On October 31, 2014, the SEC’s Division of Investment Management issued a Guidance Update1 concerning the consolidation of financial statements filed by certain investment companies (“RICs”) registered under the Investment Company Act of 1940 (the “1940 Act”) and investment companies that have elected to be treated as business development companies (“BDCs”) under the 1940 Act that have wholly owned subsidiaries.
Regulation S-X governs the requirements of financial statements filed by RICs and BDCs pursuant to, among other statutes, the 1940 Act and the Securities Act of 1933, and addresses the issue of consolidated financial statements. Article 3A of Regulation S-X provides that in deciding upon consolidation, registrants should consider what presentation is “most meaningful” and clearly exhibits their financial positions.2 There is a presumption for consolidation when “one entity directly or indirectly has a controlling financial interest in another entity”. Furthermore, RICs and BDCs are subject to an additional rule that their statements may be consolidated only with statements of subsidiaries that are investment companies.3
The Guidance Update highlights some situations where questions may arise in the application of these requirements. For example, a RIC that is a feeder fund may have a controlling financial interest in the master fund, and a RIC that is a fund of funds in the same group of investment companies may have a controlling financial interest in the underlying funds. The Guidance Update states the general positions the staff has taken in such situations, as listed here:
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Please feel free to reach out to your regular contacts at the firm if you have any questions about the matters addressed in this alert. In addition, you are welcome to contact any of the above members of the firm’s Investment Management group.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Harman-Thomas
1 The full Guidance Update No. 2014-11 is available at http://www.sec.gov/investment/im-guidance-2014-11.pdf
2 Rule 3A-02 of Regulation S-X.
3 Rule 6-03(c) of Regulation S-X.
4 The Guidance Update states that unconsolidated financial statements are more meaningful for a feeder fund, provided that among other things: (i) the feeder fund attaches the financial statements of the master fund to its financial statements; (ii) if the master fund is organized as a partnership, the feeder fund separately discloses on its statement of operations the net investment income, the net realized gain or loss, and the net change in unrealized gain or loss allocated from the master fund; and (iii) if the master fund is organized as a partnership, the feeder fund includes the net investment income and expenses allocated from the master fund in its net investment income and expense ratios in its financial highlights. If the master fund is organized as a corporation, the classification of the master fund’s income in the feeder fund’s financial statements depends on the master fund’s distribution policies.
5 The Guidance Update notes that if investment in a single underlying fund is overwhelmingly significant, the fund of funds may consider presentation similar to that of the master-feeder fund.
This article was originally published by Bingham McCutchen LLP.