Small Business Investment Companies; Leverage; Participating Securities; Conditions Affecting Good Standing of Licensees

SUMMARY: This final rule implements certain of the changes to the Small

Business Investment Act of 1958, as amended, made by the ``Small

Business Equity Enhancement Act of 1992 (September 4, 1992).'' The

changes implemented by this rule relate to Leverage provided to SBICs

by SBA, and include increasing from $35 million to $90 million the

amount of Leverage that may be outstanding to any one Licensee or group

of Licensees under common control, incrementally reducing the maximum

ratio of Leverage to capital as capital is increased, establishing a

new form of Leverage (Participating Securities) which will be available

to Licensees that make Equity Capital Investments in small concerns,

permitting Specialized SBICs that are organized as limited partnerships

to obtain Leverage from SBA in the form of a preferred limited

partnership interest, and making other technical changes necessary to

implement the legislation.

DATES: This final rule is effective April 25, 1994.

FOR FURTHER INFORMATION CONTACT: Marvin D. Klapp, Acting Director,

Office of Program Development; telephone (202) 205-6515.

SUPPLEMENTARY INFORMATION: On August 5, 1993, SBA published two

proposed rules to implement certain changes to the Small Business

Investment Act of 1958, as amended (Act), made by title IV of Public

Law 102-366 (September 4, 1992). See 58 FR 41852 and 58 FR 41882. The

first of the two rules proposed changes in the way financial assistance

(Leverage) is provided to small business investment companies (SBICs or

Licensees), including the creation of a new form of Leverage called

Participating Securities, which would be available to Licensees making

equity-type investments in small concerns. The second of the two rules

proposed changes affecting the licensing and operations of SBICs.

The public was afforded a sixty-day period in which to submit

comments on the two proposed rules to the Agency. In recognition of the

complexity of the subject matter involved, SBA reopened and extended

the comment period on both proposed rules until November 18, 1993. See

58 FR 57568 (October 26, 1993).

After receiving and giving careful consideration to approximately

109 comment letters, SBA is today finalizing both proposed rules. This

final rule finalizes the proposed rule concerning Leverage,

Participating Securities and other miscellaneous matters. The final

rule immediately following this rule in the Federal Register

(Operations Rule) finalizes the proposed rule concerning licensing and

operations of SBICs.

In addition, SBA is simultaneously finalizing in this separate part

of the Federal Register the proposed rule published on July 29, 1993

(58 FR 40603), which revises one of the size standards for the SBIC

Program (Size Rule).

1. General Leverage Provisions

a. Introduction

SBA is finalizing the renumbering and reorganization of the

``Leverage'' sections of the SBIC Program regulations (Sec. 107.210

through Sec. 107.263) as proposed. SBA intends, at a later date, to

conform the remainder of the SBIC Program regulations (part 107 of

title 13 of the Code of Federal Regulations) to the new numbering

system used in the Leverage sections.

As in the proposed rule, the term ``Licensee'' used in this final

rule always includes SBICs licensed under the authority of section

301(c) of the Act (section 301(c) Licensees) and SBICs licensed under

the authority of section 301(d) of the Act (section 301(d) Licensees).

A section 301(c) Licensee is sometimes referred to as a Regular SBIC

because there is no restriction on the type of Small Concern that it

may assist. A section 301(d) Licensee is sometimes referred to as a

Specialized SBIC or SSBIC because it is only authorized to assist Small

Concerns owned by persons whose participation in the free enterprise

system is hampered because of social or economic disadvantages.

b. Application Procedures

In proposed Sec. 107.210, SBA set forth the application procedures

and basic eligibility requirements for obtaining Leverage from SBA. SBA

received fifty-eight (58) comment letters on this section, many of

which addressed the requirement in Sec. 107.210(c)(2) that applicants

for Leverage demonstrate a need for the Leverage funds.

The requirement for a demonstration of need is not a new concept

for the SBIC Program. Historically, a Licensee was considered to

``need'' Leverage if sixty-five percent (65%) of its private capital

had been invested or committed to investments in Small Concerns.

However, if a Licensee had significant available resources of its own

(e.g., unfunded commitments from investors), it was generally

considered not to be in need of Leverage.

SBA proposed an exception to this general rule for applicants for

Participating Securities Leverage: SBA would disregard the applicant's

temporary excess liquidity resulting from unfunded commitments or

drawdowns of commitments if the Licensee had invested at least fifty

percent (50%) of its Leverageable Capital\1\ and Leverage in Equity

Capital Investments (the required investment category for issuers of

Participating Securities). Under this exception, though, Licensees with

unfunded commitments would probably find themselves ineligible for

their first issuance of Participating Securities Leverage unless fifty

percent (50%) of their Leverageable Capital had already been invested

in Equity Capital Investments.

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\1\This term and the related term ``Regulatory Capital'' are

defined in the Operations Rule.

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The comments received by SBA questioned the appropriateness of

requiring Licensees to make Equity Capital Investments in order to be

eligible for Participating Securities Leverage. They argued that such a

requirement was inconsistent with the intent of the legislation, which

required that Equity Capital Investments be made with the proceeds of

Participating Securities.

The comments also argued in favor of extending to Debenture and

Preferred Securities issuers the same ability to demonstrate a need for

Leverage while commitments from investors remain unfunded.

SBA agrees with the comments. If any Licensee has invested fifty

percent (50%) of its Leverageable Capital plus outstanding Leverage and

is in compliance with SBA regulations, it should be eligible for SBA

Leverage. This should be true for all Licensees, not just those that

issue Participating Securities, and should be true regardless of the

type of investments that have been made by the Licensee (assuming, of

course, that the Licensee's past investments have been in eligible

Small Concerns). The proposed rule has been revised and finalized

accordingly.

It should be noted here that eligibility for Leverage does not mean

that Leverage necessarily will be available and forthcoming. In the

event that the demand for Leverage exceeds the available supply, SBA

will allocate Leverage among the eligible applicants unless and until

additional funds or guarantee authority is made available to meet such

demand.

c. Fees

As proposed, Sec. 107.210(d) increased the user fee charged in

connection with obtaining Leverage to two percent (2%) of the face

amount of Debentures, and instituted the same two percent (2%) fee for

Participating Securities. SBA received twenty-two (22) comments on this

subject, some objecting to an increased fee for Debenture Leverage

unless there were a corresponding increase in the cost of administering

such Leverage, and others objecting to increased fees in general unless

the fees could be used to offset the costs of managing the SBIC

Program.

SBA believes the increased fees are necessary to maintain the

current Debenture program and implement the new Participating

Securities program. SBA currently is able to use such fees to pay the

costs associated with the Leverage fundings, including the fees of

parties with which it contracts to perform services attendant to these

fundings. Any excess fees are deposited in the U.S. Treasury and are

counted when determining the ``subsidy rate'' of the particular SBIC

program that generated the fees. The subsidy rate for a program is a

measurement that determines the multiple of SBA guarantee authority

that can be made available for each dollar appropriated to that program

by Congress. Fees in excess of actual costs associated with the

Leverage fundings have the effect of reducing the particular SBIC

program's subsidy rate, thereby resulting in more ``guarantee dollars''

being available for the program participants. This is a benefit to all

Licensees seeking Leverage, especially when appropriated funds are

being curtailed due to budgetary constraints. SBA is therefore

finalizing the provision as proposed: the new user fee will be two

percent (2%) for all Debenture and Participating Securities issuers.

d. Subordination of Debentures

Proposed Sec. 107.210(f)(5) clarified that when SBA agrees to

subordination with respect to Debentures guaranteed after July 1, 1991,

the amount of indebtedness to which such subordination applies is fixed

at the time SBA subordinates, and is limited then and later to the

lesser of two hundred percent (200%) of the Licensee's Leverageable

Capital, or $10 million. Any indebtedness of the Licensee in excess of

that amount, whether in existence at the time SBA subordinates or

acquired subsequently, will not benefit from SBA's subordination.

The comments received on this provision were supportive of the

change. The provision is adopted as proposed.

e. Restrictions on Third Party Debt

As explained under the proposed rule, Licensees have been permitted

to apply for and obtain financing from third parties without obtaining

SBA's prior approval or even notifying the Agency, except upon the

filing of annual financial statements. Third party lenders have viewed

SBA Leverage, which is unsecured and generally subordinate, as part of

the capital base of the Licensee. In some cases, third party financing,

when aggregated with Leverage, has exceeded a prudent level of

indebtedness, and SBA has been forced to suffer large losses upon the

distribution of a Licensee's assets in liquidation, receivership or

bankruptcy proceedings.

Concern over SBA's creditor position prompted the Agency to tighten

its terms of subordination in July 1991. See 56 FR 31777. The

subordination limits then adopted, however, have not discouraged some

Licensees from incurring large amounts of secured third party debt.

Recognizing its obligation to further protect its exposure as the

largest creditor of most debtor Licensees, SBA proposed that it have

the right to approve all new third party debt of a Licensee.

As proposed, Sec. 107.210(f)(6) required that, after September 30,

1993, Licensees would need to obtain the written approval of SBA before

incurring or refinancing any third party debt or obtaining any line of

credit. In addition to conventional third party debt, this restriction

covered guarantees by Licensees and other voluntarily assumed

contingent liabilities. Licensees with existing lines of credit were

required to have such lines approved by SBA before increasing the

amounts outstanding above the balance owed on September 30, 1993.

SBA received 45 comments on this provision; all were opposed to the

proposal as written. The comments expressed concern that the need for

prior approval from SBA could be very damaging to SBIC business

operations. They suggested elimination of the requirement of prior

approval for a Licensee's normal business credit arrangements, for its

short-term bridge debt and, up to a certain safe-harbor level, for any

third-party debt.

After considering these comments, SBA has concluded that it can

eliminate entirely the requirement for prior approval of a Licensee's

unsecured third-party debt and still protect the Agency's interest in

the Licensee. This change, reflected in the final rule, should allow

Licensees to engage in their ordinary business credit arrangements

without interference from SBA.

SBA is not convinced, however, that secured third-party debt, of

any amount, should be incurred by a Licensee without SBA's prior

approval. SBA understands the SBIC industry's concern regarding the

prior approval process; in the past, SBA may not have been able to

respond to SBIC requests for approval in other matters as expeditiously

as both the SBICs and SBA might have liked. While SBA expects to deal

with all requests for prior approval on a timely basis, SBA is prepared

to commit itself to a thirty-day turn-around on certain requests. Thus,

the final rule provides that if a Licensee is in regulatory compliance

and has SBA Leverage not in excess of 1.5 times its Leverageable

Capital, and if the Licensee's request is for approval of a secured

line of credit which would not cause its aggregate third-party debt to

exceed fifty percent (50%) of Leverageable Capital, then the Licensee's

request for prior approval will be considered approved unless SBA

notifies it otherwise within thirty (30) days of receiving the request.

It should be noted that all debt, whether secured or unsecured, will be

aggregated to determine whether the Licensee may avail itself of the

thirty-day turn-around.

When making its determination as to whether a Licensee's request

for secured third-party debt should be approved, SBA will take into

consideration various factors including, but not limited to, the amount

of secured indebtedness relative to other debt of the Licensee and the

amount of secured indebtedness relative to the value of the Licensee's

collateral proposed to be granted as security.

Licensees are reminded that once a line of credit is approved by

SBA, subsequent draw-downs under the line of credit do not require SBA

approval.

The final rule extends the date after which SBA approval will be

required from September 30, 1993, to the date of publication of this

final rule. Licensees with existing secured lines of credit are

reminded to obtain SBA approval of such lines before increasing the

amounts outstanding above the balance owed on the date of publication.

The final rule also clarifies that if a Licensee has no Leverage,

it is not required to have its third-party debt approved by SBA.

f. Maintenance of Unimpaired Capital

(i) General

Former Sec. 107.203(d) required Leveraged Licensees to maintain

Private Capital in an amount sufficient to avoid a condition of Capital

Impairment. Under that regulation, a section 301(c) Licensee was

Capitally Impaired and was in violation of Sec. 107.203(d) if its

Undistributed Net Realized Earnings deficit, together with any

Unrealized Depreciation in excess of Unrealized Appreciation, exceeded

fifty percent (50%) of Private Capital. For a section 301(d) Licensee,

the applicable percentage was seventy-five percent (75%).

The proposed regulation on Capital Impairment (Sec. 107.210(h))

allowed, for the first time, varying degrees of impairment depending

upon differences in the composition of the portfolios of Licensees. The

proposal took the form of two grid structures, each consisting of nine

(9) categories for section 301(c) and section 301(d) Licensees,

respectively. The proposed rule continued to permit a higher percentage

of impairment for a section 301(d) Licensee than for a section 301(c)

Licensee whose situation was otherwise identical. However, the

differential was reduced to five (5) percentage points from the former

twenty-five (25) percentage points. In addition, the proposed rule

recognized the delay in profitability that is expected to occur in

venture investing.

The rationale for moving to a grid structure that would allow an

equity investor SBIC a higher permissible level of capital impairment

than a lender SBIC was set forth in the proposed rule. Essentially, the

proposed structure recognized that in a venture portfolio, especially

during the early years, there are likely to be considerable losses

before profits are realized, and a Capital Impairment Percentage of

fifty percent (50%) or more may exist even when the portfolio has

genuine long-term value. However, for a Licensee which only provides

loan financing, a Capital Impairment Percentage of fifty percent (50%)

generally indicates a significant operating deficit that cannot be

offset by appreciation in the portfolio.

Also new in the proposed regulation on Capital Impairment was the

treatment of net Unrealized Appreciation. Under the old Capital

Impairment concept, Licensees have been required to treat net

Unrealized Depreciation as if it represented realized losses, but they

received no corresponding credit for net Unrealized Appreciation. The

proposed regulation acknowledged the existence of net Unrealized

Appreciation in a Licensee's portfolio, yet attempted to avoid

providing incentives for Licensees to inflate their portfolio values

artificially. Thus, SBA proposed to allow partial recognition of net

Unrealized Appreciation in the computation of Capital Impairment, to an

extent which would vary depending on whether or not the portfolio

securities were Publicly Traded and Marketable.

The proposed rule also provided that a violation of the Capital

Impairment regulation would constitute an event of default with respect

to Debentures and Preferred Securities (Sec. 107.261(d)), and that such

a violation also would affect the good standing of a Licensee issuing

Participating Securities (Sec. 107.262(d)). In all cases, Licensees

were afforded an opportunity to cure a violation before SBA could

impose any of the remedies available to it under the proposed

regulations.

The thirty-nine (39) comments received on the Capital Impairment

proposal generally were unfavorable. While there was little objection

to the grid structure per se, there was strong objection to the

permissible Capital Impairment percentages located within the grid. The

respondents happily accepted the relatively high percentages available

to the equity-investor SBICs, but felt that the proposed percentages

for lender SBICs were excessively low. Specialized SBICs also argued

that the percentages for section 301(d) Licensees were unfair, and that

SBA should return to a single percentage (75%) for all Specialized

SBICS, regardless of portfolio composition or amount of Leverage.

SBA has decided to retain the grid structure for the section 301(c)

Licensees, and to increase their permissible levels of Capital

Impairment by five (5) percentage points across the board. Thus, a

section 301(c) Licensee would be permitted to have impaired Regulatory

Capital of anywhere from thirty-five percent (35%) to seventy percent

(70%), depending on the Licensee's portfolio mix and its Leverage

ratio. SBA believes this is an appropriate resolution as it balances

its own concerns with those of SBICs, as expressed in the comments.

For section 301(d) Licensees, SBA intends to return to the current

permissible level of Capital Impairment. All Specialized SBICs will be

permitted a Capital Impairment level of seventy-five percent (75%),

regardless of portfolio mix or Leverage ratio. The differential between

the Regular and Specialized SBICs will be from five (5) percentage

points for an equity investor Licensee to forty (40) points for a

lender Licensee. This differential is a recognition of the more

limited, and often riskier, pool of small business concerns in which a

Specialized SBIC may make investments.

There were also a number of comments on the subject of net

Unrealized Appreciation, arguing, for the most part, in favor of full

recognition of all net Unrealized Appreciation as an offset to realized

losses, or for looser standards for recognizing net Unrealized

Appreciation on private securities.

SBA continues to believe that full recognition of all net

Unrealized Appreciation is inappropriate and that the proposed

standards for recognizing net Unrealized Appreciation on private

securities are sufficiently liberal. Licensees will now, for the first

time, be permitted some credit for net Unrealized Appreciation.

Accordingly, SBA is not prepared to loosen these criteria further.

The final Capital Impairment issue addressed in the comment letters

was the length of the forbearance periods for issuers of Participating

Securities. SBA understands the industry's desire for a longer period

of forbearance, but believes that the four and five year allowances

that were proposed, together with the increased permissible percentages

agreed to in this final rule, should be adequate for a Licensee with a

minimally successful portfolio.

SBA also reminds the SBIC industry that Capital Impairment is a

curable violation. See Secs. 107.261(d)(5) and 107.262(d)(3). In fact,

special cure methods are available to Participating Securities issuers.

See Sec. 107.210(h)(7).

One final change has been made to the proposed Capital Impairment

provision; it concerns the inclusion of non-cash gains in the

computation of Capital Impairment. Under the former definition of

Capital Impairment, all amounts required by SBA accounting rules to be

classified as Non-cash Gains/Income (as reported on SBA Form 468) were

excluded from the Capital Impairment formula. SBA believes this

provision was too stringent, and that Licensees should be able to

receive credit in the impairment computation for non-cash gains under

certain circumstances. However, when the Agency rewrote the Capital

Impairment test in the proposed rule, full credit was mistakenly

permitted for all Non-cash Gains/Income of a Licensee, regardless of

the source. This error was the consequence of using the term

``Undistributed Realized Earnings,'' which includes all Non-cash Gains/

Income, in the computation. The unintended result of this change was

that delinquent accrued interest converted into a note, interest income

accrued on deferred-interest notes and other components of Non-cash

Gains/Income which may be uncertain as to collectibility would be

counted as realized earnings in determining Capital Impairment.

It was SBA's intent when drafting the proposed Capital Impairment

provision to give capital gains credit only for certain Non-cash Gains/

Income: Specifically, those that the Agency felt had the greatest

certainty of measurement and collectibility. In this final rule, SBA

has clarified that the only Non-cash Gains/Income that may be counted

when computing Capital Impairment are those Non-cash Gains/Income that

are realized in the form of Publicly Traded and Marketable securities

or investment grade debt instruments.

A debt instrument would not be considered investment grade for

purposes of this rule unless it had actually been rated ``BBB'' or

``Baa'', or better, by Standard & Poor's Corporation or Moody's

Investment Service, respectively. A non-rated debt instrument issued by

a company with outstanding investment grade debt also could be

considered investment grade if the Licensee were to obtain a written

opinion from an investment banking firm acceptable to SBA stating that

the non-rated debt instrument is equivalent in risk to the issuer's

investment grade debt.

The following is an example of how this rule operates: If a

Licensee sells a portfolio investment with a basis of $200,000 and

receives, exchange, General Electric stock worth $300,000 plus a below

investment grade promissory note for $150,000, the Licensee should

include in the Capital Impairment computation $100,000 of the $250,000

of Non-cash Gains/Income it received.

In order to implement this change, the final rule adds a new

defined term, ``Includible Non-cash Gains/Income'', to Sec. 107.3 to

represent those non-cash gains for which SBA will give credit for

purposes of Capital Impairment. In the final version of

Sec. 107.210(h), the Licensee computes Capital Impairment by starting

with Undistributed Net Realized Earnings, which is net of all Non-cash

Gains/Income, and adds back Includible Non-cash Gains/Income.

Undistributed Net Realized Earnings has been added to the definitions

section of the regulation. This should be a familiar term to all

Licensees because of its appearance on SBA Form 468. See Sec. 107.3.

The final rule also clarifies that a Licensee's Unrealized Gain

(Loss) on Securities Held must reflect the estimated tax effects

associated with the future realization of gains or losses. See the

definition of Unrealized Gain (Loss) on Securities Held (Sec. 107.3).

In summary, the Capital Impairment proposal is finalized as

proposed except for a five (5) percentage point increase for Regular

SBICs, a return to the seventy-five percent (75%) test for Specialized

SBICS, and the inclusion of only a limited class of non-cash gains.

This final rule repeats the summary of the computation of Capital

Impairment as it appeared in the summary of the proposed rule. The only

change is the use of ``Undistributed Net Realized Earnings plus

Includible Non-cash Gains/Income'' instead of ``Undistributed Realized

Earnings'', as discussed above.

(ii) Computation of Capital Impairment Percentage

If Unrealized Gain (Loss) on Securities Held is zero or positive,

and the sum of Undistributed Net Realized Earnings plus Includible Non-

cash Gains/Income is also zero or positive, no Capital Impairment

exists and no further calculations are necessary. If either or both

amounts are less than zero, the Licensee must make the calculations

described in Secs. 107.210(h) (3) and (4). Depending upon the results

of interim calculations in these paragraphs, the Licensee may be

required to compute a Capital Impairment Percentage.

(iii) Determination of Capital Impairment Violation

As with the proposed rule, a Licensee will not be in violation of

Sec. 107.210(h) simply by having a Capital Impairment Percentage

greater than zero. Violations of Sec. 107.210(h) arise out of an

excessive Capital Impairment Percentage. For section 301(d) Licensees,

Capital Impairment of more than seventy-five percent (75%) is

considered excessive; for section 301(c) Licensees, maximum permissible

Capital Impairment percentages are set forth in a table in the

regulation.

(iv) Special Rules for Licensees With Outstanding Participating

Securities

(A) General. All Leveraged Licensees, including Licensees with

outstanding Participating Securities, are required to compute their

Capital Impairment Percentages in the same manner. A Licensee with

outstanding Participating Securities may, for as long as five years

following its initial issuance of Participating Securities, have a

Capital Impairment Percentage higher than the applicable table permits

(but not as high as eighty-five percent (85%)) without thereby being in

violation of Sec. 107.210(h) if it meets the other requirements set

forth in Sec. 107.210(h)(7). In addition, a Licensee that meets the

requirements set forth in Sec. 107.210(h)(7) (i) or (ii) will be

afforded an opportunity to cure on terms that may be more favorable

than those available to other Licensees.

(B) Curable Capital Impairment Percentage during first 48 months

following initial issuance of Participating Securities. During the

first forty-eight (48) months after initially issuing Participating

Securities, a Licensee with outstanding Participating Securities will

not be impaired if: (1) Its Capital Impairment Percentage is less than

eighty-five percent (85%); (2) at least two-thirds of its outstanding

Leverage consists of Participating Securities; and (3) at least two-

thirds of its Loans and Investments, valued at cost, are Equity Capital

Investments.

(C) Curable Capital Impairment Percentage during first 60 months

following initial issuance of Participating Securities. During the

first sixty (60) months after initially issuing Participating

Securities, a Licensee with outstanding Participating Securities will

not be impaired if: (1) Its Capital Impairment Percentage is less than

eighty-five percent (85%); (2) at least two-thirds of its outstanding

Leverage consists of Participating Securities; and (3) at least two-

thirds of its Loans and Investments, valued at cost, are Start-up

Financings. For the purposes of this regulation, a Start-up Financing

is an Equity Capital Investment in a growth-oriented Small Concern

that, at the time of the investment, (1) has not been in existence, in

any form, for more than three fiscal years, (2) has not had positive

cash flow or sales exceeding $5 million in any fiscal year, and (3) is

not formed for the purpose of acquiring any existing business.

(D) Cure of Capital Impairment. During the fifth year following its

initial issuance of Participating Securities, a Licensee that meets the

requirements described in paragraph (B) above may cure its Capital

Impairment by taking one or more of the following actions within thirty

(30) days after it determines that it has a condition of Capital

Impairment. The Licensee may increase its Regulatory Capital\2\ by

depositing in an escrow account satisfactory to SBA a cash contribution

equal to fifteen percent (15%) of outstanding Leverage; or it may

provide SBA with a guarantee satisfactory to SBA, for the benefit of

SBA, equal to fifteen percent (15%) of its outstanding Leverage. In

addition to the normal credit considerations that would determine

whether a guarantee is satisfactory to SBA, the terms of the guarantee

must provide that any guarantee fee that otherwise would be due the

guarantor from the Licensee, and any other sums that would be due the

guarantor by virtue of the guarantor's right of subrogation, must be

deferred and subordinated to the full repayment of all outstanding

Leverage plus any unpaid Earned Prioritized Payments (as defined in

Sec. 107.3) and earned Adjustments (discussed below under

Sec. 107.243(d)).

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\2\This increase in Regulatory Capital operates only to cure

what would otherwise be a Capital Impairment. It does not increase

the Licensee's eligibility for Leverage.

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During the sixth year following its initial issuance of

Participating Securities, a Licensee that meets the above requirements

may cure its Capital Impairment by taking one of the actions described

in the preceding paragraph, except that the amount of the cash deposit

or guarantee shall be equal to thirty percent (30%) of outstanding

Leverage. Any amount deposited previously may be used as a credit

against the thirty percent (30%) requirement.

2. Leverage for Section 301(c) Licensees

No comments were received on proposed Sec. 107.220; accordingly, it

is finalized as proposed. This section provides Leverage requirements

for section 301(c) Licensees, and reflects amendments to the Act

contained in Section 402 of Public Law 102-366. Section 107.220 permits

SBA to provide Leverage to section 301(c) Licensees through the

purchase or guarantee of Debentures and/or Participating Securities.

After March 31, 1993, a section 301(c) Licensee's amount of Leverage

outstanding at any time shall not exceed three hundred percent (300%)

of its Leverageable Capital up to $15 million; two hundred percent

(200%) of its Leverageable Capital of more than $15 million, but not

more than $30 million; and an amount, not exceeding $15 million, which

is equal to one-hundred percent (100%) of its Leverageable Capital over

$30 million. The aggregate amount of outstanding Leverage by any

Licensee or group of two or more Licensees under Common Control\3\

shall not exceed $90 million. On a case-by-case basis, SBA may grant an

exception to this ceiling to a group of Licensees under Common Control

and permit a higher amount, subject to such terms and conditions as SBA

considers appropriate to minimize risk of loss in the event of default.

In no event, however, shall the aggregate amount of a Licensee's

Participating Securities exceed two hundred percent (200%) of

Leverageable Capital.

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\3\This term is defined in the Operations Rule.

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A ``grandfather clause'' is provided for Licensees that, on March

31, 1993, have outstanding Debentures in excess of three hundred

percent (300%) of Leverageable Capital, so that such Licensees are not

required to prepay such excess. Such Licensees also may apply to issue

additional Debentures or Participating Securities solely to pay the

amount due on such maturing Debentures. The maturity date of any new

Debenture or Participating Securities issued for this purpose may not

be later than September 30, 2002.

3. Leverage for Section 301(d) Licensees

In proposed Sec. 107.230, SBA described some of the terms and

conditions of Leverage for section 301(d) Licensees. SBA may provide

Leverage to section 301(d) Licensees through the purchase or guarantee

of Debentures and/or Participating Securities, and/or through the

purchase of Preferred Securities. As further described below, the

proposed rule provided that section 301(d) Licensees would be eligible

for subsidized Debenture Leverage and for Preferred Securities Leverage

up to a maximum of four hundred percent (400%) of Leverageable Capital

or $35 million, whichever is less. Leverage in excess of that amount

would be nonsubsidized.

Six (6) comments were received on proposed Sec. 107.230. The

comments were supportive of the proposal, except for the ceiling of $35

million for subsidized Leverage. As the comments recognized, however,

the $35 million ceiling on subsidized Leverage is statutory in origin.

Section 402 of Public Law 102-366, which increased the general Leverage

ceiling for the SBIC program above its prior level of $35 million,

established the subsidized Leverage ceiling for section 301(d)

Licensees. The regulation cannot permit a higher amount of subsidized

Leverage than is permitted by the Act.

SBA therefore is finalizing Sec. 107.230 as proposed, with the

exception of one minor change, designed to correct an error: The four

percent (4%) dividend on preferred stock and the four percent (4%)

return on the preferred limited partnership interest accrue on an

annual basis (rather than on a daily basis, as stated in the proposed

rule).

The Articles of section 301(d) Licensees are required to be

conformed to the requirements discussed in paragraphs a. or b. below,

as appropriate, in order to issue Preferred Securities after the date

hereof.

a. Preferred Stock

In the case of corporate Licensees, the preferred stock purchased

by SBA prior to November 21, 1989, shall be non-voting stock with a

three percent (3%) cumulative preferred dividend paid out of Retained

Earnings Available for Distribution. Preferred stock issued after

November 21, 1989, shall provide for four percent (4%) preferred

cumulative dividends payable out of Retained Earnings Available for

Distribution. Four percent (4%) preferred stock shall be redeemed not

later than fifteen (15) years after issuance at a price not less than

par value plus unpaid dividends accrued to the redemption date. SBA may

guarantee non-subsidized Debentures offered for sale by a Licensee

immediately prior to the redemption of its four percent (4%) preferred

stock in such amounts as will permit simultaneous redemption of such

stock.

b. Preferred Limited Partnership Interest

Section 412 of Public Law 102-366 authorizes unincorporated section

301(d) Licensees to issue preferred limited partnership interests to

SBA which would have the same terms and conditions as the four percent

(4%) preferred stock described immediately above (that is, a preferred

and cumulative return at an annual rate of four percent (4%), payable

from Retained Earnings Available for Distribution). Such preferred

limited partnership interests shall be redeemed not later than fifteen

(15) years from the date of issuance at a price not less than SBA's

contributed capital plus accumulated and unpaid distributions through

the redemption date. SBA may guarantee non-subsidized Debentures issued

by a section 301(d) Licensee immediately preceding such redemption in

such amounts as will permit simultaneous redemption of such preferred

limited partnership interests.

C. Leverage Ceiling

As in the proposed rule, Sec. 107.230(c) establishes maximum

Leverage eligibility for section 301(d) Licensees. All types of

Leverage issued by such Licensees shall be aggregated for purposes of

determining Leverage eligibility, including aggregation of Leverage

issued by Licensees under Common Control. As stated earlier, section

301(d) Licensees are eligible for maximum subsidized Leverage

(consisting of Preferred Securities and Debentures issued with a rate

reduction) of four hundred percent (400%) of Leverageable Capital or

$35 million, whichever is less. Section 301(d) Licensees also are

eligible for nonsubsidized Leverage in excess of $35 million, subject

to the amounts and conditions specified for section 301(c) Licensees.

In order to qualify for Leverage exceeding three hundred percent

(300%) of Leverageable Capital, at least thirty percent (30%) of the

Licensee's Total Funds Available for Investment must be invested in or

committed to Venture Capital Financing of Disadvantaged Concerns, and a

Licensee must maintain thirty percent (30%) of its Total Funds

Available for Investment in such investments while Leverage in excess

of three hundred percent (300%) of Leverageable Capital is outstanding.

For the purpose of meeting the thirty percent (30%) test, the Venture

Capital Financings shall be valued at cost. The present definition of

Venture Capital Financing remains unchanged and is set forth in

Sec. 107.230(c)(3)(iii).

d. Second Tier of Preferred Securities

As in the proposed rule, SBA is authorized to purchase Preferred

Securities in amounts in excess of one hundred percent (100%) of

Leverageable Capital, but not in excess of two hundred percent (200%)

of Leverageable Capital, from certain Licensees. These are section

301(d) Licensees with Leverageable Capital of $500,000 or more, or

section 301(d) Licensee licensed on or before October 13, 1971,

regardless of the amount of Leverageable Capital. In either case, a

Licensee must have Qualified Investments (as defined in

Sec. 107.230(c)(4)(iv)) equal, at cost, to the amount of Preferred

Securities in excess of one hundred percent (100%) of Leverageable

Capital. Commitments to make Qualified Investments may be counted to

satisfy this requirement.

It should be noted that the definition of Qualified Investments is

similar, but not identical to, the definition of Venture Capital

Financing as set forth in Sec. 107.230(c)(3)(iii). The most important

difference is that a secured debt instrument may qualify as a Venture

Capital Financing but would not qualify as a Qualified Investment.

e. Participating Securities

Section 107.230(c)(6) authorizes section 301(d) Licensees to issue

Participating Securities in an amount not exceeding two hundred percent

(200%) of Leverageable Capital, less an amount equal to Licensee's

outstanding Preferred Securities. Prioritized Payments and Profit

Participation on Participating Securities issued by section 301(d)

Licensees shall not be subsidized.

f. Other Provisions

Section 107.230(d) describes the types of Debentures which section

301(d) Licensees may issue, and Sec. 107.230(e) permits section 301(d)

Licensees, in SBA's discretion, to retire Debentures through the

issuance of Preferred or Participating Securities.

Section 107.230(f) is a recodification of former

Sec. 107.201(a)(2)(iii).

4. Participating Securities

As proposed, Secs. 107.240 through 107.247 described special rules

which would apply to Licensees issuing Participating Securities.

SBA received many comments on these proposed rules. Most were very

supportive, although many suggestions for improving the proposal were

received. Comments related to specific provisions of the Participating

Securities are addressed in the discussion of those respective sections

of the rule.

The Small Business Equity Enhancement Act of 1992 (title IV of Pub.

L. 102-366) was a mandate for a new relationship between SBA and the

venture capital community. The salient feature of this new relationship

is the creation of Participating Securities. These are equity-type

securities with the characteristics of preferred stock or a preferred

limited partnership interest.

SBA recognizes that venture capital companies usually make initial

equity capital investments, manage their portfolios (making follow-on

investments as necessary), and finally sell their investments as they

mature, with the objective of realizing capital gains. As investments

are sold, funds customarily are distributed to investors rather than

reinvested.

Under this rule, as a means of financing Licensees that issue

Participating Securities, SBA will guarantee the payment of Prioritized

Payments on, and the Redemption Price of, the Participating Securities

to an authorized Trust or pool which purchases the Participating

Securities. Prioritized Payments are the equivalent of dividend

payments of the Participating Securities. As an inducement for its

guarantee, SBA will be entitled to a share in the profits that are

generated from investments made while the Participating Securities are

outstanding (Profit Participation).

Pass-through Trust Certificates evidencing rights in the Trust or

pools of guaranteed Participating Securities will be sold to investors.

The rights and obligations evidenced in the Trust Certificates also

will be guaranteed by SBA. The proceeds of the sale of the Trust

Certificates will be used to fund the Participating Securities.

SBA anticipates that the Prioritized Payments made by Licensees

that issue Participating Securities normally will not be adequate to

fund debt service obligations of the guaranteed Trust Certificates in

the early years of the Participating Securities' existence.

Accordingly, SBA will be called upon to make such payments. Over the

duration of a Participating Security's life, SBA expects to be repaid

most of such guarantee payments through a combination of Earned

Prioritized Payments and Profit Participation. Since Prioritized

Payments on Participating Securities are payable only to the extent of

earnings, SBA realizes that the repayment of its guarantee payments

will depend upon the ability of its Licensees to operate profitably as

equity investors.

SBA understands that venture capital equity investments in Small

Concerns are risky on an individual basis, and that losses on such

investments frequently occur earlier than profits. It anticipates that

Licensees issuing Participating Securities will incur losses in the

early years of their investment cycle as investments in a limited

number of portfolio concerns prove unprofitable and are written off.

SBA recognizes that it must be patient in expecting profitable

operations from Licensees with Participating Securities. At the same

time, SBA has the responsibility to assure that publicly-guaranteed

funds are administered prudently by capable managers. Accordingly, SBA

has sought to formulate an economic and regulatory structure which will

enhance the likelihood that Licensees participating in the program will

be successful.

In issuing this final rule, SBA believes that it can fulfill the

objectives of the Small Business Equity Enhancement Act of 1992 to

foster a venture capital industry that is able to serve the needs of

eligible Small Concerns, create or retain jobs, expand the tax base,

and achieve other objectives such as commercialization of technology,

supporting manufacturing firms, fostering urban and rural business

development, and stimulating exports.

SBA recognizes that its guarantee of Participating Securities will

be an essential factor in the decision of investors to fund Licensees,

and that such investors will need to have confidence in SBA's long-term

investment philosophy. While SBA intends that Participating Securities

serve as patient capital, investors must recognize SBA's special

responsibilities to protect public funds and assure compliance with

program objectives and regulations.

It should be noted that section 410 of Public Law 102-366

authorized inclusion in a Licensee's private capital of investments by

public and private pension funds as well as limited investments by

state and local governments. The form of Participating Securities has

been structured with the intention of avoiding the imposition of

Unrelated Business Taxable Income (UBTI) on certain tax-exempt

investors. SBA believes that pension funds and other tax-exempt

investors will find it advantageous to invest in SBICs using

Participating Securities. Since such institutional investors

historically have provided investment capital to the private venture

capital industry and have acquired expertise in selecting managers and

monitoring investments, SBA anticipates that SBICs will benefit from

this investor expertise. SBA also hopes to benefit from the expertise

of institutional investors to help assure the profitability of the

Licensees that issue Participating Securities.

a. General Provisions

Proposed Sec. 107.241 set forth general provisions for Licensees

issuing Participating Securities. This section reflects SBA's effort to

use marketplace dynamics to assure a successful program.

(i) Minimum Regulatory Capital

Proposed Sec. 107.241(a) set forth minimum capital requirements for

eligibility to issue Participating Securities. In general, a Licensee

would be required to have Regulatory Capital of at least $10 million in

order to be considered eligible to issue Participating Securities. A

Licensee with less than $10 million, but not less than $5 million, in

Regulatory Capital also could be eligible if it were able to

demonstrate to SBA's satisfaction that if could be financially viable

over the long term.

SBA received nineteen (19) comments on this provision, with some

comments favoring the minimum capital requirements and others opposing

them. Many of those opposed to the requirements argued in favor of a $5

million threshold, and voiced the concern that larger SBICs may not

serve the needs of smaller businesses and early-stage companies.

SBA shares the concern that SBICs capitalized at over $10 million

may not be oriented toward investing in smaller concerns. SBA is

addressing that concern by requiring all Licensees to make a certain

percentage of their investments in companies that are smaller than the

maximum size permitted under the Size Rule. This requirement appears in

Sec. 107.101(i) and is more fully discussed in the Operations Rule.

In view of this requirement, SBA is comfortable with the $10

million minimum capital requirement, and feels it is warranted for the

following reasons:

(1) A Licensee making venture capital type investments with

Regulatory Capital of less than $10 million normally will be incurring

excessively high fixed and marginal costs relative to the amount of its

capital; and

(2) Successfully raising $10 million for venture capital

investments constitutes a significant affirmation by the investment

community of the management capabilities of a Licensee. A more detailed

discussion of SBA's rationale for adopting the $10 million threshold

may be found in the proposed rule at 58 FR 41856.

As stated above, SBA will consider authorizing the issuance of

Participating Securities by a Licensee with Regulatory Capital of less

than $10 million, but not less than $5 million, if the Licensee can

show that it has a reasonable prospect of being profitable over the

long term. Thus, a Licensee with Regulatory Capital of less than $10

million might qualify to issue Participating Securities if it is a

subsidiary of a bank, bank holding company, or other large organization

which undertakes to subsidize management expenses of the Licensee and

to provide management personnel and operation support.

A Licensee with Regulatory Capital of less than $10 million also

may be acceptable to SBA if it operates in a rural area or within a

specific geographic area, such as a reasonably compact and focused

urban area. Any such Licensee must have management with proven

expertise in the types of investments proposed and must show, through

its plan of operations, how it can be operated soundly and profitably

over the long term without depleting its capital base through excessive

overhead.

It should be noted that some readers may have misunderstood the

significance of the $10 million threshold. Raising $10 million will not

automatically qualify an applicant for licensing as an SBIC that will

issue Participating Securities. As has always been the case, applicants

for licensing must demonstrate financial viability and qualified

management, regardless of the amount of their Regulatory Capital. It is

possible that a license applicant with $10 million in Regulatory

Capital will have such high overhead expenses or such inexperienced

management that its likelihood of profitability is put into question.

SBA would not issue a license under such circumstances. Under ordinary

circumstances, however, it can be expected that $10 million should

serve as adequate capital for licensing as an SBIC in the Participating

Securities program.

(ii) Equity Capital Investments

Since no comments were received on proposed Sec. 107.241(b), SBA is

finalizing it as proposed. This section requires Licensees issuing

Participating Securities to invest an amount equal to the Original

Issue Price of such securities solely in Equity Capital Investments.

Equity Capital Investments must be maintained at such level and may be

reduced only by the amount of repayments of such Participating

Securities. ``Equity Capital Investments'' means common or preferred

stock, limited partnership interests, options, and warrants or similar

equity instruments, including subordinated debt with equity features if

such debt provides only for interest payments contingent upon and

limited to the extent of earnings. Equity Capital Investments in the

form of debt may not be amortized.

(iii) Management and Ownership Diversity

Proposed Sec. 107.241(c) required that there be some diversity

between the ownership and the management of a Licensee that issues

Participating Securities. The eight comments on this provision were

mixed, with some supporting the proposal as an appropriate means of

preventing self-dealing, and others opposing the proposal as unduly

restrictive.

SBA believes that the benefits of this proposal far outweigh any

inconvenience to Licensees. It is important that Licensees issuing

Participating Securities have investors who are independent of

management and who have a substantial stake in the Licensee's financial

performance. SBA believes that the presence of such investors will help

to assure that Licensees are operated with the objective of optimizing

returns and protecting the interests of all investors, including SBA.

The proposal is therefore finalized without change.

Under paragraph (1) of Sec. 107.241(c), SBA will consider the

diversity requirement satisfied if at least three (3) unaffiliated

shareholders or limited partners (only one is required in the case of

Institutional Investors) own, in the aggregate, at least thirty percent

(30%) of a Licensee or Licensee's ultimate parent entity. Such

diversity also will be deemed to be achieved if a Licensee or its

ultimate parent entity is publicly traded under U.S. securities laws.

The independence and ability of investors to exercise oversight is

maintained by the prohibition against the delegation of voting rights

contained in paragraph (2) of Sec. 107.241(c). An exception is made for

certain proxies and the use of unaffiliated advisors so as not to

interfere with the routine operations of a Licensee.

(iv) Management Fees

Under proposed Sec. 107.241(d), a Licensee issuing Participating

Securities would be subject to a ceiling on its Management Expenses of

2.5% of Combined Capital (Regulatory Capital plus outstanding

Leverage), plus $125,000 in the case of Licensees with Combined Capital

of less than $20 million. SBA could permit a higher amount or, in the

case of larger funds, require a lower amount.

SBA received sixteen (16) comments on this proposal. A frequently-

appearing objection was that the regulatory provision was more

restrictive than the underlying statutory provision. Another objection

concerned SBA's ability to unilaterally reduce allowable Management

Expenses for larger funds.

It is true that the proposal was more restrictive than the

underlying statutory provision. Section 403 of Public Law 102-366

provided a ceiling on Management Expenses only for purposes of

computing SBA's Profit Participation. In the proposed rule, SBA

extended the ceiling to a Participating Securities issuer's actual

expenditures for Management Expenses, but allowed for an amount in

excess of the ceiling if there were a clearly demonstrable need. SBA

felt that the Management Expenses allowed under the proposal were

adequate for most Licensees and were consistent with current venture

capital industry practices.

Based on the comments, SBA has reconsidered its position. Under

this final rule, a Licensee issuing Participating Securities will be

subject to the limits discussed above only for purposes of computing

Earmarked Profits, which (as further discussed below) determine the

amounts that may be allocated to Earned Prioritized Payments and to

Profit Participation. See Sec. 107.242(d). Accordingly,

Sec. 107.241(d), as finalized, no longer provides that a Licensee's

actual Management Expenses are subject to percentage limits; however,

the section still provides that actual Management Expenses must be

approved by SBA.

It should be understood by readers new to the SBIC Program that SBA

presently approves, and will continue to approve, the management

compensation for all Licensees, not just issuers of Participating

Securities.\4\ Management compensation is but one component of

Management Expenses, which includes such additional items as office

expenses and office and equipment rentals. See the definition of

Management Expenses in Sec. 107.3. Depending on the particular

circumstances of the Licensee, approved management compensation and

Management Expenses for a larger fund may be lower, on a percentage

basis, than approved amounts for a smaller fund.

---------------------------------------------------------------------------

\4\Licensees with outstanding Leverage must have increases in

their management compensation approved before such increases are

adopted. Licensees with no outstanding Leverage may have increases

in their management compensation approved after the fact.

---------------------------------------------------------------------------

This final rule also now provides that Licensees placed under

``restricted operations'' under Sec. 107.262(d) are required to re-

obtain SBA's approval of their Management Expenses (or, for issuers of

Preferred Securities, their management compensation) at the time

restricted operations are imposed.

(v) Third-Party Debt (Temporary Debt)

Proposed Sec. 107.241(e) limited the type and amount of third-party

debt that a Licensee issuing Participating Securities could incur, and

required that the Licensee obtain the written approval of SBA before

incurring any such debt. Under the proposal, the only third-party debt

that Licensees issuing Participating Securities would be permitted to

have would be ``Temporary Debt'' in an amount not to exceed fifty

percent (50%) of Leverageable Capital. Licensees would have to pay off

and remain free of all Temporary Debt for at least thirty (30)

consecutive days during each fiscal year.

The fifteen (15) comments received on this provision objected to

the requirement that a Licensee obtain prior SBA approval in order to

incur Temporary Debt. The requirement was characterized as unduly

restrictive and unnecessary. As with the comments discussed above under

''Third-party Debt'' (subsection 1.(e) above), concern was expressed

over possible delays in SBA's response time.

SBA continues to believe that prior SBA approval of third-party

debt is an important component of its administration of the SBIC

Program. This is true for all Licensees, including those that issue

Participating Securities. In order to unify its approach to third-party

debt, SBA is finalizing Sec. 107.241(e) so that it conforms to the

general Third-party Debt provision discussed above. In other words, if

an issuers of Participating Securities is in regulatory compliance and

has Leverage not in excess of 1.5 times its Leverageable Capital, and

if the Licensee's request is for approval of a secured line of credit

which would not cause its aggregate third-party debt to exceed the

Temporary Debt limitation of fifty percent (50%) of Leverageable

Capital, then the Licensee's request shall be considered approved

unless SBA notifies it otherwise within thirty (30) days of receiving

the request. Unsecured Temporary Debt up to the permissible level of

Temporary Debt shall not require prior approval.

(vi) Liquidity Requirement

Proposed Sec. 107.241(f) established a liquidity requirement for

Licensees issuing Participating Securities in order to assure that such

Licensees have sufficient cash to cover their operating overhead during

the ensuing year. A Licensee would have a condition of Liquidity

Impairment if the Liquidity Ratio (as defined in Sec. 107.241(f)(2))

obtained by dividing Total Current Funds Available\5\ by Total Current

Funds Required is less than 1.20. No Distributions could be made if

they would cause a condition of Liquidity Impairment.

---------------------------------------------------------------------------

\5\Section 107.241(f)(2) includes a self-explanatory chart that

shows how the respective values for Total Current Funds Available

and Total Current Funds Required are to be determined.

---------------------------------------------------------------------------

Few comments were received on this provision. Some opposed the

concept as an unnecessary administrative burden; others recommended

different weightings to some of the calculation inputs.

SBA considers this provision important and does not agree that it

is burdensome to the Licensee. SBA considers it essential that

Licensees maintain a level of liquid assets sufficient to meet

operating expenses, make necessary follow-on investments, and allow

investments to be held until they mature and can be sold in the normal

course of business. Accordingly, SBA is finalizing the provision

without change.

(vii) Mandatory Redemption

No comments were received on proposed Sec. 107.241(g), which

required that Participating Securities be redeemed not later than

fifteen (15) years after their issue date. The provision is finalized

without change. As stated in the proposed rule, the redemption date

generally will be ten (10) years after the date of issue and always

will be the same as the maturity date of the Trust Certificates.

(viii) Priority in Liquidation

No comments were received on proposed Sec. 107.241(h), which

provided that upon liquidation of a Licensee, the Redemption Price of

any Participating Securities, plus any Prioritized Payments, Profit

Participation and other amounts that may be due SBA, shall be senior in

priority to all other equity interests of the Licensee. The provision

is finalized without change.

As explained in the proposed rule, SBA recognizes that Prioritized

Payments and Profit Participation are distributable only to the extent

of profits on Earmarked Assets, notwithstanding the cumulative feature

of Prioritized Payments. When a Licensee is liquidated, however, there

can be no Distributions to investors before amounts due SBA, its agent,

or Trustee are paid.

b. Computation of Earmarked Profits (Losses)

SBA received no comments on the computation of Earmarked Profits

(Losses), proposed Sec. 107.242. The provision is finalized as it was

proposed, except for minor wording changes in the paragraph on

Earmarked Investment Expenses. Since it should prove useful to have a

complete summary of the Participating Securities regulations in one

document, SBA is reprinting here the discussion on the computation of

Earmarked Profits (Losses) that appeared in the proposed rule.

There are seven steps in the computation of Earmarked Profits

(Losses) as set forth in Sec. 107.242. (Please note that SBA will

provide the spreadsheet templates and/or other software necessary for

making the ensuing calculations.)

(i) Step 1: Determination of Earmarked Assets

Earmarked Assets are a Licensee's Loans and Investments\6\ that are

outstanding at the time a Licensee issues Participating Securities\7\

or acquired while Participating Securities are outstanding, plus any

non-cash assets given in consideration for the disposition or exchange

of any such asset. Even after all Participating Securities have been

redeemed, Earmarked Assets maintain such status. See Sec. 107.242(b).

---------------------------------------------------------------------------

\6\``Loans and Investments'' is a term that is defined in this

rule as ``Portfolio Securities, Assets Acquired in Liquidation,

Operating Concerns Acquired, and Other Securities Received as set

forth in the Statement of Financial Position (SBA Form 468)''.

\7\A company licensed on or before March 31, 1993 may elect to

exclude its entire portfolio as it existed on that date (but not

less than its entire portfolio) from the category of ``Earmarked

Assets.'' In addition, if a company licensed on or before such date

is refinancing outstanding Debentures by the issuance of

Participating Securities, the company's entire portfolio must be

included in Earmarked Assets. Special rules for such Licensees are

located in Sec. 107.247.

---------------------------------------------------------------------------

(ii) Step 2: Calculating the Earmarked Asset Ratio

This step establishes the percentage of a portfolio that is

earmarked. Since a Licensee may have non-Earmarked Assets deriving from

assets acquired after all Participating Securities have been redeemed,

or determined under the special rules governing SBICs licensed on or

before March 31, 1993 (see Sec. 107.247), it is necessary that all

Licensees calculate an Earmarked Asset Ratio (EAR) as delineated in

Sec. 107.242(c). The ratio is calculated on a weighted average basis

(that is, on a month-by-month basis, which is then averaged) for the

year or fraction of the year in question. For companies licensed after

March 31, 1993 that have not yet redeemed any Participating Securities,

EAR will equal one hundred percent (100%). The formula is:

EAR=[(EA+UPPS)/(L&I+UPPS)] x 100

where:

EA=Earmarked Assets valued at cost

UPPS=Uninvested proceeds of Participating Securities

L&I=Total Loans and Investments (valued at cost).

The example that follows would apply only to companies licensed on

or before March 31, 1993. Assume that such a Licensee had $15 million

in Loans and Investments, issued $10 million of Participating

Securities two months prior to the close of its fiscal year, and had

elected to exclude its pre-existing portfolio from being Earmarked

Assets (as permitted in Sec. 107.247). The following calculations would

apply:

Values at Close of Month 1

------------------------------------------------------------------------

Uninvested

Earmarked assets proceeds Loans and investments

------------------------------------------------------------------------

Zero....................... $10,000,000 $15,000,000 (acquired on or

before 3/31/93).

------------------------------------------------------------------------

If the Licensee invested $2 million from the proceeds of

Participating Securities during the next month, and sold $1 million of

assets for cash, the following would occur:

Values at Close of Month 2

------------------------------------------------------------------------

Uninvested Loans and

Earmarked assets proceeds investments

------------------------------------------------------------------------

$2,000,000.............................. $8,000,000 $16,000,000

------------------------------------------------------------------------

As of the close of Month 1, the Licensee's (interim) EAR was 40

percent [(0=10,000,000)/(15,000,000=10,000,000)].

As of the close of Month 2, for Month 2, (interim) EAR was 41.666

percent [(2,000,000+8,000,000)/(16,000,000+8,000,000)].

As of the close of the Licensee's fiscal year, the Licensee's EAR

was 40.833 percent [(40+41.666)/2] or [(2,000,000+18,000,000)/

(31,000,000+18,000,000)]. For the purposes of the calculations

hereafter discussed, this Licensee's EAR is 40.833 percent.

(iii) Step 3: Ascertaining Earmarked Investment Income

Earmarked Investment Income (EII) is defined in Sec. 107.242(d)(1)

by the formula:

EII=IDA+([IIF+OI] x EAR)

where

IDA=All income directly attributable to Earmarked Assets

IIF=Interest on idle funds

OI=Other income not attributable to specific assets

EAR=Earmarked Asset Ratio

Thus, if IDA were $1,000,000 and other income not attributable to

specific assets were $500,000, EII would be:

($1,000,000+($500,000 x 40.833%)) or $1,204,165.

(iv) Step 4: Calculating Earmarked Investment Expenses

As defined in Sec. 107.242(d)(2), Earmarked Investment Expenses has

two components--Management Expenses and non-Management Expenses.

For the purposes of the calculations in Sec. 107.242(d)(2),

Management Expenses means the lesser of (1) Licensee's approved

Management Expenses multiplied by its EAR; or (2) 2.5 percent of the

product of the Licensee's Combined Capital, multiplied by its EAR

(plus, in the case of a Licensee whose Combined Capital is less than

$20 million, an additional sum equal to the product of $125,000 and the

Licensee's EAR). Expressed in formula terms, this would be:

Management Expense (ME)=0.025 x (CC x EAR) for a Licensee with Combined

Capital (CC) of $20 million or more.

ME = [(0.025 x {CC x EAR}) + ($125,000 x EAR)] for a Licensee with

Combined Capital of less than $20 million.

The second component of Earmarked Investment Expense is non-

Management Expense. Some non-Management Expenses can be attributed

directly to Earmarked Assets and, of course, are to be allocated to

Earmarked Investment Expenses. In addition, Licensee must allocate to

Earmarked Investment Expense a sum equal to the product of non-

Management Expense not attributable to specific assets (specifically

including interest on SBA-guaranteed Debentures) times Licensee's

Earmarked Asset Ratio. See Sec. 107.242(d)(2)(ii).

The sum of the above-described Management and non-Management

Expenses constitutes Earmarked Investment Expenses.

(v) Step 5: Determining Earmarked Net Investment Income (Loss)

Subtract Earmarked Investment Expenses (step 4) from Earmarked

Investment Income to determine Earmarked Net Investment Income (Loss)

(step 3).

(vi) Step 6: Determining Earmarked Realized Gain (Loss) on Securities

Section 107.242(e) sets forth rules for determining gain or loss on

securities that constitute Earmarked Assets (Earmarked Realized Gain

(Loss) on Securities). For the purpose of determining whether a gain or

a loss has been realized\8\ on the sale of an Earmarked Asset, the

asset's cost basis and net sales price shall be used. The asset's cost

basis shall not be increased, even by capitalization of unpaid

interest, except that if the basis of an investment in an

unincorporated Small Concern is appropriately determined by using the

equity method of accounting, the Licensee's basis may be increased by

the Licensee's share of the Small Concern's income. See

Sec. 107.242(e)(3).

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\8\Unrealized Appreciation or Unrealized Depreciation, as the

case may be, on Earmarked Assets that are Distributed shall be

recognized as if the appreciation or depreciation were realized at

the time of the In-Kind Distribution. See Sec. 107.242(3)(4), and

see also Sec. 107.245(e)(3), which relates to In-Kind Distributions.

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(vii) Step 7: Computing Earmarked Profits (Losses)

Earmarked Profits (Losses) must be computed no less frequently than

annually as of the close of a Licensee's fiscal year, and at such other

times as Licensee elects to make a Distribution. See Sec. 107.242(a).

The computation is simple enough: Earmarked Profits (Losses) is the

sum, positive or negative, of Earmarked Net Investment Income (Loss)

and Earmarked Realized Gain (Loss) on Securities. See Sec. 107.242(f).

c. Computation, Allocation, and Distribution of Prioritized Payments

(i) Introduction

Proposed Sec. 107.243 provided for the computation, allocation, and

payment of Prioritized Payments. These payments are preferred and

cumulative at the Trust Certificate Rate, which is the rate SBA

guarantees to pay annually to the Trust Certificate holders.

Prioritized Payments resemble dividends on preferred stock or

equivalent distribution on preferred or senior limited partnership

interests.

The few comments received on this portion of the proposed rule

objected only to the Adjustments to the Prioritized Payments. In

general, the Adjustments are additional amounts that become payable to

SBA in the event the Licensee has sufficient profits. They are the

result of the compounding that must be performed by a Licensee if it

does not pay, at the end of its fiscal year, an amount equal to its

annual Prioritized Payments. During the course of that year, SBA will

have been making the interest payments as they come due under Trust

Certificates issued against a pool containing the Licensee's

Participating Securities. SBA's payment will be an amount equal to the

Prioritized Payments on all the Participating Securities in the pool.

The Licensees are not expected to be able to reimburse SBA immediately

for those payments; SBA may wait years for reimbursement, and may never

be reimbursed fully. The Adjustments are intended as partial

compensation to SBA for the time-value of the payments the Agency makes

in the interim. The Adjustments also help to lower the subsidy rate for

the Participating Securities program. For these reasons, SBA feels it

is important to retain the proposed concept of compounding of

Prioritized Payments in this final rule. It should be emphasized that

the Adjustments, like the Prioritized Payments themselves, are not due

and payable unless the Licensee has sufficient Earmarked Profits to pay

them.

As a reminder to the reader, the calculation of Prioritized

Payments is to be performed at least annually within ninety (90) days

after the end of the Licensee's fiscal year, and also at the end of any

fiscal quarter for which a Distribution is contemplated. If the

Licensee has cumulative Earmarked Profits, Prioritized Payments up to

the amount of such profits are characterized as Earned Prioritized

Payments and are to be distributed automatically within (90) days after

the end of the Licensee's fiscal year, except to the extent that such

Distribution would create a condition of Liquidity Impairment.

A Licensee with Participating Securities or Earmarked Assets in its

portfolio is prohibited from making any Distributions that are

considered to be a return on capital until all Prioritized Payments

have been distributed. Before returns of capital can be made, all

Earned Prioritized Payments must have been distributed. See

Sec. 107.245. We repeat in paragraphs (ii) through (vii) below, for the

reader's benefit, the detailed discussion of the computation of Earned

Prioritized Payments and Earned Adjustments that appeared in the

proposed rule. There are no changes to the related regulatory

provisions in this final rule.

(ii) Establishment of Prioritized Payment Accounts

To assist in the process of determining whether, or when, a

Licensee is responsible for making payments, two Prioritized Payment

accounts must be established: A Prioritized Payment Accumulation

Account (AA) which is a memorandum account, and a Prioritized Payment

Distribution Account (DA) which is a liability account. For the sake of

simplicity, the hypothetical examples set forth in paragraphs (iii) and

(iv) below illustrate the computations at the fiscal year end following

the first issuance of Participating Securities.

(iii) Initial allocations to Prioritized Payment Accumulation Account

The Prioritized Payment Accumulation Account initially reflects the

``accrual'' (as a memorandum entry only) of Prioritized Payments.

Computations involving this account always begin with the entry of a

sum equal to all Prioritized Payments for the fiscal period in

question. For example, if a Licensee had issued $10 million of eight

percent (8%) Participating Securities at the beginning of its fiscal

year, the initial amount to be added to the AA at the close of the

fiscal year would be $800,000. See Sec. 107.243(b)(1). As subsequently

explained, the Adjustments referred to above may also be added to this

account.

(iv) Initial Allocations to Prioritized Payment Distribution Account

(DA)

The first step in determining what should be added to the DA is to

ascertain cumulative Earmarked Profits (Losses). If, at the fiscal year

end following the first issuance of Participating Securities, the

Licensee has cumulative Earmarked Profits, that sum constitutes

Distributable Earmarked Profits.

The second step is to compare Distributable Earmarked Profits with

the balance in the AA. The lesser of the two is subtracted from the AA

and is added to the DA. This amount now constitutes Earned Prioritized

Payments. See Sec. 107.243(c).

For example, suppose that Earmarked Profits were $20,000. Since

$20,000 is less than the $800,000 of Prioritized Payments, $20,000 is

subtracted from the AA and is added to the DA. At this point there

would be $780,000 in the AA and $20,000 in the DA. The latter sum

represents Earned Prioritized Payments and is the amount the Licensee

will distribute to SBA or the Trust, unless such Distribution would

cause a Liquidity Impairment. See Sec. 107.243(c).

(v) Subsequent Allocations to Prioritized Payment Accumulation Account

and to Prioritized Payment Distribution Account

Subsequent allocations to these accounts will be made similarly,

except that Distributable Earmarked Profits for subsequent years are

calculated by subtracting from cumulative Earmarked Profits all

previous Earned Prioritized Payments and all earned Adjustments (as

described below) for prior fiscal periods.

In our example, at the end of the second year following issuance of

$10 million of eight percent (8%) Participating Securities, an

additional $800,000 would be allocable preliminarily to the AA,

bringing that account (temporarily) up to $1,580,000. If Earmarked

Profits for the second year were $40,000, cumulative Earmarked Profits

would be $60,000. Ignoring for the moment ``earned Adjustments'',

Distributable Earmarked Profits for Year 2 would be $40,000. Since

$40,000 is less than 41,580,000, the sum of $40,000 would be added to

the DA and subtracted from the AA. Thus, at the close of Year 2, the

balance in the AA would be $1,540,000 (exclusive of any Adjustments)

and, assuming no Distribution of Earned Prioritized Payments had been

made to SBA, the balance in the DA would be $60,000.

In making these calculations, Earmarked Losses are disregarded.

Thus, if the Licensee had Earmarked Profits of $20,000 for the first

year and Earmarked Losses of $100,000 during the second year, the

$20,000 ``obligation'' already reflected in the DA would have been

unaffected. See Sec. 107.243(d).

(vi) Distributions of Prioritized Payments

With one exception, a Licensee is required to remit the balance in

its DA to SBA, its agent or Trustee within 90 days after the end of the

Licensee's fiscal year, or before any Distribution is made to its own

investors, as appropriate. Any amount remitted to SBA is subtracted

from the DA. If a Licensee has issued Participating Securities on more

than one occasion, Prioritized Payments are made in order of maturity

of the underlying Participating Security.

As an exception, a Licensee is excused from remitting the balance

in the DA to the extent that such remittance would cause the Licensee

to violate the liquidity requirement set forth in Sec. 107.241(f).

Thus, if a Licensee has Earned Prioritized Payments of $1,400,000, and

a cash balance of $1,800,000, but needs to retain $1,000,000 in cash to

attain the required liquidity ratio, the Licensee must remit only

$800,000 to SBA. See Sec. 107.243(c)(3)(iii). Failure to make

Distributions because of insufficient liquidity does not trigger a

regulatory violation.

(vii) Adjustments to Prioritized Payments

A Licensee's failure to make timely distributions of Earned

Prioritized Payments in an amount equal to Prioritized Payments results

in the accumulation of additional amounts which may become payable to

SBA, subject to the existence of sufficient Earmarked Profits. If, at

the end of any fiscal year, there is an unpaid balance in the AA, an

amount equal to the average monthly balance in that account is

multiplied by a rate equal to the average of the rates on new Trust

Certificates (TCs) sold to the public\9\ during the Licensee's fiscal

year, and the product is added to the balance in the AA as a supplement

to Prioritized Payments. See Sec. 107.243(d)(1).

---------------------------------------------------------------------------

\9\SBA will publish a notice of the TC rate from time to time in

the Federal Register.

---------------------------------------------------------------------------

Similarly, if there is an unpaid balance in the DA account at the

end of the Licensee's fiscal year, an amount equal to the average

monthly balance in that account is multiplied by a rate equal to the

average of the rates on new TCs sold to the public during the

Licensee's fiscal year, and the product is added to the balance in the

AA, not to the balance in the DA. See Sec. 107.243(d)(2).

These additional amounts added to the AA are referred to as

``Adjustments''. Once added to the AA, the Adjustments are

indistinguishable from Prioritized Payments; they are characterized as

``earned'' and transferred to the DA in the same manner as Prioritized

Payments are characterized as ``earned.''

As long as unpaid Earned Prioritized Payments, including earned

Adjustments, are outstanding, the Licensee must make the calculations

described in this paragraph ``c'' as of the end of each subsequent

fiscal quarter until all such amounts are paid in full. See

Sec. 107.243(c)(3).

d. Calculation and Allocation of Profit Participation

(i) Introduction

In proposed Sec. 107.244, SBA described its right to a percentage

of the profits of a Licensee issuing Participating Securities. In

consideration for its guarantee of a Licensee's Participating

Securities, SBA\10\ has a contractual right to Profit Participation

consisting of a specified percentage of the Licensee's Earmarked

Profits. The percentage is determined, in part, by the ratio of

outstanding Participating Securities Leverage to Leverageable Capital.

---------------------------------------------------------------------------

\10\Neither the holders of TCs, nor the Trust itself has any

interest in the Profit Participation to which SBA may be entitled.

---------------------------------------------------------------------------

SBA received eighteen (18) comments on the subject of the Profit

Participation. Most complained that the regulations should provide a

mechanism for offsetting prior distributions of profits to SBA against

subsequent losses of the Licensee. This so-called ``levelling up'' is a

component of many venture capital funds, and is designed to ensure that

partners ultimately receive only their agreed-upon profit shares.

SBA was aware of this issue when it drafted the proposed rule.

Under the Distributions section of the preamble to the proposed rule

(section 4.e.(vi)), SBA discussed the reasons for not including a

level-up in the proposed rule. See 58 FR 41862. SBA believed then, and

continues to believe, that Section 403 of Public Law 102-366 prohibits

a recharacterization of amounts already distributed to SBA. There is no

discretion on SBA's part to include a ``levelling-up'' provision in

this final rule.

Even if a recharacterization of distributed amounts were legally

permissible, SBA believes that it would be extremely difficult to

calculate because of the complexity produced by changes in SBA's profit

share (the Profit Participation) and its share of Distributions under

Secs. 107.245 (c) and (d). SBA's profit share in a Licensee is

increased when new Participating Securities are issued by the Licensee

and/or the Licensee's Leverageable Capital is decreased. SBA's profit

share is decreased when approved increases in Leverageable Capital

occur. At the same time, SBA's share of Distributions (in the form of

returns on capital or returns of capital) is changed as increases or

decreases occur in either the Licensee's Leverageable Capital or its

Leverage outstanding. See discussion of Secs. 107.245 (c) and (d)

below. SBA currently does not have a mechanism that can account

accurately for all these changes in order to identify what SBA's share

of Distributions would have been if ``losses after profits'' were taken

into account.

SBA also believes that there should be less need for a

recharacterization of distributed amounts if the Licensee has been

valuing its portfolio investments fairly, especially the determination

of Unrealized Depreciation on Loans and Investments. SBA regulations

require Licensees to reduce their Undistributed Net Realized Earnings

by their Unrealized Depreciation on Loans and Investments in order to

determine Retained Earnings Available for Distribution (READ). See

Sec. 107.3. Distributions of SBA's Profit Participation, which the

commenters would like to be able to recharacterize as a return of

capital, can only be made out of the Licensee's READ. Therefore, if the

Licensee has not grossly underestimated its Unrealized Depreciation,

the Licensee's READ and consequently its Distributions of Profit

Participation to SBA should already reflect, to some degree, future

realized losses. There should be reduced need for a major

recharacterization of earlier distributed amounts when the later losses

are actually realized.

In conclusion, in the absence of a statutory amendment allowing for

a recharacterization, a satisfactory mechanism to implement the change,

and a compelling justification of the need for it, SBA is finalizing

the proposed rule without incorporating a level-up or

recharacterization of prior distributions. SBA expects that discussions

on the subject will continue between it and interested industry members

and that it might at some time in the future propose a different

resolution.

The method for computing, allocating and distributing the Profit

Participation is described below. Although the method has been

simplified from that set forth in the proposed rule, the result is

identical.

In summary, Sec. 107.244 mandates the establishment of a Profit

Participation Account to reflect the allocation and distribution of the

Profit Participation due SBA. The sum to be allocated is determined by

multiplying the Base for Profit Participation, if positive, by the

applicable Profit Participation Rate.

(ii) Computing the Profit Participation Base

The computation of the Profit Participation Base is to be made at

the end of the Licensee's fiscal year and at the end of any fiscal

quarter for which a Distribution is contemplated. Briefly, the Base for

Profit Participation (Base) is a number equal to year-to-date Earmarked

Profits (Losses) minus year-to-date Prioritized Payments and

Adjustments, minus any unused loss carryforward, as determined in the

manner hereafter discussed.

(iii) Determination of Unused Loss Carryforward

To determine its unused loss carryforward, a Licensee must look

back to the Base computed at the end of its previous fiscal year (the

``Previous Base''). If the Previous Base was zero or greater, then the

Licensee's unused loss carryforward is zero. However, if the Previous

Base was less than zero, then the unused loss carryfoward is equal to

the Previous Base. During or at the end of its first year of operation,

a Licensee has no Previous Base and, therefore, no loss carryforward.

In effect, a Previous Base which is negative reflects all prior

losses and Accumulated Prioritized Payments of the Licensee, which are

carried forward to offset future earnings. Conversely, a Previous Base

which is positive is not carried forward because once Earmarked Profits

are used as the basis for an allocation to the Profit Participation

Account, they are disregarded in any subsequent allocation or

computation. See Sec. 107.244(b)(2).

Some illustrations may help clarify this concept. Assume that a

Licensee had issued $10 million of 8 percent Participating Securities

on July 1, 1994, the first day of its fiscal year, and had Earmarked

Profits of $20,000 as of the close of the fiscal year, June 30, 1995.

The Licensee's Base would be ($780,000), computed by subtracting

Prioritized Payments of $800,000 for Earmarked Profits of $20,000 (the

unused loss carryfoward would be zero because the Licensee had not

previously computed a Base). Now assume that fiscal year 1995-96 was

extremely successful and that the Licensee's Earmarked Profits for that

year were $2 million. Since the Previous Base was negative, it would be

the Licensee's unused loss carryforward. The new Base, therefore, would

be $420,000: ([$2,000,000 current period Earmarked Profits--$800,000

current period Prioritized Payments]-$780,000 unused loss

carryforward).

As a second example, assume that the Licensee had instead posted an

Earmarked Loss of $20,000 during the first year that Participating

Securities were outstanding. The unused loss carryforward would be

$820,000. At the end of the second year, the Base for Profit

Participation would be only $380,000 ([$2,000,000-$800,000]-$820,000).

(iv) Computing Profit Participation Rates

(A) When computation is required; general rules. Computation of a

Profit Participation Rate for the relevant fiscal period must be made

at least annually or prior to any Distribution. A Licensee should use

one of the two formulas, as appropriate, which are set forth in

paragraphs (B) and (C), below. Except as described in paragraph (E)

below, the Profit Participation Rate that any particular Licensee must

use depends on the highest ratio of Leverageable Capital to

Participating Securities outstanding which has ever been computed for

such Licensee. This is the Participating Securities to Leverageable

Capital (PLC) ratio.

(B) Participating Securities not at any time in excess of

Leverageable Capital. Subject to the indexing described in paragraph

(D) below, for a Licensee whose outstanding Participating Securities

have never exceeded its Leverageable Capital, the Profit Participation

Rate is equal to the PLC ratio multiplied by nine percent (9%). Thus,

the Profit Participation Rate=PLC ratio x 0.09. For a Licensee that has

a PLC ratio equal to exactly one hundred percent (100%) of Leverageable

Capital, the Profit Participation Rate is nine percent (9%); for every

other Licensee described in this paragraph (B), the Profit

Participation Rate is less than nine percent (9%).

(C) Participating Securities in excess of Leverageable Capital at

any time. Subject to the indexing described in paragraph (D), for a

Licensee whose outstanding Participating Securities have exceeded its

Leverageable Capital, the Profit Participation Rate is equal to nine

percent (9%) plus an additional percentage equal to the product of .03

multiplied by an amount obtained by subtracting one (1) from the PLC

ratio. In other words, Profit Participation Rate=.09+(.03 x [PLC

ratio-1]). If a Licensee has $10 million in Leverageable Capital and

$15 million in Participating Securities, the PLC ratio =1.5 and Profit

Participation Rate equals 10.5 percent, .09+(.03 x [1.5-1]).

(D) Indexing. No indexing of the Profit Participation Rate is

required if, on the date the Participating Securities were issued, the

yield-to-maturity rate on Treasury bonds with a remaining term of ten

years (the ``Treasury Rate'') is exactly eight percent (8%). Otherwise,

the Profit Participation Rate calculated in accordance with

Sec. 107.244(c) (2) or (3) shall be adjusted upward or downward

proportionately to such Treasury Rate (that is, by the percentage,

rather than the same number of percentage points or basis points, by

which the Treasury Rate may be above or below eight percent (8%)).

For example, if the Treasury Rate were ten percent (10%) and the

unindexed Profit Participation Rate were nine percent (9%), the

appropriate indexed Rate would be 11.25 percent. Ten (10) is twenty-

five percent (25%) more than eight (8); 125 percent of nine percent

(9%) is 11.25 percent.

If a Licensee has issued Participating Securities on two or more

occasions, any indexing of the Profit Participation Rate will be based

on the average Treasury Rate for all such issuances, weighted to

reflect the dollar amount of each issue and the portion of the fiscal

period during which each issue was outstanding. See

Sec. 107.244(c)(4)(ii).

(E) Approved increases in Leverageable Capital. Computation of the

Profit Participation Rate is not to be affected by any subsequent

increase in Leverageable Capital, except to the extent that (1) the

increase in Leverageable Capital is the result of the funding of

unfunded commitments or the conversion to cash of assets previously

recognized by SBA as a part of Private Capital, but not of Leverageable

Capital, or (2) such increase is expressly provided for in a plan of

operations previously approved by SBA. See Sec. 107.244(c)(5).

(v) Computing Profit Participation

The amount of SBA's Profit Participation for a fiscal year or

fiscal year-to-date is computed by multiplying the Base as of the end

of such period by the Profit Participation Rate for such period, and

subtracting from the result any amounts of Profit Participation that

were paid or reserved for payment to SBA for any prior interim period

during the same fiscal year.

Any computation of Profit Participation made as of the close of an

interim fiscal quarter is subject to adjustment whenever any subsequent

interim distributions are contemplated, and at the end of the fiscal

year, in order to account for any increase in the Profit Participation

Rate. If the Profit Participation Rate decreases as a result of an

approved increase in Leverageable Capital, Profit Participations

already computed for any interim periods shall not be adjusted. See

Sec. 107.244(d)(3).

(vi) Allocation of Profit Participation

Prior to any Distributions, and in any event within 90 days

following the end of the Licensee's fiscal year, the amount of any

Profit Participation calculated in accordance with Sec. 107.244(d)

shall be allocated to a Profit Participation Account. Funds equal to

the amount allocated to this account shall be reserved for SBA and

shall not be available for reinvestment in Small Concerns or for any

other use by the Licensee; these funds shall be distributed only to

SBA.

(vii) Distribution of Profit Participation

Distribution of allocated Profit Participation shall be made at the

same time that profits are distributed to the Licensee's investors,

either as a tax Distribution or as a return on capital.

e. Distributions

(i) General

Proposed Sec. 107.245 set forth restrictions and other conditions

on a Licensee's Distributions other than Prioritized Payments. All

Prioritized Payments must be paid before any Distributions are made

that are classified as a tax Distribution or a return on capital.

Earned Prioritized Payments and earned Adjustments, as recorded in the

DA, must be paid before any Distributions are made that are classified

as returns of capital. Distributions pursuant to Sec. 107.245 may be

made only to the extent that they do not cause a condition of Liquidity

Impairment. See Sec. 107.241(f).

Comments received on proposed Sec. 107.245 are addressed in the

particular subsection (Tax Distributions, Returns on Capital, or

Returns of Capital) to which such comments relate.

(ii) Tax Distributions

(A) General. Pursuant to proposed Sec. 107.245(b), a Licensee that

is organized as a limited partnership, S Corporation, or similar pass-

through entity, could elect to make an annual Distribution from

Retained Earnings Available for Distribution (READ) to each of its

investors (specifically including SBA) in amounts not greater than the

``Maximum Tax Liability'' (as computed in paragraph (B) below) for

Federal and State income taxes on the Federal taxable income imputed to

each investor for that fiscal year. Since SBA is not a tax-paying

entity, the amount of SBA's share of any such Distribution would be

determined by multiplying the tax Distribution to all partners by SBA's

``Profit Participation Rate'', determined in accordance with

Sec. 107.244. Anything that SBA received as its share of a tax

Distribution would be credited first against Profit Participation as

described below.

Some comments warned that the Agency's interest would not be

protected adequately if Licensees were permitted to make tax

Distributions based on annual profits, without regard to the tax

benefit that had been conferred on investors by prior years' losses. A

cumulative measure of income comparable to that used for Prioritized

Payments or returns on capital was recommended.

While not disagreeing with the need for protection, SBA believes

that the final rule offers adequate safeguards against an unfair

result. A Licensee's ability to make a tax Distribution is always

dependent upon the existence of sufficient Retained Earnings Available

for Distribution. Tax Distributions can only be made from a Licensee's

READ, which is a cumulative measure of income. Although a Licensee may

compute a Maximum Tax Liability (which is based on annual income) in

excess of its Retained Earnings Available for Distribution, its tax

Distribution can never exceed its READ. Thus, prior years' losses do

affect a Licensee's ability to make a tax Distribution.

Furthermore, SBA has revised the proposed tax Distribution

provision to clarify that to the extent a Licensee is unable or elects

not to make a tax Distribution for any fiscal year within ninety (90)

days following the end of such fiscal year, it shall have no right to

make such Distribution at any later date. With this clarification, SBA

has decided to finalize the proposal on tax Distributions.

There are two other important limitations on the right of a

Licensee to make tax Distributions. There can be no unpaid Prioritized

Payments and the Distribution can not cause the Licensee to have a

``Liquidity Impairment''.

Although Sec. 107.245(b) refers to ``tax Distributions'', the

amounts distributed may exceed any true tax liability (particularly for

those investors that are exempt from Federal or State taxation). Other

than SBA, every investor in a Licensee that is a pass-through entity is

presumed conclusively (1) to be a resident, for tax purposes, of the

State in which the Licensee's principal office is located; and (2) to

be liable to pay Federal and State income taxes at the highest marginal

tax rates applicable to each category of income (such as ordinary

income as opposed to capital gains). If individuals are taxed at a

higher rate than corporations, every investor will be presumed

conclusively to be an individual even if actually a corporation or a

pension fund. See Sec. 107.245(b).

(B) Computation of tax Distribution to Investors. The maximum

amount potentially distributable to all investors (including SBA) is

determined by multiplying the aggregate amounts of ordinary income and

capital gains imputed to investors by the highest combined marginal

Federal and State tax rates applicable to each category, taking into

account the deductibility of State taxes when computing Federal taxes.

Local taxes (for example, county and city taxes) are disregarded for

this purpose.

By way of illustration, assume that at the end of the Licensee's

first fiscal year, $1,000 in ordinary income had been imputed to all

investors (including tax-exempt organizations). If the highest rate of

Federal tax on ordinary income is thirty-five percent (35%) and the

highest rate of State tax on ordinary income is five percent (5%), it

is conclusively presumed that investors will have to pay $50 in State

income taxes on the $1,000 in the Licensee's hands. But since the $50

payable to the State is deductible from the investors' Federal taxable

income, their Federal income tax liability is based on only $950, and

is therefore equal to $332.50. The maximum amount that may be

distributed to investors (including SBA) pursuant to Sec. 107.245(b)

would be $332.50 plus $50.00 or $382.50 (not $400, which would be forty

percent (40%) of $1,000).

The proposed rule incorrectly suggested that SBA's share of the tax

Distribution was in addition to the tax Distribution to investors as

computed above. SBA is here clarifying that, in accordance with section

403 of Public Law 102-366, the tax Distribution to investors as

computed above includes SBA's tax Distribution. In other words, the

amount calculated as the tax Distribution for all investors is not

available for distribution to all non-SBA investors; SBA's portion must

be deducted for distribution to SBA.

(C) Computation of tax Distributions to SBA. The amount to be

remitted to SBA is computed by multiplying the total tax Distribution

as computed above by the Profit Participation Rate computed in

accordance with Sec. 107.244(c). The amount of such tax Distribution to

SBA shall be subtracted from the Profit Participation Account referred

to above.

(iii) Returns on Capital

(A) General. Proposed Sec. 107.245(c) established requirements for

all Distributions in the form of returns on capital and some

Distributions in the form of returns of capital. The proposal provided

that after making all Prioritized Payments and any tax Distributions, a

Licensee with READ would be required, within 90 days following the

close of its fiscal year (or in its discretion, a fiscal quarter), to

make Distributions under this section to its investors and SBA to the

extent that they would not cause a Liquidity Impairment. In appropriate

circumstances, SBA could waive this requirement. All such Distributions

to investors must be made from READ (and would be returns on capital);

Distributions to SBA may or may not be from READ (and may be returns on

capital or returns of capital).

A number of comments indicated dissatisfaction with the requirement

that Distributions be made within 90 days of the Licensee's fiscal year

end. They argued that it can often be imprudent for a Licensee to

distribute all of its profits, and expressed concern over potential

delays in obtaining waivers from SBA.

SBA is particularly sympathetic to issues affecting the prudent

management of Licensees. The Liquidity Impairment test itself is

imposed on all Distributions to ensure that Licensees are prudent

managers of their cash flows. Still, SBA recognizes that prudent

management of cash flow and investments means more than merely

satisfying the Liquidity Impairment test, and that there will be times

when a Licensee should refrain from distributing all profits. While SBA

believes that the waiver provision will help to prevent the imprudent

distribution of a Licensee's profits, it agrees with the need for

prompt consideration of waiver requests.

In order to assure Licensees that requests for prior approval will

be processed on a timely basis, the final rule provides that the

Licensee's request for prior approval will be considered approved

unless SBA notifies it otherwise within thirty (30) days of receiving

the request. All requests for prior approval should be accompanied by

sufficient information for SBA to make an informed decision.

SBA has concluded that Licensees may need more than ninety (90)

days after their respective fiscal year-ends to calculate and make

Distributions under Sec. 107.245(c). Accordingly, this final rule

provides that a Licensee is required to make such Distributions within

120 days of the end of its fiscal year.

Each Licensee that expects to need prior approval under

Sec. 107.245(c) should make sure its request is received by SBA before

the ninetieth day after its fiscal year end so that SBA is able to

respond before the arrival of the 120th day, when Distributions must be

made. SBA believes that with the addition of a definitive thirty-day

response time, Licensees should be able to plan for their needs and yet

meet the requirements of the regulation.

The balance of Sec. 107.245(c) is finalized as it was proposed. It

provides that while the dollar amount of Profit Participation is

determined by formula according to the ratio of Participating

Securities to Leverageable Capital, the actual amount to be distributed

to SBA when there is a return on capital to private investors is a

function of the ratio of total Leverage (Debentures, and Preferred

Securities, and Participating Securities) to Leverageable Capital. See

Sec. 107.245(c).

As with the proposed rule, if SBA determines that the value of the

Licensee's assets are materially overstated and if SBA provides the

Licensee with timely notice of such determination in advance of a

proposed Distribution, SBA reserves the right to restrict

Distributions.

Distributions paid to SBA under Sec. 107.245(c) are applied in the

following sequence:

(i) Profit Participation;

(ii) Dividends or equivalent distributions on Preferred Securities;

(iii) Redemption or prepayment of outstanding Participating

Securities;

(iv) Redemption or prepayment of outstanding Preferred Securities;

and

(v) Repayment of principal of outstanding Debentures. If there are

restrictions on prepayment of outstanding Debentures, that part of

SBA's share of a Distribution that is to be applied toward such

prepayment shall be deposited in an escrow account on such terms and

conditions as SBA may prescribe.

It is noted that Distributions to SBA will be made from READ only

to the extent of Profit Participation and dividends or equivalent

distributions, if any, on Preferred Securities. To the extent that a

Distribution is applied as a repayment or redemption of Leverage, it

shall not reduce READ.

(B) Computation of SBA's share. As in the proposed rule, if

outstanding Leverage is more than two hundred percent (200%) of

Leverageable Capital, SBA's share of any Distribution under

Sec. 107.245(c) shall be in the ratio of Leverage to Leverageable

Capital. In other words, if a Licensee has outstanding Leverage equal

to three hundred percent (300%) of Leverageable Capital, SBA's share

shall be \3/4\ or seventy-five percent (75%) of any such Distribution

and SBA would be entitled to $3 for every $1 distributed to other

investors. If outstanding Leverage were two hundred fifty percent

(250%) of Leverageable Capital, SBA would be entitled to $2.50 for

every $1 distributed to other investors.

If outstanding Leverage is more than one hundred percent (100%) of

Leverageable Capital, but not more than two hundred percent (200%),

SBA's share of any such Distribution shall be equal to the aggregate

shares of all other investors. For every $1 distributed to other

investors, SBA shall receive $1.

If outstanding Leverage is not more than one hundred percent (100%)

of Leverageable Capital, SBA's share of any such Distribution shall be

a percentage equal to the Profit Participation Rate.

(iv) Returns of Capital

Under this heading, it is appropriate to discuss comments received

regarding the definition of ``Retained Earnings Available for

Distribution'' (READ). Any changes in that definition would affect the

allocation of Distributions between returns on capital and returns of

capital for companies with Participating Securities. It should be

noted, however, that READ is a defined term which applies to all

Licensees. Any change in the definition would actually have a more

significant effect on Licensees without Participating Securities

because they are subject to much stricter limitations on their ability

to return capital to investors.

In general, the comments expressed the opinion that READ should

include Unrealized Appreciation as an offset to Unrealized

Depreciation. In other words, READ would be defined to mean

Undistributed Net Realized Earnings less net Unrealized Depreciation.

SBA understands the arguments of the industry, including issues of

fairness and good faith, but remains unconvinced. As a general rule,

the portfolio valuation process is not sufficiently reliable to allow

Unrealized Appreciation to be a component of READ without introducing

an undue risk of premature distributions. While the calculation of

Capital Impairment allows for an offset of Unrealized Appreciation

against Unrealized Depreciation, and even gives credit against realized

losses for some net Unrealized Appreciation, Capital Impairment and

READ serve different purposes in the SBIC Program. The former is a

regulatory measure of financial health; the latter is the basis for

distributing cash out of the company. Accordingly, SBA intends to

retain the conservative measure of READ in its final rule, defining

READ to mean Undistributed Net Realized Earnings less Unrealized

Depreciation.

SBA recognizes that there may be occasions when otherwise

unauthorized distributions should be approved. A Licensee may request

SBA's prior approval to make a distribution in excess of READ in

accordance with the provisions of Sec. 107.1201. In considering such

requests, SBA will consider all relevant factors, including the

existence of Unrealized Appreciation.

Since there were no other comments on Sec. 107.245(d), SBA is

finalizing it without any other change. It provides that after paying

all Earned Prioritized Payments including earned Adjustments in the DA,

and all allocated Profit Participation, and provided the Licensee does

not have a condition of Capital Impairment, a Licensee that has either

outstanding Participating Securities or Earmarked Assets in its

portfolio may return capital to its investors and SBA, pursuant to the

terms set forth in Sec. 107.245(d). This provision allows an exception

to Sec. 107.802, which prohibits Licensees from distributing capital in

excess of two percent (2%) per year without the prior written approval

of SBA, subject to certain restrictions. However, unless SBA decides

otherwise on a case-by-case basis, any such Distribution shall be

subject to the liquidity requirement in Sec. 107.241(f).

Generally, Distributions in the form of returns of capital shall be

made to SBA and private investors in the ratio of Leverage to

Leverageable Capital as of the date of the proposed Distribution. For

example, if outstanding Leverage is equal to three hundred percent

(300%) of Leverageable Capital, SBA's share will be $3 for every $1

distributed to the private investors.

If, however, a Licensee has a Capital Impairment Percentage greater

than zero, the relative shares of SBA and the private investors must be

computed differently. In such a case, Leverageable Capital for the

purposes of Sec. 107.245(d) is deemed to be Leverageable Capital

multiplied by a percentage equal to the difference between one hundred

percent (100%) and the Licensee's Capital Impairment Percentage.

Assuming a Licensee had $10,000,000 of Leverageable Capital and a

Capital Impairment Percentage of forty-two percent (42%), the

Licensee's Leverageable Capital for purposes of this computation will

be deemed to be $5,800,000 ([100%-42%] x [$10,000,000]).

The proceeds of SBA's share of any capital Distribution shall be

credited in the manner prescribed for returns on capital under

Sec. 107.245(c), as set forth in Sec. 107.245(c)(5).

(v) In-Kind Distributions

No comments were received on the subject of In-kind Distributions,

proposed Sec. 107.245(e). The provision is therefore finalized in the

form in which it was proposed. Under Sec. 107.245(e), Distributions of

READ or of capital need not be in cash, but may be in the form of

portfolio securities, subject to certain restrictions. The securities

to be distributed must be Publicly Traded and Marketable, as defined in

Sec. 107.3, at the time of Distribution.

At the time a corporate Licensee declares an In-kind Distribution,

or an Unincorporated Licensee actually makes one, the Licensee must

impute a gain or loss to the securities in question, determined as of

the date of the declaration or distribution, as the case may be. Such

imputed gain or loss shall be used to calculate Earmarked Profits

pursuant to Sec. 107.242(e) as if it were a realized gain or loss.

All Distributions of securities that constitute part of an In-kind

Distribution must be made on a pro-rata basis to each investor,

including SBA, as if the securities previously had been converted to

cash and the proceeds constituted the entire Distribution. A Licensee

may not distribute a disproportionate percentage of the stock of

company A to investor X and a disproportionate share of the stock of

company B to investor Y, even if the values of the shares of A and B

are equal.

SBA's share of an In-kind Distribution shall be deposited with the

Central Registration Agent (CRA) unless SBA and the Licensee agree that

the Licensee will dispose of SBA's share of such securities. If the

Licensee disposes of SBA's share of securities, it shall remit the

proceeds promptly to SBA or to SBA's designated agent or Trustee.

f. Post-Redemption Obligations

No comments were received on proposed Sec. 107.246, which described

the continuing obligations of Participating Securities issuers after

their Participating Securities have been redeemed. The section is

finalized without change, except to clarify that post-redemption

Distributions of Accumulated Prioritized Payments are to be computed

and paid on a quarterly basis, but otherwise in the same manner as

before redemption.

If, after redeeming all of its outstanding Participating

Securities, a Licensee has both Earmarked Assets in its portfolio and

an unpaid outstanding balance in the Prioritized Payment Accumulation

Account (AA), the Licensee remains ``obligated'' to determine, at the

end of each fiscal quarter, whether any Prioritized Payments have

become Earned Prioritized Payments and to distribute such amounts to

SBA in accordance with Sec. 107.243. See Sec. 107.246(a). After the

last Earmarked Asset has been disposed of, and any resulting Earned

Prioritized Payments paid to SBA, the Licensee is under no further

obligation to pay the remaining balance, if any, in the AA. See

Sec. 107.246(b).

Section 107.246(c) overrides the language of Sec. 107.245(e) (In-

kind Distributions) in cases involving In-kind Distributions to be made

after redemption of all Participating Securities if there are also

unpaid Prioritized Payments. Under Sec. 107.246(c), no In-kind

Distributions of Earmarked Assets may be made unless SBA is paid a sum

equal to the full amount of the unpaid Prioritized Payments or the full

amount of Unrealized Appreciation on the Earmarked Assets in question,

whichever is less. Subject to this rule, a Licensee that has fully

redeemed its Participating Securities may distribute Earmarked Assets

that are not Publicly Traded and Marketable if it has SBA's prior

written consent to such Distribution and to the valuation assigned by

the Licensee.

g. Special Rules for Companies Licensed On or Before March 31, 1993

(i) General

SBA did not receive any comments on proposed Sec. 107.247, the

special rules for companies licensed on or before March 31, 1993. The

section is therefore finalized without change. It provides that a

company licensed on or before March 31, 1993 that thereafter applies

for SBA's guarantee of its Participating Securities must meet certain

procedural requirements not applicable to other Licensees. These

companies are also afforded certain exemptions or options not available

to companies licensed after March 31, 1993. See Sec. 107.247. The

details are set forth below.

(ii) Special Requirements

When applying for SBA's guarantee of a first issuance of

Participating Securities, any company licensed on or before March 31,

1993 must submit:

(a) A valuation report for each portfolio asset as of the date of

the financial statements that accompany the application, and as of the

end of each of the preceding three years, and

(b) A copy of each portfolio concern's last annual report and/or

fiscal year-end financial statements, and most recent interim financial

statements. See Sec. 107.247(d). This information is required in

addition to the financial information that all Licensees, including

companies licensed after March 31, 1993, are required to submit in

connection with an application for SBA's guarantee of their

Participating Securities.

If the Licensee has negative Undistributed Realized Earnings and/or

a net Unrealized Loss on Securities Held, SBA may make its approval of

the Licensee's request for a guarantee of Participating Securities

contingent upon a quasi-reorganization in accordance with generally

accepted accounting principles. See Sec. 107.247(d)(2).

If the financial statements of the Licensee submitted with the

application are interim financial statements, the Licensee shall have a

limited scope audit performed by its SBA-approved independent

accountants. These accountants shall use whatever auditing procedures

are necessary to enable them to express an opinion on the Licensee's

Statement of Financial Position and the accompanying Schedule of

Investments.

(iii) Refinancing of Debentures

Subject to the two following conditions, a company licensed on or

before March 31, 1993 may use part or all of the proceeds of

Participating Securities to repay or prepay Debentures outstanding on

that date. The Licensee must demonstrate to SBA that it has outstanding

Equity Capital Investments, valued at cost, in an amount equal to the

amount of Participating Securities that would be used to refinance the

outstanding Debentures that are to be repaid or prepaid. The Licensee

also may not elect to exclude any of its pre-existing portfolio from

the category of Earmarked Assets.

A Licensee that pays or prepays an outstanding Debenture after it

has issued Participating Securities is presumed to have used the

proceeds of the Participating Securities for this purpose unless it can

demonstrate the availability of other funds to pay the principal amount

of the Debenture in question. See Sec. 107.247(a).

(iv) Exclusion of Pre-Existing Portfolio Assets

Unless a Licensee intends to use part or all of the proceeds from

the issuance of Participating Securities to repay or prepay a Debenture

outstanding on March 31, 1993, it may elect, when its first application

for SBA's guarantee is submitted, to exclude all, but not less than

all, portfolio assets outstanding on March 31, 1993 from the category

of Earmarked Assets. In such event, SBA is not obligated to extend its

guarantee if it concludes that exclusion of the Licensee's March 31,

1993 portfolio would significantly decrease SBA's chances of obtaining

a satisfactory return on its guarantee.

5. Financing by Use of SBA Guaranteed Trust Certificates

Proposed Sec. 107.250 was a recodification of existing

Sec. 107.201(c), revised to include the new Participating Securities.

No comments were received on the proposal, which is therefore finalized

without substantive change.

6. Conditions Affecting Good Standing of Leveraged Licensees

a. Introduction

SBA received forty-three (43) comment letters concerning SBA's

proposed remedies for regulatory violations by Leveraged Licensees

(Sec. Sec. 107.261 and 107.262). SBA had proposed to separate the

remedies for violations by issuers of Debentures and Preferred

Securities (Sec. 107.261) from the remedies for violations by issuers

of Participating Securities (Sec. 107.262). The comments supported the

distinction made between Debentures and Participating Securities. The

suggestion that remedies be different for Preferred Securities and

Participating Securities, however, was opposed by Specialized SBICs.

These Licensees objected to the characterization of Preferred

Securities as more akin to Debentures than Participating Securities.

They argued that the Preferred Security, which has attributes of both

debt and equity securities, should be treated as an equity security for

purposes of the remedies section. They expressed concern that if

Preferred Securities continue to carry the same remedies as Debentures,

tax-exempt entities such as pension funds will refrain from investing

in Specialized SBICs in order to avoid incurring Unrelated Business

Taxable Income (UBTI).

SBA expresses no opinion as to whether tax-exempt entities

investing in Specialized SBICs that issue Preferred Securities would

incur UBTI as a result of SBA's former remedies (former Sec. 107.203)

or its proposed remedies (proposed Sec. 107.261). Nevertheless, SBA

believes that there is sufficient justification for treating Preferred

Securities as if they were an equity-type security and relocating them

into the Participating Securities remedies section (Sec. 107.262). The

rule is finalized with this change.

The overall structure of the remedies sections remains otherwise

intact. In order to maintain the separation between the two sections on

remedies, no cross-default provisions are provided between Debentures,

on the one hand, and Preferred Securities and Participating Securities,

on the other. If a Licensee has both Debentures and Participating

Securities, a default under the former will not automatically trigger a

``default'' under the latter, and vice versa.

b. General Conditions and Remedies

Many comments on the proposed remedies sections objected to the

requirement that all Licensees issuing Leverage after publication of

this final rule amend their articles of incorporation or partnership

agreements to indicate consent, in advance, to SBA's right to require

the removal of officers, directors, or general partners and to the

appointment of SBA or its designee as receiver of the Licensee for the

purpose of continuing to operate the company. See Sec. Sec. 107.261(f)

and 107.262 (b) and (c). Such remedies would only take effect upon the

occurrence of certain specified violations involving, for the most

part, fraudulent activities or willful actions.

The principal effect of the consent to a receivership would be that

SBA would be entitled to the receivership promptly, as a matter of

right. Except upon the occurrence of an automatic event of default

under a Debenture (see Sec. 107.261(b)), Licensee's consent would not

include consent to a receivership for the purpose of liquidating the

company.

The comments objected strongly to the consent provision,

particularly as it relates to Debenture issuers (Sec. 107.261(f)). They

recommended that SBA rely upon its current statutory authority for

removal of management and/or the appointment of a receiver, which

allows a Licensee the opportunity to challenge, in advance, SBA's

intended action. Unfortunately, SBA has found that SBICs have used that

opportunity to delay the availability of SBA's remedy while they file

for protection under Federal bankruptcy laws.

SBA looked carefully at the specific violations that could trigger

the advance consent remedies. The Agency is convinced that, with one

small exception, the advance consent is appropriate for the very

serious nature of the defaults in question.

The one exception is the payment default by issuers of Debentures

(Sec. 107.261(c)(7)). SBA intends to continue its customary practice of

affording Licensees an opportunity to cure payment defaults. The

proposed rule would have permitted SBA to use its remedial powers

before allowing the Licensee an opportunity to cure its payment

default. Accordingly, SBA is moving the default referred to as

``Failure to make payment'' from the category of non-curable defaults

(Sec. 107.261(c)) to the category of curable defaults

(Sec. 107.261(d)).

With this change, a Licensee issuing Debentures after the effective

date of this rule will be required to consent in advance to the forced

removal of management and the appointment of an operating receivership

for the following events: fraud, fraudulent transfers, willful

conflicts of interest, willful noncompliance, repeated events of

default, transfer of control of the Licensee, uncured excessive fees,

uncured improper Distributions and uncured payment defaults.

These consent provisions will not apply to any Licensee which only

has Leverage issued prior to the effective date of this final rule.

Prospectively, however, the consent will be incorporated in all newly-

issued Debentures, Preferred Securities, and Participating Securities.

As a result, for Licensees with Leverage issued both before and after

the effective date of this rule, the Licensee will be deemed to have

consented to a receivership upon the occurrence of a default under

Leverage issued after such date, but not if the default is only under

Leverage issued before such date.

SBA also is making clear in this final rule that while the Agency

determines appropriate cure periods for curable violations on a case-

by-case basis, the cure period under Sec. 107.261 or Sec. 107.262 will

never be less than fifteen (15) days. As with the proposed rule, an

opportunity to cure is made available in the final rule under

Secs. 107.261(d) and 107.262(c). In response to comments from

Licensees, this final rule also affords an issuer of Participating

Securities or Preferred Securities an opportunity to cure before being

placed under ``restricted operations.'' See Sec. 107.262(d).

SBA does not agree with the recommendation in some comment letters

that, in the case of bankruptcy, voluntary assignment for the benefit

of creditors, and transfers of control, Licensees issuing Participating

or Preferred Securities still should have the opportunity to remove the

responsible party and/or otherwise effect a cure before SBA can use its

remedial powers. SBA believes strongly that if one of these violations

occurs, the Agency must be free to exercise its remedies as rapidly as

possible, since time may be of the essence in preserving any value left

in the company.

SBA is concerned that it may have risked ceding too much of its

regulatory responsibility in formulating the proposed remedy for

Capital Impairment for Participating Securities issuers (and now

Preferred Securities issuers) under Sec. 107.262(d)(3), which remedy

may not be adequate in the case of ``extreme'' Capital Impairment. The

remedy proposed for Capital Impairment was to place the Licensee under

restricted operations, a status which allows SBA to control the flow of

money in and out of the Licensee until the violation is cured. This is

appropriate for Capital Impairment levels of under one hundred percent

(100%), when a Licensee's Regulatory Capital (but not SBA's investment)

has essentially been lost. When Capital Impairment equals or exceeds

one hundred percent (100%), SBA believes it must have the ability to

take necessary action to protect its investment.

Since SBA considers Capital Impairment of at least one hundred

percent (100%) as equivalent in risk to actual insolvency because it

means that the Licensee has lost one hundred percent (100%) of its

Regulatory Capital, the remedies available for a Licensee's insolvency

will now be available for extreme Capital Impairment. These remedies

include Licensee's consent to the forced removal of management and/or

the appointment of a receiver for the purpose of continuing to operate

the company. Accordingly, in this final rule, a provision for extreme

Capital Impairment is added to the insolvency default. Since issuers of

Participating Securities can be expected to have high Capital

Impairment during the earlier years of the security's life, with the

impairment level declining as later profits are taken, such Licensees

will be exempted from the extreme Capital Impairment provision until

the end of the eighth (8th) year following the Licensee's initial

issuance of Participating Securities.

A Licensee with extreme Capital Impairment will be afforded an

opportunity to cure such impairment only if it has not already been

afforded an opportunity to cure a lesser degree of Capital Impairment

under Sec. 107.262(d)(3). In other words, SBA does not intend to permit

a second cure period if a Licensee has failed to cure during its prior

opportunity.

The remaining provisions in the remedies sections are finalized as

proposed. A more detailed discussion of the violations and associated

remedies for the different types of Leverage securities is provided in

paragraphs c. and d. below.

c. Licensees With Outstanding Debentures; Events of Default

As finalized, Sec. 107.261 will apply to all Licensees issuing

Debentures after the effective date of this rule. As with the former

regulation (Sec. 107.203), all such Licensees will be deemed to have

consented to the remedies provision in effect on the date of issuance

of Debentures as if such remedies were fully set forth in the

Debentures. Such remedies include, but are not limited to, a right to

acceleration or redemption of the Debentures and the establishment of a

receivership with SBA or its designee as receiver.

As with the proposed rule, Sec. 107.261 sets forth three (3)

categories of defaults or violations that could result in the

acceleration of a Licensee's outstanding Leverage and the appointment

of SBA as receiver of the Licensee. The first such category, set forth

in Sec. 107.261(b), consists of three (3) events that automatically

accelerate all outstanding Leverage without notice or demand to the

Licensee, and allow SBA to apply for receivership of the Licensee

without Licensee's objection.

The events in question are insolvency, a voluntary assignment for

the benefit of creditors, and the filing of a voluntary or involuntary

petition for relief under the Bankruptcy Code. A Licensee is insolvent

for purposes of this regulation and Sec. 107.262(b) if its liabilities

exceed its assets or if it is unable to pay its debts as they come due,

even if its assets exceed its liabilities at the time.

Under the second category of defaults, upon written notice, SBA may

demand immediate repayment or redemption of all outstanding Debentures,

or take any other action permitted under the Act. See Sec. 107.261(c).

As finalized, nine (9) defaults are included in this category, all of

which include an element of either willfulness or actual fraud. No

opportunity to cure the default will be afforded the Licensee.

Moreover, for six (6) of the defaults in this category the Licensee

already will have consented to SBA's right to require the Licensee to

replace officers, directors, or general partners with persons approved

by SBA, and to SBA's appointment as receiver for the purpose of

continuing Licensee's operations. See Sec. 107.261(f). It should be

noted that the written notice contemplated under Sec. 107.261(c) is

notification by SBA that the Licensee's Leverage must be immediately

repaid or redeemed, not a notice that SBA will make such a demand in

the future.

With respect to the third category of nine (9) violations or

defaults, SBA will afford the Licensee the opportunity to cure its

violations. See Sec. 107.261(d). ``Failure to make payment'' has been

moved to this section of the regulations, and is now a curable default.

As discussed above, SBA will never require that a default be cured in

less than fifteen (15) days. If the Licensee fails to cure to SBA's

satisfaction, SBA may accelerate and/or, in the case of three (3) of

the violations, pursue the other remedies discussed in the previous

paragraph. See Sec. 107.261(f).

Section 107.261(e) authorizes SBA to impose a limited sanction on

Licensees that repeatedly fail to comply with one or more ``non-

substantive'' provisions of the Act or the regulations. Such Licensees

will be denied additional Leverage, and also may be required to take

actions necessary to come into full compliance. If, under such

circumstances, a Licensee were to fail to take the steps necessary to

accomplish the remedial actions required by SBA, such Licensee's

Debentures could be accelerated, or other remedies, including a

receivership, could be instituted. See Sec. 107.261(c)(7).

SBA is repeating here the guidance it provided in the proposed rule

regarding the distinction between ``substantive'' and ``non-

substantive'' provisions of the Act and the regulations promulgated

under it. SBA considers each of the provisions of the Act and the

regulations to have an important purpose. Even a regulation as

seemingly minor as the one that requires all Licensees to maintain a

listed telephone number and regular business hours serves a significant

purpose: Licensees should be accessible to their communities, not just

their friends. An unlisted telephone number or irregular business

hours, in the absence of other violations, should not be equated with

more serious violations, however. Thus such violations are not as

significant or ``substantive'' as are violations due to unacceptably

high levels of capital impairment or financings that are tainted by

conflicts of interest. Accordingly, phone listing and business hour

requirements will be characterized as ``non-substantive'', as will

other housekeeping-type requirements. All other requirements under the

Act and the regulations, specifically including the filing of required

financial and disclosure forms with SBA, will be considered

``substantive''.

d. Licensees With Outstanding Participating Securities and/or Preferred

Securities; Conditions Affecting Licensee's Good Standing

As discussed above, SBA is extending the reach of Sec. 107.262 to

cover violations under Preferred Securities in addition to those under

Participating Securities. As finalized, Sec. 107.262 will apply to any

Licensee that issues Participating Securities or, after the date

hereof, Preferred Securities. It will continue to apply until the

Licensee repays or redeems its Preferred Securities, or repays or

redeems its Participating Securities and sells or otherwise liquidates

its Earmarked Assets.

Section Sec. 107.262 sets forth four (4) categories of events that

would affect prejudicially a Licensee's good standing. The remedies

available to SBA under this section, and the Licensee's consent to such

remedies, are required to be set forth in the articles of incorporation

or partnership agreement of the Licensee prior to its issuance of

Participating Securities or, after the effective date of this rule,

Preferred Securities.

The first category of events set forth in Sec. 107.262(b) consists

of six (6) events, the occurrence of any of which will permit SBA to

take certain action. If the offending Licensee is a corporation, SBA

can, upon notice to the Licensee, require the Licensee to replace, with

individuals approved by SBA, one or more of its officers and/or a

sufficient number of its directors to constitute a majority of the

board. If the offending Licensee is a partnership, SBA can, upon notice

to the Licensee, require the removal of the responsible party and/or

require replacement of the general partner by a new general partner

selected by the Licensee but approved by SBA. Alternatively, or in

addition to the remedies just described, SBA can apply for the

institution of an operating receivership, with SBA or its designee as

receiver. As in the case of Debenture Leverage, Licensees with

Participating Securities or Preferred Securities will be deemed to have

consented to such receivership.

Section 107.262(c) lists three (3) events with remedies identical

to those provided under Sec. 107.262(b). SBA would have the right to

avail itself of such remedies only if the Licensee failed to remove the

person(s) identified by SBA as responsible for the violation and/or to

cure the violation within a time period of not less than fifteen (15)

days, as determined by SBA. One of the three (3) events in this

category is the willful or repeated noncompliance by the Licensee with

the substantive provisions of the Act or regulations. Repeated

noncompliance should be understood to mean an additional violation of a

statutory or regulatory provision after the Licensee has been notified

of the initial violation. If a Licensee willfully distributes amounts

in excess of Distributions permitted by SBA, such action will

constitute willful noncompliance under Sec. 107.262(c), not merely an

``improper distribution'' under Sec. 107.262(d).

Section 107.262(d) lists eleven (11) events, the occurrence of any

of which will allow SBA, on written notice to the Licensee, to take

certain action aimed at controlling the flow of money in and out of the

Licensee until such time as the Licensee were to cure the event(s) to

SBA's satisfaction. SBA may prohibit Distributions to parties other

than SBA, its agent or Trustee. SBA also may prohibit the Licensee from

investing in any Small Concern which it is not currently financing

unless it were legally bound to make such investment. SBA may require

that any unfunded commitments to invest in the Licensee be funded as

soon as possible. If the Licensee fails to comply with the restrictions

imposed by SBA (as described above), SBA can apply for the institution

of an operating receivership with SBA or its designee as receiver,

again without any objection from the Licensee. As mentioned above under

the discussion of Management Expenses, Licensees placed under

restricted operations will be required to re-obtain SBA's approval of

their Management Expenses or, in the case of Preferred Securities

issuers, their management compensation.

Section 107.262(e), regarding repeated non-substantive violations,

corresponds to Sec. 107.261(e), previously discussed. If a Licensee

fails to take the steps necessary to accomplish the remedial actions

required by SBA under Sec. 107.262(e), SBA may take the actions

described in the preceding paragraph to control the flow of money in

and out of the Licensee.

e. Non-Waiver

No comments were received on proposed Sec. 107.263, which is a

recodification and amplification of the non-waiver provision formerly

found in Sec. 107.203(b)(5). It has been and will continue to be SBA's

policy to attempt to resolve all problems with a Licensee before taking

formal remedial action. Section 107.263 clarifies that if SBA does not

resort to the full measure of the remedies available under

Secs. 107.261 and 107.262, or does so only after a delay, SBA will not

be deemed to have waived its right to pursue such remedies in

connection with either the original default or any subsequent default.

Compliance With Executive Orders 12866, 12612 and 12778 and the

Regulatory Flexibility and Paperwork Reduction Acts

Executive Order 12866 and Regulatory Flexibility Act

This final rule will be a significant regulatory action for

purposes of E.O. 12866 because it will have an annual effect on the

economy of more than $100 million. For purposes of the Regulatory

Flexibility Act, 5 U.S.C. 601 et seq., it also will have a significant

economic impact on a substantial number of small entities.

This final rule is being adopted pursuant to a statutory mandate

(Section 415 of Pub. L. 102-366) which requires SBA to promulgate

regulations implementing The Small Business Equity Enhancement Act of

1992.

Prominent among the statutory provisions implemented by this final

rule is the creation of a new class of SBA-guaranteed securities

(Participating Securities), as further described in this rule. The

potential benefits of this final rule, and in particular the

Participating Securities provisions, include attracting new capital

into the SBIC Program from a variety of sources. This new capital,

together with SBA Leverage, will substantially exceed $100 million per

year and ultimately will be invested by SBICs in eligible small

business concerns.

Financing small concerns is consistent with the Administration's

goal to encourage the formation of new businesses and the growth of

existing businesses. While it is not possible to quantify the

anticipated benefits of this regulatory action, it is expected that the

availability of new capital to small businesses will result in a

substantial number of new jobs and associated increases in payroll,

corporate and capital gains tax revenues.

The potential costs of this regulation cannot be quantified or

estimated. A portion of the cost to the government of administering the

Participating Securities program is expected to be offset by the two

percent (2%) user fee imposed on Licensees issuing such securities.

Potential costs of this regulation to Licensees can not be quantified;

however, no Licensee is ever require to issue Participating Securities

or any other form of Leverage.

There are no reasonably feasible alternatives to this final rule

that would accomplish the intent and direction of Title IV of Public

Law 102-366.

Executive Order 12612

SBA certifies that this final rule will have no Federalism

implications warranting the preparation of a Federalism Assessment in

accordance with Executive Order 12612.

Executive Order 12778

SBA certifies that this final rule is drafted, to the extent

practicable, in accordance with the standards set forth in Section 2 of

E.O. 12778.

Paperwork Reduction Act

For purposes of the Paperwork Reduction Act, 44 U.S.C., ch. 35, SBA

certifies that this final rule will impose no additional reporting or

recordkeeping requirements.

[Catalog of Federal Domestic Assistance Program No. 59.011, Small

Business Investment Companies]

List of Subjects in 13 CFR Part 107

Investment companies, Loan programs-business, Reporting and record-

keeping requirements, Small businesses.

For the reasons set forth above, part 107 of title 13, Code of

Federal Regulations is amended as follows:

PART 107--SMALL BUSINESS INVESTMENT COMPANIES

1. The authority citation for part 107 is revised to read as

follows:

Authority: Title III of the Small Business Investment Act, 15

U.S.C. 681 et seq.; 15 U.S.C. 687(c); 15 U.S.C. 683; 15 U.S.C. 687d;

15 U.S.C. 687g; 15 U.S.C. 687b; 15 U.S.C. 687m, as amended by Pub.

L. 102-366.

2. Section 107.1 is amended by adding at the end the following two

sentences, to read as follows:

Sec. 107.1 Scope of Part 107.

* * * Provisions of this part which are not mandated by the Act

shall not supersede existing State law. A party claiming that a

conflict exists shall submit an opinion of independent counsel, citing

authorities, for SBA's resolution of the issues involved.

3. Section 107.3 is amended by revising the definitions for

``Leverage'' and ``SBA'' and by adding additional definitions, in

alphabetical order, to read as follows:

Sec. 107.3 Definition of terms.\2\

---------------------------------------------------------------------------

\2\Terms defined in this section are capitalized hereafter.

---------------------------------------------------------------------------

Accumulated Prioritized Payments means Prioritized Payments which

are not payable as of any given date because the Licensee has

insufficient cumulative Earmarked Profits. It is the aggregate of

cumulative Prioritized Payments less Earned Prioritized Payments.

* * * * *

Affiliate or Affiliates has the meaning set forth in Sec. 121.401.

* * * * *

Central Registration Agent or CRA means one or more agents

appointed by SBA for the purpose of issuing TCs and performing the

functions enumerated in Sec. 107.250(b) and performing similar

functions for Debentures and Participating Securities funded outside

the pooling process.

* * * * *

Combined Capital means the sum of Regulatory Capital and

outstanding Leverage.

* * * * *

Debentures means debt obligations issued by Licensees pursuant to

section 303(a) of the Act and held or guaranteed by SBA.

* * * * *

Distributable Earmarked Profits shall have the meaning set forth in

Sec. 107.243(c)(2) and shall be the source for allocation of

Prioritized Payments pursuant to Section 303(g)(2) of the Act.

Distribution means any transfer of cash or non-cash assets to SBA,

its agent or Trustee, or to partners in an Unincorporated Licensee, or

to shareholders in a Corporate Licensee. Distributions shall include

interest on Debentures, returns on Preferred Securities, Prioritized

Payments and adjustments thereto pursuant to Sec. 107.243(d), Profit

Participation, returns on capital to private investors, repayment of

Leverage and returns of Private Capital. Capitalization of Retained

Earnings Available for Distribution shall constitute a Distribution.

Earmarked Assets shall have the meaning set forth in

Sec. 107.242(b) (See also Sec. 107.247).

Earmarked Profits (Losses) mean the aggregate amount of Earmarked

Net Investment Income (Loss) and Earmarked Realized Gain (Loss) on

Securities which becomes the basis for Prioritized Payments and Profit

Participation (See Sec. 107.242).

Earned Prioritized Payments means Prioritized Payments which have

been distributed, or are distributable or deferred in accordance with

Sec. 107.243(c).

Equity Capital Investments means investments in a Small Concern in

the form of common or preferred stock, limited partnership interests,

options, warrants, or similar equity instruments, including

subordinated debt with equity features if such debt provides only for

interest payments contingent upon and limited to the extent of

earnings. Equity Capital Investments shall not require amortization.

Equity Capital Investments may be guaranteed; however, neither Equity

Capital Investments nor such guarantee shall be collateralized or

otherwise secured.

* * * * *

Guaranty Agreement means the contract entered into by SBA which is

a guarantee of the full faith and credit of the United States

Government as to timely payment of principal and interest on Debentures

or the redemption price of and Prioritized Payments on Participating

Securities and SBA's rights in connection with such guarantee.

Includible Non-Cash Gains means those non-cash gains (as reported

on SBA Form 468) that are realized in the form of Publicly Traded and

Marketable Securities or investment grade debt instruments. For

purposes of this definition, investment grade debt instruments means

those instruments that are rated ``BBB'' or ``Baa'', or better, by

Standard & Poor's Corporation or Moody's Investors Service,

respectively. Non-rated debt may be considered to be investment grade

if Licensee obtains a written opinion from an investment banking firm

acceptable to SBA stating that the non-rated debt instrument is

equivalent in risk to the issuer's investment grade debt.

* * * * *

Leverage means the aggregate outstanding amount of the Original

Issue Price of a Licensee's Debentures, Participating Securities, and

Preferred Securities.

* * * * *

Loans and Investments means Portfolio Securities, Assets Acquired

in Liquidation of Portfolio Securities, Operating Concerns Acquired,

and Notes and Other Securities Received, as set forth in the Statement

of Financial Position (SBA Form 468).

Management Expenses means, for Licensees which have Participating

Securities or have Earmarked Assets in their portfolios, those expenses

that include salaries, office expenses, travel, business development,

office and equipment rental, bookkeeping and the development,

investigation and monitoring of investments, but shall not include the

cost of services provided by specialized outside consultants, outside

lawyers and independent public accountants, if they perform services

not generally expected of a venture capital company, nor shall such

term include the cost of services provided by any Associate of the

Licensee which are not part of the normal process of making and

monitoring venture capital financings. See also Sec. 107.903.

* * * * *

Original Issue Price means the price paid by the purchaser for

securities at the time of issuance.

Participating Securities means preferred stock, preferred limited

partnership interests, or similar instruments, including debentures

having interest payable only to the extent of earnings, all of which

are subject to the terms set forth in Secs. 107.240 through 107.247 and

section 303(g) of the Act.

* * * * *

Pool means an aggregation of SBA guaranteed Debentures or SBA

guaranteed Participating Securities approved by SBA.

* * * * *

Preferred Securities means nonvoting preferred stock issued to SBA

by a for-profit section 301(d) Corporate Licensee, or securities having

similar characteristics issued by a section 301(d) Licensee organized

as a nonprofit corporation, or nonvoting preferred limited partnership

interests issued by a section 301(d) Unincorporated Licensee. (See also

Sec. 107.230)

Prioritized Payments means amounts which are preferred and

cumulative and are distributable to the holder of Participating

Securities provided the issuing Licensee has sufficient cumulative

Earmarked Profits, and may be represented by dividends on preferred

stock or interest on qualifying Debentures issued by a corporate

Licensee, or priority returns on preferred limited partnership

interests issued by limited partnership Licensees. For a given fiscal

period, Prioritized Payments shall be the amount resulting from

multiplying the Redemption Price of Participating Securities by the

Trust Certificate Rate, weighted to reflect the number of days such

securities were outstanding.

* * * * *

Profit Participation means a specified percentage of a Licensee's

Earmarked Profits which is computed in accordance with Sec. 107.244 and

to which SBA is entitled, by agreement, in consideration for its

guarantee of such Licensee's Participating Securities.

Publicly Traded and Marketable means securities that are salable

without restriction or that are salable within 12 months pursuant to

Rule 144 of the Securities Act of 1933, as amended, by the holder

thereof (or in the case of an In-kind Distribution by the distributee

thereof), and are of a class which (a) is traded on a regulated stock

exchange, or (b) is listed in the Automated Quotation System of the

National Association of Securities Dealers (NASDAQ), or (c) has, at a

minimum, at least two market makers as defined in the relevant sections

of the Securities Exchange Act of 1934, as amended, and in all cases

the quantity of which can be sold over a reasonable period of time

without having an adverse impact upon the price of the stock.

Qualified Investments shall have the meaning set forth in

Sec. 107.230(c)(4)(iv).

* * * * *

Realized Gain (Loss) on Securities means the amount by which

proceeds from the disposition of Loans and Investments are greater than

(less than) the cost or other basis permitted by SBA. Disposition of

Loans and Investments shall include sale, exchange, write-off,

recoveries from prior disposition, or any other such transaction

resulting in recognition of a gain or loss.

Redemption Price means the amount required to be paid by the

issuer, or successor to the issuer, of Preferred or Participating

Securities to repurchase such securities from the holder. The

Redemption Price shall be the Original Issue Price less any prepayments

or prior redemptions.

Retained Earnings Available for Distribution means Undistributed

Net Realized Earnings less any Unrealized Depreciation on Loans and

Investments (as reported on SBA Form 468), and represents the amount

that may be distributed to investors (including SBA) or transferred to

Private Capital.

SBA means the Small Business Administration, 409 Third Street, SW.,

Washington, DC 20416.

* * * * *

Trust means the legal entity created for the purpose of holding

guaranteed Debentures or Participating Securities and the guaranty

agreement related thereto, receiving, holding and making any related

payments, and accounting for such payments.

Trust Certificate Rate means a fixed rate determined at the time

Participating Securities are issued by the Secretary of the Treasury

taking into consideration the current average market yield on

outstanding marketable obligations of the United States with maturities

comparable to the maturities of the Trust Certificates being guaranteed

by SBA, adjusted to the nearest one-eighth of one percent.

Trust Certificates (TCs) means certificates issued by SBA, its

agent or Trustee and representing ownership of all or a fractional part

of a Trust or Pool of Debentures or Participating Securities.

Trustee means the trustees or trustees of a Trust.

Undistributed Net Realized Earnings means Undistributed Realized

Earnings less Non-cash Gains/Income as reported on SBA Form 468.

Undistributed Realized Earnings means the cumulative sum of Net

Investment Income plus Realized Gain (Loss) on Sale of Securities, less

the cumulative sum of Distributions of Earned Prioritized Payments and

Other Distributions made from Retained Earnings Available for

Distribution.

* * * * *

Unrealized Appreciation means the amount by which a Licensee's

valuation of Loans and Investments, as determined by its Board of

Directors or General Partner(s) in accordance with Licensee's valuation

policies, exceeds the cost basis thereof.

Unrealized Depreciation means the amount by which a Licensee's

valuation of Loans and Investments, as determined by its Board of

Directors or General Partner(s) in accordance with Licensee's valuation

policies, is below the cost basis thereof.

Unrealized Gain (Loss) on Securities Held means the amount by which

a Licensee's aggregate valuation of its Loans and Investments is above

(below) their aggregate cost basis, and is equal to the sum of the

Unrealized Appreciation and Unrealized Depreciation on all Loans and

Investments, net of estimated future income tax expense or estimated

realizable future income tax benefit, as appropriate.

Venture Capital Financing shall have the meaning set forth in

Sec. 107.230(c)(3).

4. Part 107, title 13, of the Code of Federal Regulations is

amended by removing the undesignated center heading ``Borrowing by

Licensee'' and Secs. 107.201 through Sec. 107.205 and by adding after

Sec. 107.105 the undesignated center heading ``Leverage'' and

Secs. 107.210 through 107.263 to read as follows:

Leverage

Sec. 107.210 Leverage--General.

(a) General. (1) SBA may purchase or guarantee three types of

Licensee securities:

(i) Debentures,

(ii) Preferred Securities, and

(iii) Participating Securities.

(2) All Licensees issuing Preferred Securities after August 16,

1982, or Debentures or Participating Securities shall be deemed to have

agreed to the terms and conditions set forth in Secs. 107.260 through

107.263 as in effect at the time of such issuance and as if fully set

forth in such Preferred Securities, Debenture or Participating

Securities.

(b) Application procedures. All Leverage applications shall be

filed with SBA's Investment Division located at 409 Third Street SW.,

Washington, DC 20416.

(1) A section 301(c) Licensee may apply for Debentures pursuant to

section 303(b) of the Act on SBA Form 1022, and for Participating

Securities pursuant to section 303(g) of the Act on SBA Form 1022B, in

accordance with accompanying instructions.

(2) A section 301(d) Licensee may apply for Debentures pursuant to

section 303(b) of the Act on SBA Form 1022, for Preferred Securities

pursuant to section 303(c) of the Act on SBA Form 1022A, and for

Participating Securities pursuant to section 303(g) of the Act on SBA

Form 1022B, in accordance with accompanying instructions.

(c) Basic requirements. Leverage applicants shall demonstrate to

SBA's satisfaction that they meet the following requirements:

(1) Eligibility for the amount of Leverage requested in accordance

with Sec. 107.220 for section 301(c) Licensees and Sec. 107.230 for

section 301(d) Licensees.

(2) A need for Leverage as evidenced by Licensee's investment

activity and its lack of sufficient funds available for investment;

Provided, however, that a Leverage applicant that has invested at least

fifty percent (50%) of its aggregate Leverageable Capital and

outstanding Leverage shall be presumed to lack sufficient funds

available for investment.

(3) Adequacy of Private Capital and an ability to meet its

obligations.

(4) Applicants for Participating Securities shall meet the

requirements of Sec. 107.241 in addition to all other Leverage

requirements.

(5) Compliance with the regulations as set forth in this part.

(d) Fees and charges. (1) Licensees offering Debentures or

Participating Securities for sale to, or for guarantee by, SBA are

required to pay a one-time fee equal to two percent (2%) of the face

amount of the Participating Securities or of the Debentures.

(2) The fee on Debentures or Participating Securities which are

issued for the purpose of refunding maturing obligations shall be paid

before such Debentures or Participating Securities are purchased or

guaranteed. If the Licensee's Debentures or Participating Securities

evidence a new indebtedness, as distinguished from the refinancing of a

pre-existing indebtedness, the fee shall be deducted from the proceeds

remitted to the Licensee.

(3) No portion of the fee shall be refundable upon prepayment of

any Debenture or early redemption of any Participating Security by the

Licensee.

(4) SBA may establish a fee structure for the performance of

services by the CRA; however, SBA shall not collect any fee for the

guarantee of TCs.

(e) Employment of SBA officials. Without the prior written consent

of SBA, for a period of two years after the date of the most recent

Leverage issued by Licensee (or the receipt of any SBA Assistance as

defined in part 105 of this chapter), Licensee shall not employ, or

tender any offer of employment to, or retain for professional services,

any person who on or within one year prior to such date:

(1) Served as an officer, attorney, agent, or employee of SBA; and

(2) As such, occupied a position or engaged in activities which SBA

shall have determined involved discretion with respect to the granting

of Assistance under the Act.

(f) SBA guarantee. (1) SBA may in its discretion agree to guarantee

a Licensee's Debentures or Participating Securities unconditionally,

irrespective of the validity, regularity or enforceability of such

Debentures or Participating Securities or any other circumstances which

might constitute a legal or equitable discharge or defense of a

guarantor and, pursuant to its guarantee, make timely payments of

principal and interest on such Debentures or the Redemption Price of

and Prioritized Payments on such Participating Securities, irrespective

of any default by the issuing Licensee or acceleration of the maturity

of such Debentures by SBA, or the inability of the Licensee to pay the

Redemption Price of or to make the Prioritized Payments on such

Participating Securities, or any early redemption of the Participating

Securities by SBA pursuant to Sec. 107.245.

(2) SBA in its discretion may arrange for public or private

financing under its guarantee authority. Such financing arranged by SBA

may be accomplished by the sale of individual Debentures or

Participating Securities, aggregations of Debentures or Participating

Securities, or Pools or Trusts of Debentures or Participating

Securities issued or sold pursuant to Sec. 107.250. Persons interested

in providing funds to Licensees with SBA's guarantee shall notify SBA

by letter, certifying any direct or indirect beneficial interest, or

actual or potential voting rights, in any Licensee, or in any person

directly or indirectly controlling, controlled by or under common

control with, any Licensee. These reporting requirements are approved

under OMB No. 3245-0081.

(3) No SBA guarantee shall be extended to any entity:

(i) Having a direct or indirect beneficial interest of ten or more

percent in the Regulatory Capital of the Licensee whose securities are

to be guaranteed, or in any Person directly or indirectly controlling,

controlled by, or under Common Control with, such Licensee; or

(ii) Having such interest in another Licensee which has received or

is about to receive, pursuant to any understanding, arrangement, cross-

dealing, reciprocal or circular arrangement, any direct or indirect

financing (or commitment for financing) from another lender with SBA's

guarantee.

(iii) SBA may void any guarantee obtained in violation of this

paragraph (f)(3), but the foregoing shall not apply to lenders whose

borrowers are selected or approved by SBA or its agents.

(4) In the event SBA pays a claim under its guarantee, it shall be

subrogated fully to the rights satisfied by such payment; and no state

law, and no Federal law, shall preclude or limit SBA's exercise of its

ownership rights acquired by subrogation upon payment under its

guarantee.

(5) With respect to Debentures guaranteed after July 1, 1991, SBA's

claim against any Licensee shall be subordinated, as of the effective

date of SBA's guarantee, in the event of the insolvency of such

Licensee, only in favor of existing and future indebtedness outstanding

to lenders, not including Associates of a Licensee, and only to the

extent that the aggregate amount of such indebtedness does not exceed

the lesser of two hundred percent (200%) of such Licensee's Regulatory

Capital, or $10 million; Provided, however,

(i) That in its sole discretion SBA may agree in advance and in

writing to a subordination in favor of an Associate or in favor of one

or more loans from Lending Institutions or other lenders that would

cause the aggregate amount of outstanding senior debt to exceed the

foregoing limitation;

(ii) That nothing contained in these regulations shall limit the

authority of SBA to refuse to subordinate its claims against any

Licensee if SBA determines at the time of issuing its guarantee, that

the exercise of reasonable investment prudence and the financial

soundness of the Licensee warrant such a refusal; and

(iii) That nothing contained in these regulations shall affect the

seniority of any indebtedness created prior to July 11, 1991, over the

claims of SBA derived from any debenture(s) and/or guarantee(s)

outstanding as of that date.

(6) Af

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