SBIA Comments on the SEC Concept Release on Harmonization of Securities Offering Exemptions
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-0609
September 25, 2019
Re: File No. S7-08-19: SBIA Comments on the SEC Concept Release on Harmonization of Securities Offering Exemptions
The Small Business Investor Alliance (“SBIA”) appreciates the opportunity to comment on the “Concept Release on Harmonization of Securities Offering Exemptions”1 (“Concept Release”) that was released on June 18, 2019 by the Securities & Exchange Commission (“SEC” or “Commission”).
SBIA is a national association that develops, supports, and advocates on behalf of policies that benefit investment funds that finance small and mid-size businesses in the lower middle market, as well as the investors that provide capital to these funds. Our membership consists of the advisers of traditional 3(c)(1) and 3(c)(7) private funds, funds and their advisers that have been licensed by the Small Business Administration (“SBA”) as Small Business Investment Companies (“SBICs”), funds registered as business development companies (“BDCs”) under the Investment Company Act of 1940, and the investors that invest in these funds, including banks, family offices, and funds of funds.
As we stated in our previous comment letter on the 2015 SEC Staff Report on the Review of the Definition of “Accredited Investor” (the “Prior Letter”),2 SBIA generally supports proposals that expand the pool of available capital for small business investment, and generally recommends against proposals that would reduce the pool of potential investors in small business funds. SBIA also encourages the Commission to consider changes that would improve secondary trading opportunities for BDCs, including exempting BDCs from the definition of an “Acquired Fund” for purposes of calculating Acquired Fund Fees and Expenses (“AFFE”).
I. The Impact on SBIA Members Due to Recommendations on Adjusting the Accredited Investor Definition
As we noted in our Prior Letter, SBIA’s members overwhelmingly rely on Rule 506 of Regulation D, for the exemption from registration under the Securities Act of 1933, and on section 3(c)(1), section 3(c)(7), or both of the Investment Company Act of 1940, for exemption from investment company registration requirements, when offering and selling interests in their funds. Accordingly, these funds generally restrict their offerings to natural persons and entities that qualify as accredited investors under Rule 501 of Regulation D. As a result, any change of the accredited investor definition to further limit its scope would have a significant negative effect on the ability of our members to raise capital for small business investments. We remain concerned that adjusting the “accredited investor” financial thresholds upward and setting new caps on the amounts each investor may invest, without a demonstrated need for these measures, will unduly limit the ability of our members to both raise capital and support small businesses.
II. The Recommended Changes to the Income and Net Worth Thresholds in the Concept Release Will Reduce the Pool of Potential Investors in Small Business Funds
The Concept Release suggests the following changes that SBIA believes would significantly harm the pool of available capital for small business investment: (1) introducing investment limits to the current income and net worth thresholds already in place; (2) creating new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limits; and; (3) indexing all financial thresholds for inflation on a going-forward basis.
As we stated in the Prior Letter, we do not believe there is a demonstrated need for instituting these changes and further restricting Americans’ ability to invest. Not only do these restrictions take away the freedom of investment choice from more Americans, but also would further restrict private investments to individuals who already are wealthy. This would be a significant detriment to capital formation and harm job creation. In our Prior Letter, we noted that the SEC has admitted that there has been no demonstrated investor protection need to raise the financial threshold, which, for example, were significantly increased in a previous rule amendment by excluding an investor’s primary residence from the accredited investor calculation. There have been no major regulatory or economic developments that we believe change the analysis in our Prior Letter.
We note that we agree with other commentators that believe that introducing new or additional thresholds would create complicated tiers of accredited investors, thereby increasing the complexity and costs of raising capital.3 Determining the tier for which an investor qualifies, based on their net worth or current income, would be burdensome and make it more difficult for funds to comply with the regulations. As a result, we believe the definition for an accredited investor should be binary: either the investor is accredited, or the investor is not.
III. SBIA Supports the Concept Release’s Recommendations to Allow New Alternative Methods to Establish Financial Sophistication for Americans
SBIA supports the new and alternative recommendations in the Concept Release that increase investment opportunities with little, if any, impact on investor protection. These recommendations include: (1) revising the definition to include all entities, rather than specifically enumerated types of entities; (2) expanding accredited investor status to individuals who, after receiving disclosure about the risks, opt into being accredited investors; and (3) permitting an investor, whether a natural person or an entity, that is advised by a registered financial professional to be considered an accredited investor. We believe that each of these recommendations appropriately balances the goal of investor protection with prompting capital formation.
Additionally, as stated in our Prior Letter, SBIA continues to support the following recommendation: (1) permitting spousal equivalents to pool their finances to achieve accredited investor status; (2) grandfathering existing accredited investors for future offerings from existing issuers; (3) expanding accredited investor status to those that can establish sophistication in other ways, including permitting individuals with a minimum amount of investments; with certain professional credentials; with experience investing in exempt offerings; or who pass an accredited investor examination; and; (4) permitting knowledgeable employees of private funds or operating companies to qualify as accredited investors for investments in their employer’s fund or operating company.
We believe that each of the recommendations listed above would help encourage small business investment, as well as drive job creation. We support other comments that correctly discuss the need to expand the definition as it applies to entities. Entities, regardless of their form, can demonstrate their sophistication through possessing the requisite amount of investments. This would allow entities like 529 plans and other similar plans to invest in small businesses. Moreover, entities with $5 million invested are both sophisticated enough to protect themselves from investment risks and also secure enough to withstand potential loss. However, we would like to reiterate that a $5 million threshold remains very high, regardless of entity form.
IV. The Concept Release Fails to Provide Sufficient Evidence of the Need for Further Restrictions on Investor Choice
As stated in our Prior Letter, we do not believe there is a demonstrated need for investment limits, additional thresholds, or inflation-indexed thresholds. These changes only serve to further limit the number of people who can invest in funds that support small business, thereby reducing investment in such businesses. As it was in 2015, large funds continue to be too large to invest efficiently in small businesses, and their investors tend to be institutions. Smaller funds, however, are appropriately sized to invest in small businesses, and rely on individual investors. Proposed changes that either reduce the number of accredited investors or limit the amounts that accredited investors are able to invest, likely would unfairly limit the ability of investors to access promising investment opportunities. In addition, these changes would have a concentrated detrimental effect for small businesses in rural areas that already have difficulty attracting institutional investment capital, due to their distance from urban areas and differences in income and living costs. These changes would make it even more difficult for small businesses and others to receive the capital they need for economic growth and job creation, and hinder legislation specifically designed to encourage investment in “small, growing and financially troubled businesses.”4 As such, we wish to reiterate that any changes to these thresholds must be approached with care, with strong evidence that investor protection is needed, and while balancing the objective of raising capital in an efficient and effective manner.
V. The SEC Should Exempt BDCs from the Definition of “Acquired Fund” to encourage the improvement of secondary trading opportunities for BDCs.
As outlined in SBIA’s comments on the Proposed Rule regarding Fund of Funds Arrangements submitted on April 30, 2019,5 the SEC should exempt BDCs from the definition of “Acquired Fund” under Forms N-1A, N-2, N-3, N-4 and N-6 (the “Forms”). Most mutual funds, ETFs, and other registered investment companies (aside from BDC-focused ETFs) have either limited or avoided investing in BDCs since the AFFE requirements were adopted. In response to the AFFE requirements, most of the major index providers in 2014 – including S&P, MSCI, and Russell – dropped BDCs from their families of indices. In announcing this policy change, Russell cited the “distortive impact” that the AFFE requirements have had on fund expense ratios.6
The decline in investments in BDCs by mutual funds and ETFs also harms investors by suppressing the liquidity and market depth of BDC shares. Notably, the average trading volume of BDC shares has decreased by nearly 50 percent since 2014, which SBIA believes is largely due to the application of the AFFE rule to BDCs. This reduction in market activity has also likely contributed to the lack of independent third-party research coverage for BDCs.7 SBIA believes that exempting BDCs from the definition of an “Acquired Fund” for purposes of calculating Acquired Fund Fees and Expenses (“AFFE”) would help restore liquidity and market depth to BDC shares.
SBIA is happy to provide continued feedback on this important issue to our membership. Please contact SBIA’s Executive Director, BDC Council, Tonnie Wybensinger, at (202) 628-5055 or via email if we can provide additional assistance on this issue.
About the Small Business Investor Alliance (SBIA)
The Small Business Investor Alliance (SBIA) is the premier organization of lower middle market private equity funds and investors. SBIA works on behalf of its members as a tireless advocate for policies that promote competitive markets and robust domestic investment for growing small businesses. SBIA has been playing a pivotal role in promoting the growth and vitality of the private equity industry for over 50 years. For more information, visit www.SBIA.org or call (202) 628-5055.
1 U.S. Securities & Exchange Commission, Concept Release on Harmonization of Securities Offering Exemptions, June 18, 2019, available at: https://www.sec.gov/rules/concept/2019/33-10649.pdf.
2 Small Business Investor Alliance, SBIA Comments on the SEC Report on the Review of the Definition of Accredited Investor, March 7, 2016, available at: https://www.sec.gov/comments/4-692/4692-15.pdf.
3 Todd McCracken, CEO, National Small Business Association, NSBA Comments on the SEC Report on the Review of the Definition of Accredited Investor, March 19, 2016, available at https://www.sec.gov/comments/4-692/4692-18.pdf.
4 See, e.g., Act of Sept. 17, 1980, Pub. L. No. 96-477, H.R. Rep. 96-1341 (Small Business Investment Incentive Act of 1980).
5 Brett Palmer, Small Business Investor Alliance, SBIA Comments on the Proposed Rule regarding Fund of Funds Arrangements, available at https://www.sec.gov/comments/s7-27-18/s72718-5431570-184653.pdf.
6 See, e.g., Barron’s, Russell Sets Terms for Booting BDCs: Should You Buy the Dip? (Mar. 4, 2014) (Brendan Conway), available at https://www.barrons.com/articles/russell-sets-terms-for-booting-bdcs-should-you-buy-the-dip-1393960960. By eliminating BDCs from the Russell 2000 Index, Russell index funds with disclosed expense ratios from 20 to 30 basis points could reduce the expense ratio disclosed in their prospectus fee tables by 5 to 7 basis points. Wells Fargo Securities Equity Research, the 2Q18 BDC Scorecard (Jan. 18, 2017) (“2Q18 BDC Scorecard”). The disclosed expense ratio reduction, of course, would have no effect on fund performance)
7 See, e.g., Bock, O’Shea and Mazzoli, New SEC Leadership Announced and Hopefully A Fresh Take on an Old Rule, Equity Research (Wells Fargo Securities, LLC) (Sept. 7, 2017), Exhibit 11 – Russell Commentary on BDC Exclusion at 9).