American Energy Production Inc(fka AENP)

[Jagman]

New Rules for BDC's - Invitation to Abuse?
News and Commentary
December 12 2004
Let's give credit where it is due - but let us not forget to allocate responsibility as well.

So credit the Securities and Exchange Commission with making an effort to keep pace in a constantly changing marketplace by updating the rules for business development companies (BDCs) operating under the Investment Company Act of 1940. And allow us to hope that before these changes become effective, the SEC will have second thoughts.

It should come as no surprise that a number of obscure, struggling over-the-counter companies recently have decided to redefine themselves as BDCs. See ZannWell, Inc. – A Doctor in the House; Update: ZannWell, Inc. – The Doctor is Out; and ATNG, Inc. – BDC or Bust. BDC status carries several significant advantages, including the ability to issue unregistered shares, broad standards for calculation of assets, and a legitimate exemption from burdensome penny stock rules that place limits on the ability of brokers to peddle low-valued risky stocks. See The Investment Company Act of 1940 – It Was a Very Good Year. Although BDCs may be risky and have little intrinsic worth, brokerage firms can recommend them freely, without first qualifying clients.

Now the SEC has added an additional temptation for companies considering BDC status; one that has the potential to open the floodgates and introduce to the mix a group of companies that are particularly susceptible to abuse and manipulation – over-the-counter companies with no established business, few assets, negligible revenues, unidentified insiders and untested management. It is a disturbing prospect.

First, a little perspective. BDCs were established under The Investment Company Act of 1940 by a 1980 amendment which was designed to make capital available to small and financially struggling businesses. BDC status became available to companies that invested in the securities of certain qualified "portfolio companies" and provided those entities with management assistance. In order to qualify, a BDC was required to maintain at least 70% of its assets in the securities of such qualified companies. In order to be eligible, a portfolio company could not have any securities that were eligible for margin credit. The drafters reasoned that companies that issued marginable securities probably were mature enough to attract sufficient financing.

Unfortunately, the marginable securities test has left BDCs with slim pickin's. A 1998 amendment to Regulation T severely reduced the number of eligible portfolio companies by making all securities eligible for margin if they are traded on a national securities exchange or NASDAQ (including the NASDAQ Small Cap Market). That meant BDCs would have to accumulate interest in private companies or those that traded on the over-the-counter markets (the OTC Bulletin Board and Pink Sheets) none of which had the benefit of the vetting process imposed by NASDAQ and the national exchanges. In other words, the BDCs were very much on their own when it came time to determining the value of their investments – intrinsic or otherwise.

That 1998 amendment had a second prong, which the SEC now identifies as a principal reason for changing the definition of portfolio companies. It expanded the definition of margin securities to include any security that does not represent "equity" – effectively precluding entities that issue debt securities from the definition of portfolio companies.

Six years later, the SEC is seeking to address these developments. On November 1, 2004, the SEC proposed a rule that would expand the definition of portfolio companies. Most companies that are listed on NASDAQ or a national stock exchange would continue to be excluded. Eligible portfolio companies would include all companies that are not listed on one of those exchanges, and those companies that have been notified they are about to lose their listing on NASDAQ or a national stock exchange and would not qualify for initial listing on any such exchange. In addition, BDCs would be permitted to make 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.

While these changes tend to further the original agenda for BDCs – providing support for financially trouble companies, they also tend to further distance BDCs from regulatory oversight and BDC investors from regulatory protection. A portfolio consisting of untested over-the-counter companies, entities resulting from reverse-mergers, and businesses that trade on the unregulated Pink Sheets, almost necessarily means that investing in a BDC will be a dicey proposition for investors.

The over-the-counter markets have become a magnet for conniving stock promoters, pump and dump schemes, and short-selling antics that regulators have been unable to stem. Worse yet, over-the-counter companies have begun to opt for BDC status at an alarming rate. Consequently, the very sort of financially challenged public companies that the SEC seeks to classify as qualified portfolio investments will instead become BDCs themselves – and they in turn will hold portfolios consisting of other financially struggling businesses.

The prospects are alarming. Investors will hold shares of marginally viable companies, which control under-financed, under-capitalized businesses. Is this any way to run a marketplace?