs are more renowned for longer term, less liquid credit – advanced to US-based, non-public, middle-market issuers – they are not the only product in the regulated US fund sector that can accommodate illiquid credit. “Interval funds can be structured as either a BDC or a registered closed-end fund, and they can be either exchange-traded or non-traded. Conceptually, interval funds’ liquidity profile is a hybrid between a mutual fund and a regulated closed-end fund. Interval funds continuously offer shares but only repurchase them, at current NAV less typically a 2 percent repurchase fee, quarterly, semi-annually or annually, with each redemption often capped at 5 percent of a fund’s outstanding equity. In contrast, mutual funds might be required to redeem 100 percent in a single day,” says Mahon. Therefore, interval funds can have substantial allocations to less liquid alternative credit such as private syndicated debt and direct lending investments, though probably not up to 100 percent of gross assets. “They must still keep enough liquidity to fund the required repurchases, which can only be foregone in extreme circumstances or discontinued with shareholder approval,” says Mahon. Where shares are trading at a discount to NAV, buying them back at NAV clearly costs more than a tender offer, which would be accretive to shareholder NAV. “Interval fund share repurchase can be a less onerous regulatory process than a full tender offer, however, and avoids the Regulation M issue associated with having a concurrent continuous public offering,” says Mahon. “Interval funds can also command higher fees, including performance fees based on investment income, than traditional mutual funds, while they can still be sold to US retail investors in much the same manner as mutual funds,” adds Mahon.
Different rules apply where interval funds are structured as registered closed-end funds, in terms of FINRA offerings (a potentially more streamlined review process), leverage ratios (generally lower than for non-traded BDCs) and incentive fees (on income but not capital gains). Interval funds structured as registered closed-end funds also avoid US state “blue sky” registration requirements, which would generally apply to interval funds structured as BDCs that remain non-listed.
Private BDCs are another fund structure that has gained in popularity recently as an alternative to a traditional private credit fund structure. “While subject to the public reporting, transparency, compliance and investor protection obligations of a regulated fund (including the 1940 Act, the Exchange Act and Sarbanes-Oxley), they have a private equity-style liquidity profile, drawing down committed capital from investors as and when they can deploy it into investments. This helps mitigate cash drag,” says Mahon.
Their investment time horizon is more flexible than for many limited life closed-end funds. Rather than a pre-determined fund life, liquidity can be obtained through an IPO, exchange listing or merger with an existing public vehicle which can be an affiliated one with appropriate structuring, with timing decided opportunistically.
Private BDCs are marketed by private placement to accredited investors, most of which tend to be institutional investors that have historically invested in a sponsor’s other private credit vehicles. Notably, offshore investors can invest in the same structure as onshore ones, removing the need for master/feeder structures, and dual prospectuses and subscription agreements. “Investors also gain certainty with respect to the level of reporting and compliance they can expect for the new fund, given the SEC oversight and the Exchange Act and 1940 Act requirements to which it will be subject,” notes Mahon.