Development Companies and Business Loans; Passive Business

SMALL BUSINESS ADMINISTRATION

13 CFR Parts 108 and 120

Development Companies and Business Loans; Passive Business

AGENCY: Small Business Administration (SBA).

ACTION: Notice of proposed rulemaking.

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SUMMARY: This proposed rule would allow certain passive businesses to

be eligible for SBA financial assistance under both the SBA's

development company and 7(a) business loan programs if the real estate

(or personal property) it holds would be used by an eligible small

business concern in which any owner of at least 20 percent of the

passive business owns at least 20 percent of the small business

concern. The proposed rule would eliminate many requirements and

restrictions which presently limit the use of real estate holding

entities in SBA's business loan and development company programs.

DATES: Comments must be submitted on or before April 25, 1994.

ADDRESSES: Comments may be mailed to John R. Cox, Acting Assistant

Administrator for Financial Assistance, Small Business Administration,

409 3rd Street SW., Washington, DC 20416.

FOR FURTHER INFORMATION CONTACT:

John R. Cox, 202/205-6490.

SUPPLEMENTARY INFORMATION: Section 120.101-2(e) of SBA's regulations

(13 CFR 120.101-2(e) (1993)) provides that a real estate holding entity

(known as an alter ego) may be eligible as an applicant for financial

assistance under the SBA business loan program if it is organized and

operated for profit as a corporation, partnership or individual

proprietorship. It must be in the business of owning and leasing

property to an operating small business concern for the latter's

exclusive use. There must be an identity of ownership in the borrower

and the small business concern. The regulation also contains a

complicated description of certain familial relationships which qualify

as identical for purposes of ownership interest. The regulation also

requires as collateral for the assistance that: (1) The applicant

pledge the lease between it and the operating concern, (2) the

operating concern must be a guarantor or coborrower on the loan, and

(3) the owners of the operating concern must guarantee the loan.

Section 108.8(d) of the regulations governing SBA's development

company program (13 CFR 108.8(d) (1993)) allows a real estate holding

entity (known as an alter ego) to be eligible for a loan made pursuant

to that program if, among other requirements, it is a business

organized for profit, the ownership interests in the holding entity and

the small business concern to which it leases the property are

identical except for the complicated exceptions with respect to

selected family owners, the collateral for the assistance includes an

assignment of the lease between the holding entity and the small

business, and the small business guarantees the loan or is a co-

borrower. In addition, there is a provision which covers the

possibility that the operating concern could sublease part of the

property to a third party.

These detailed requirements and restrictions are confusing and

burdensome for the public. Numerous interpretations and guidelines have

failed to eliminate inconsistent treatment by SBA of applicant holding

entities from program to program. The public has become frustrated by

some of the subtle distinctions between the two programs with respect

to these real estate holding entities, and the SBA servicing of loans

which have been made to them has added to the general confusion.

SBA recognizes that valid business reasons (such as estate planning

or tax purposes) may exist for an operating small business concern to

spin off into an affiliate the real estate on which the operating

concern operates its business, and SBA wants to provide assistance in

such situations where possible. The Agency, at the same time, wants to

ensure that it will not finance purely passive investments in real or

personal property. The holding entity regulations were initially

promulgated fifteen years ago to accomplish this intent, but the

changes, revisions and amendments to the regulations have caused

confusion, inconsistency and frustration by the public and SBA

personnel.

Therefore, the Agency is proposing to simplify the present

regulations by eliminating many of the above referenced limitations and

restrictions. This proposed regulation, if enacted in final form, would

eliminate the inconsistency which is inherent under the present rules,

and it would greatly assist potential small business applicants which

seek SBA financial assistance through their real estate holding

affiliates. The Agency will no longer refer to the real estate holding

entity as an alter ego, but will consider it to be the passive

business.

It must be reiterated that SBA does not intend under this proposal

to finance a passive business or investment property which requires no

active involvement by the business owners. A passive business would be

an acceptable and eligible applicant under these proposed regulations

because it is a holding entity affiliated with an otherwise eligible

small business concern.

Under this proposal, a passive business applicant would be eligible

if the real estate (or personal property) it holds would be used by an

eligible small business concern and at least one 20 percent owner of

the passive business also owns at least 20 percent of the small

business concern. Under this proposal, a trust could qualify as an

eligible passive business if the grantor or trustee of the trust owns

at least 20 percent of the small business concern, or if a beneficiary

of at least 20 percent of the trust assets has at least a 20 percent

ownership in the small business concern. This ownership requirement

would identify the passive business with the operating business for SBA

regulatory purposes. The proposed regulation does not require that

there be more than one 20 percent owner of both entities or that the

principals control either entity. As long as one person is a 20 percent

owner in both entities that would be sufficient to make an entity the

eligibility passive business affiliate of the small business concern

since that person would be considered to be a principal in both

entities. Alternatively, if members of the same family (father, mother,

son, daughter, wife, husband, brother or sister) meet the 20 percent

ownership requirement in both the passive business and the small

business concern they would be considered to be the same principal for

SBA purposes.

Both the passive business and the small business concern would be

required to be obligated on the vote evidencing the assistance, and any

person who has a 20 percent ownership interest in both entities would

provide a personal guarantee to support the SBA financial assistance.

Proprietors, partners, officers, directors and owners of 20 percent or

more in either entity would also be subject to the collateral

provisions set forth in Sec. 120.103-2(c) of the SBA regulations.

Under this proposed rule, SBA would eliminate the present

requirement in the business loan program that the passive business must

only be a proprietorship, partnership or corporation in order to

accommodate SBA's policy that a trust can be an eligible passive

business if it otherwise comports with the requirements of this

regulation. It would eliminate the present convoluted and complicated

provisions which detail the listed family members who can hold

ownership interests in the passive business and small business concern

in varying percentages of ownership. It would also eliminate the

present requirement which mandates that non-family owners have complete

identity of interests. The purpose of these proposed changes is to

simplify the rules and to ensure that SBA financial assistance remains

available for a legitimate passive business affiliate of an eligible

small business concern when the affiliate holds real estate or personal

property leased to the small business concern and utilized for business

purposes. SBA has proceeded in its business assistance programs on the

assumption that a principal owns at least 20 percent of a business and,

under Sec. 120.103-2(c) of its regulations, SBA generally requires a

proprietor, partner, officer, director, or 20 percent owner to execute

a personal guarantee as collateral for the assistance. This requirement

would apply to such enumerated persons in either entity. Prudent

standards of banking practice will continue to dictate the rules in

providing SBA financial assistance to eligible passive businesses. In

addition, SBA would evaluate on a case by case basis whether the small

business concern must make use of all the real property subject to the

lease immediately after execution or whether it could sublease part of

the property for an interim period of time. SBA does not want to

interpose itself into the details of the arrangements, so long as the

Agency is assured, pursuant to the statutory provisions, that the

financial assistance will be repaid.

Compliance With Executive Orders 12612, 12778 and 12866, the Regulatory

Flexibility Act, 5 U.S.C. 601 et seq., and the Paperwork Reduction Act,

44 U.S.C. ch. 35

For purposes of the Regulatory Flexibility Act, 5 U.S.C. 601 et

seq., SBA certifies that this proposed rule, if promulgated in final

form, will not have a significant impact on a substantial number of

small entities.

SBA certifies that this proposed rule, if promulgated in final

form, will not constitute a significant regulatory action for the

purposes of Executive Order 12866, since the proposed change is not

likely to result in an annual effect on the economy of $100 million or

more.

SBA certifies that the proposed rule, if promulgated in final form,

would not impose additional reporting or recordkeeping requirements

which would be subject to the Paperwork Reduction Act, 44 U.S.C.

Chapter 35.

SBA certifies that this proposed rule would not have federalism

implications warranting the preparation of a Federalism Assessment in

accordance with Executive Order 12612.

Further, for purposes of Executive Order 12778, SBA certifies that

this proposed rule, if promulgated in final form, is drafted, to the

extent practicable, in accordance with the standards set forth in

section 2 of that order.

(Catalog of Federal Domestic Assistance Programs, No. 59.012, Small

Business Loans and No. 59.013, State and Local Development Loans)

List of Subjects

13 CFR Part 108

Loan programs--business, Small businesses.

13 CFR Part 120

Loan programs--business, Small businesses.

Accordingly, pursuant to the authority contained in section 5(b)(6)

of the Small Business Act (15 U.S.C. 634(b)(6)), SBA hereby proposes to

amend parts 108 and 120, chapter I, title 13, Code of Federal

Regulations, as follows:

PART 108--LOANS TO STATE AND LOCAL DEVELOPMENT COMPANIES

1. The authority citation for part 108 would continue to read as

follows:

Authority: 15 U.S.C. 687(c), 695, 696, 697a, 697b, 697c.

2. Section 108.8 would be amended by revising paragraph (d) to read

as follows:

Sec. 108.8 Borrower requirements and prohibitions.

* * * * *

(d) Eligibility of passive business. A concern is ineligible if it

is a passive business primarily engaged in investing in property,

Provided, however, That a passive business is eligible if it owns and

leases or it proposes to own and lease real or personal property to an

otherwise eligible small business concern so long as:

(1) The passive business and the small business concern share a

common principal, as defined in this paragraph (d);

(2) The passive business engages in no activity other than

acquiring or owning property which it leases to the small business

concern for its exclusive use within a reasonable period of time, and

the proceeds of any section 502 or 503 assistance are used only for

this purpose;

(3) The passive business and the small business concern are both

obligated on the note evidencing the SBA assistance;

(4) The collateral for the financial assistance includes a lien on

the property and an assignment of the lease (including options

exercisable by the small business concern) between the passive business

and the small business concern, and such lease has a remaining term at

least equal to the term of the section 502 or 503 loan;

(5) Each person who is a principal as defined in this paragraph (d)

must provide a personal guarantee, and Sec. 120.103-2(c) of this title

(relating to collateral) is applicable to all persons enumerated

therein who are associated with either entity; and

(6) For purposes of this paragraph (d), a person is a ``principal''

if he or she is the legal or beneficial owner of at least 20 percent of

both the passive business and the small business concern to which the

passive business intends to lease real or personal property. If the

passive business exists in the form of a trust, the trust's grantor or

trustee would be a ``principal'' if he or she owns at least 20 percent

of the small business concern, and a beneficiary of at least 20 percent

of the trust's assets would be a ``principal'' if he or she owns at

least 20 percent of the small business concern. If members of the same

family (father, mother, son, daughter, wife, husband, brother or

sister) meet the 20 percent ownership requirement in both the passive

business and the small business concern they would be considered to be

the same ``principal'' for SBA purposes.

* * * * *

PART 120--BUSINESS LOAN POLICY

1. The authority citation for part 120 would continue to read as

follows:

Authority: 15 U.S.C. 634(b)(6) and 636(a) and (h).

2. Section 120.101-2 would be amended by revising the introductory

text and paragraph (e) to read as follows:

Sec. 120.101-2 Type of business.

Most small concerns are eligible for Financial Assistance. The

following types of businesses, however, are not eligible for SBA

assistance except where otherwise stated in this section.

* * * * *

(e) Lending or investment; eligibility of passive business.

Concerns which are primarily engaged in the business of lending or

investing. However, an applicant business passively engaged in

investing in property is eligible for SBA financing or refinancing if

it owns and leases or it proposes to own and lease real or personal

property to an otherwise eligible small business concern, so long as:

(1) The passive business and the small business concern share a

common principal, as defined in this paragraph (e);

(2) The passive business engages in no activity other than

acquiring or owning property which it leases to the small business

concern for its exclusive use within a reasonable period of time, and

the proceeds of any SBA guaranteed loan shall be used only for this

purpose or for working capital by the small business concern;

(3) The passive business and the small business concern are both

obligated on the note evidencing the SBA guaranteed loan;

(4) The collateral for the financial assistance includes a lien on

the property and an assignment of the lease (including options

exercisable by the small business concern) between the passive business

and the small business concern, and such lease has a remaining term at

least equal to the term of the SBA guaranteed loan;

(5) Each person who is a principal as defined in this paragraph (e)

must provide a personal guarantee, and Sec. 120.103-2(c) (relating to

collateral) is applicable to all persons enumerated therein who are

associated with either entity; and

(6) For purposes of this paragraph (e), a person is a ``principal''

if he or she is the legal or beneficial owner of at least 20 percent of

both the passive business and the small business concern to which the

passive business intends to lease real or personal property. If the

passive business exists in the form of a trust, the trust's grantor or

trustee would be a ``principal'' if he or she owns at least 20 percent

of the small business concern, and a beneficiary of at least 20 percent

of the trust's assets would be a ``principal'' if he or she also owns

at least 20 percent of the small business concern. If members of the

same family (father, mother, son, daughter, wife, husband, brother or

sister) meet the 20 percent ownership requirement in both the passive

business and the small business concern they would be considered to be

the same ``principal'' for SBA purposes.

* * * * *

Dated: November 16, 1993.

Erskine B. Bowles,

Administrator.

[FR Doc. 94-3670 Filed 2-18-94; 8:45 am]

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