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A small but notable step would be exempting business development companies, or BDCs, from the acquired fund fees and expenses, or AFFE, rule, which the Securities and Exchange Commission finalized in 2006. The rule may seem somewhat esoteric, but it has had the unintended consequence of dramatically curbing investment in BDCs — a category of closed-end investment vehicles — and ultimately limiting access to much-needed capital for small and midsize businesses.
More than 20 years after finalizing the AFFE rule, it is time the SEC or Congress fix the problem and unlock the full potential of BDCs to support American Main Street businesses as originally intended.
Undoubtedly, the SEC had good intentions in 2006 when it implemented the AFFE rule. The stated goal was to provide transparency in the fees that investors are required to pay through a fund's underlying holdings. However, an unintentional consequence of the AFFE rule was that S&P and Russell excluded BDCs from their stock indexes in 2014, erroneously mischaracterizing business expenses for BDCs as fees paid by their investors. These decisions led institutional investors who had bought BDCs through index funds to reduce their investments, thereby limiting their ability to raise capital from public equity markets and lend to growing middle-market companies.
Our analysis of the BDC exclusion event in a
The Senate Thursday joined the House in passing a resolution to overturn the SEC's SAB 121 accounting guidance for financial firms holding crypto in custody. President Biden has vowed to veto the measure.
Given the negative impact of the AFFE rule on BDCs and their borrowers, one may wonder why the SEC has not already exempted BDCs. After all, the SEC already exempts real estate investment trusts, or REITs, which are similar in structure to BDCs and incur similar "operating" expenses to BDCs that would otherwise be captured in AFFE. So why not BDCs as well?
It seems that status quo bias is the key factor in the lack of BDC exemption. This view can be inferred by looking at the comments on and conclusions from an SEC proposed rule change in 2020 that included a change to AFFE disclosure requirements. The proposed rule would have allowed many funds to report AFFE in a footnote rather than the main disclosure table. This change would likely have been sufficient for S&P and Russell to re-introduce BDCs into their indexes, thereby fixing the key source of harm caused by the AFFE rule. This potential benefit was acknowledged by the SEC at the time; nonetheless, the SEC chose not to adopt the proposed rule change. Recently, Congress has introduced a number of bipartisan bills to address this issue if the SEC does not.
Would the SEC have excluded BDCs from the AFFE rule in 2006 if it knew what it knows now? We believe so. The SEC's rulemaking process is inherently driven by a welfare analysis. Our analysis clearly demonstrates the significant unanticipated costs ultimately borne by small and midsize businesses.
We understand that most of the arguments to exempt BDCs from the AFFE rule have been made by industry participants over the past few years. However, we believe that the results from our study meaningfully add to this discourse. We hope policymakers agree so that we can sensibly change the rules to exempt BDCs from the AFFE rule to help small and midsize businesses — and the critical local jobs they create — and add price transparency in the private credit space.
When Congress created the BDC charter in 1980, it realized that growing companies needed to be able to access capital from equity markets as well as from banks. This is true now more than ever in today's economy. We urge the SEC, and if not, Congress, to act to make BDCs as efficient as possible.
