[Federal Register Volume 69, Number 215 (Monday, November 8, 2004)]
[Proposed Rules]
[Pages 64816-64824]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-24788]



[[Page 64815]]

-----------------------------------------------------------------------

Part II





Securities and Exchange Commission





-----------------------------------------------------------------------



17 CFR Part 270



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

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

[[Page 64816]]


-----------------------------------------------------------------------

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 [email protected]. 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 
closed-end 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\
---------------------------------------------------------------------------

    \1\ Pub. L. 96-477, 94 Stat. 2275 (1980) (codified at scattered 
sections of the United States Code).
    \2\ See 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.
    \3\ House Report at 23.
    \4\ For 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).
---------------------------------------------------------------------------

    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,

[[Page 64817]]

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\
---------------------------------------------------------------------------

    \5\ House Report at 22.
    \6\ These 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.
    \7\ Section 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, well-
established businesses.'').
    \8\ Section 55(a)(1) of the Investment Company Act.
    \9\ See 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.
    \10\ Section 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.
    \11\ House 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.'').
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \12\ Section 3 of the Investment Company Act [15 U.S.C. 80a-3].
    \13\ Sections 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.
    \14\ See House Report at 29.
    \15\ Section 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \16\ House Report at 30.
    \17\ See 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.'').
    \18\ 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 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.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \19\ Securities 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.
---------------------------------------------------------------------------

    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

[[Page 64818]]

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.
---------------------------------------------------------------------------

    \21\ Section 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.
    \22\ Convertible 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.
    \24\ See supra note 18.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \25\ See supra notes 12-14 and accompanying text.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \26\ See proposed Rule 2a-46(a).
    \27\ See proposed Rule 2a-46(b).
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------

    \28\ Under 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.
    \29\ See supra note 17.
    \30\ An 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.
---------------------------------------------------------------------------

    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

[[Page 64819]]

serve as mediums for the over-the-counter 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.
---------------------------------------------------------------------------

    \31\ For 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 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.
    \33\ We 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.
---------------------------------------------------------------------------

    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:
---------------------------------------------------------------------------

    \34\ H.R. 3170, 108th Cong. 1st Sess. (2003) (passed in the 
House of Representatives, Apr. 28, 2004) embodies such an approach.
    \35\ For 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].
    \36\ See supra note 4.
    \37\ Certain 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.
---------------------------------------------------------------------------

     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

[[Page 64820]]

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.
---------------------------------------------------------------------------

    \38\ Absent 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.
    \39\ Section 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \40\ The 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.
    \41\ While 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.
    \42\ Economic 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.
---------------------------------------------------------------------------

    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.
---------------------------------------------------------------------------

    \43\ See, 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.
---------------------------------------------------------------------------

     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

[[Page 64821]]

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.
---------------------------------------------------------------------------

    \44\ See supra note 40.
---------------------------------------------------------------------------

     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\
---------------------------------------------------------------------------

    \45\ House Report at 23.
    \46\ Section 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.
---------------------------------------------------------------------------

    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 non-
public offerings from the issuer or certain of its affiliates.
---------------------------------------------------------------------------

    \47\ Proposed Rule 55a-1 incorporates by reference the 
conditions set forth in Section 55(a)(1)(B). See supra note 46.
---------------------------------------------------------------------------

    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

[[Page 64822]]

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.
---------------------------------------------------------------------------

    \48\ See Section I of this Release.
---------------------------------------------------------------------------

    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\
---------------------------------------------------------------------------

    \49\ But see supra note 41.
---------------------------------------------------------------------------

    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 follow-on 
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\
---------------------------------------------------------------------------

    \50\ 15 U.S.C. 80a-2(c).
---------------------------------------------------------------------------

    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,

[[Page 64823]]

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.
---------------------------------------------------------------------------

    \51\ 17 CFR 270.0-10.
    \52\ 17 CFR 230.157; 17 CFR 240.0-10.
---------------------------------------------------------------------------

    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 follow-on 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

[[Page 64824]]

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\
---------------------------------------------------------------------------

    \53\ Comments on the IRFA will be placed in the same public file 
that contains comments on the proposed rules themselves.
---------------------------------------------------------------------------

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:


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:
    (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:


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 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