Small Business Investment Companies; Definitions of Various Terms; Miscellaneous Final Rules; Valuation Guidelines

SMALL BUSINESS ADMINISTRATION

13 CFR Part 107

Small Business Investment Companies; Definitions of Various

Terms; Miscellaneous Final Rules; Valuation Guidelines

AGENCY: Small Business Administration.

ACTION: Final rule.

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SUMMARY: This final rule adopts proposed rules published by the Small

Business Administration (SBA) on August 5, 1993. The purpose of this

rule is to implement certain provisions of the Small Business Equity

Enhancement Act of 1992, and to clarify and simplify the regulations

governing Small Business Investment Companies (Licensees) in order to

encourage increased private investment in Licensees.

EFFECTIVE DATE: April 25, 1994.

ADDRESSES: Robert D. Stillman, Associate Administrator for Investment;

Small Business Administration; suite 6300; 409 3rd Street, SW.,

Washington, DC 20416.

FOR FURTHER INFORMATION CONTACT:

Marvin D. Klapp, Acting Director, Office of Program Development;

Telephone (202) 205-6515.

SUPPLEMENTARY INFORMATION:

Alter Ego Financing

SBA had proposed to amend its regulations in order to permit

Licensees to extend Financial Assistance to a Small Concern whose sole

business was the leasing of commercial or industrial real estate to an

operating concern under identical ownership. In the Small Business

Investment Company Program there has never been an ``alter ego''

exception to the general rule that forbids Financial Assistance to

Small Concerns engaged in leasing real estate, although other programs

administered by SBA had such exceptions in their rules. See 13 CFR

Secs. 108.8(d) and 120.101-2(e). One reason for the proposal was to

bring the rules of the Small Business Investment Company Program into

greater, though not absolute, conformity with these rules. However, SBA

has since published proposals that would change these other ``alter

ego'' rules. Accordingly, SBA has decided to defer consideration of the

rule proposed on August 5, 1993 until it has completed the rule-making

process with respect to Parts 108 and 120 of its regulations. It should

be clearly understood that the proposed rule is neither withdrawn nor

adopted in final to become effective simultaneously with the adoption

of final amendments to Parts 108 and 120. Licensees also are reminded

that no existing rule forbids the extension of Financial Assistance to

an eligible Small Concern for the acquisition of industrial or

commercial real estate on which their business operations will be

conducted.

Associate of a Licensee

The proposal to amend the definition of Control Person in

connection with the proposal to allow limited partnerships to serve as

a general partner of a Licensee elicited a number of comments raising

issues that SBA deemed best addressed by a change in the definition of

Associate of a Licensee.

Generally speaking, an investor with an equity interest of 10

percent or more in a Licensee will continue to fall within the

definition of Associate of a Licensee, without regard to whether that

equity interest consists of stock or a limited partner's interest. The

rule reflects SBA's assumption that anyone with a 10 percent equity

interest in a Licensee will have a degree of influence with the

Licensee's management, even if such influence can't be openly exercised

by virtue of the investor's status as a limited partner. However, the

statutory changes intended to make the program more attractive to large

institutional investors, and the response received by SBA in connection

with its proposal to amend the definition Control Person, have

persuaded SBA of the necessity to draw a distinction between a limited

partner whose policy in dealing with the Licensee and/or the general

partner is likely to be ``hands off'', and a limited partner that is

likely to seek to influence the general partner. Accordingly, the

distinction is being drawn between the generality of investors with a

stake of 10 percent or more in the Licensee, and an Institutional

Investor whose investment as a limited partner in the Licensee does not

represent more than 33 percent of the Licensee's partnership capital

and does not exceed 5 percent of such investor's net worth.

Commitment

Although the proposed new definition of ``Commitment'' is being

adopted without change, the comments received indicate a need for a

more detailed explanation of SBA's underlying purpose. Since

``Commitment'' is being defined as an undertaking by a Licensee to

Finance a Small Concern, there was some concern as to whether the use

of the word ``commitment'' to describe an Institutional Investor's

undertaking to make future investments in a Licensee might not be

unduly confusing. Upon consideration, the term ``commitment'', which is

the term used in the Act, will continue to be used to describe an

Institutional Investor's undertaking or obligation; the context will

preclude confusion on the reader's part.

SBA intends to apply the new definition primarily to determine

whether a Licensee is inactive within the meaning of Sec. 107.902, and

whether the Licensee is obligated to return part of any processing fee

it may have collected pursuant to Sec. 107.402(d), as adopted this day.

Therefore SBA has no particular concern with the terms of any

Commitment or purported Commitment extended after the adoption of this

regulation that has been fully funded by a Financing to a Small

Concern.

The new definition of ``Commitment'' assigns a meaning to the term

that is narrower than the sense in which many Licensees have used the

term. SBA, in practice, has never considered a general statement of

willingness to extend Financing to constitute a Commitment. Now, SBA's

position is a matter of record. Even though the new definition of

``Commitment'' excludes a number of letters that some Licensees may

have previously considered to be commitments, the effect of such

exclusion will not be as disruptive as some comments have predicted.

In general, the new definition will not be used to test a

Licensee's need for Leverage. However, the definition of Commitment

will be used in the review of any application submitted for Preferred

Securities Leverage in excess of 100 percent of the Licensee's

Leverageable Capital, or Leverage in excess of 300 percent of the

Licensee's Leverageable Capital. This distinction is mandated by the

language of sections 303(c)(1)(E) and 303(c)(4) of the Act,

respectively, both of which speak of ``funds * * * legally committed''.

Some comments had expressed concern that the new definition of

Commitment would impair the right of a Licensee to provide additional

Financing, pursuant to Sec. 107.706, to a portfolio concern that was no

longer a Small Concern. In response to these and other comments, SBA

has revised paragraph (a) of Sec. 107.706 to eliminate existing

restrictions or preconditions with respect to further Financing of

portfolio concerns that have ceased to be eligible solely because they

have ceased to be Small Concerns, but which have not yet made a public

offering of their securities.

Two themes ran through almost all the comments submitted to SBA.

One was that ``reasonable conditions precedent'' should be further

defined or described; the other was that completion of the Licensee's

due diligence process with results satisfactory to the Licensee should

be considered a reasonable condition precedent. Although SBA is

reluctant to provide a list of reasonable conditions precedent in the

regulation for fear that such list might be regarded as an exclusive

one, it is willing to describe ``reasonable conditions precedent'' in

general terms. A ``reasonable condition precedent'' is one that does

not lie within the Licensee's ability to cause or prevent. ``Completion

of due diligence with results satisfactory to the Licensee'' is an

example of a condition precedent that lies within the Licensee's

control. On the other hand, requirements that a disinterested person

verify the value of the Small Concern's assets or its net worth, or

that there be no adverse change in the Small Concern's financial

condition between the date of the commitment and the scheduled

disbursement date, or that the Small Concern do or achieve something

that lies reasonably within its capacity would all be considered a

``reasonable condition precedent.''

Common Control

The proposed definitions of ``Common Control'' and of ``Control''

are adopted with an editorial change. The last two sentences of the

proposed definition of ``Control'', beginning with the words ``Two or

more Licensees * * *'' have been moved, without change, to the

definition of ``Common Control.''

A change in the present definition of ``Control'' and a new

definition, ``Common Control'' both were made necessary because section

402 of Public Law 102-366 (September 4, 1992) imposed a $90 million

ceiling on the aggregate amount of Leverage of all forms that might be

outstanding in any Licensee, or in any group of Licensees under common

control, ``unless the Administration determines on a case by case basis

to permit a higher amount for companies under common control and

imposes such additional terms and conditions as it determines

appropriate to minimize the risk of loss to the Administration in the

event of default.''

SBA believes that Congress did not intend the words ``commonly

controlled'' to mean only ``commonly owned'', since there are many

different methods of control other than mere ownership of record.

Rather, SBA believes that Congress intended to limit the dollar amount

for which SBA would be at risk as a result of the business judgment of

a single management group, even though the managers are not the owners.

Consequently, the intention of this regulation is that two or more

Licensees will be presumed to be ``commonly controlled'' if there is an

affiliate relationship between or among them, which could be based upon

ownership of stock or partnership capital of the Licensees, or upon

management (including arrangements that are characterized as investment

advisory contracts in which the adviser participates in the selection

of the Licensee's investments) by affiliated persons or entities, even

if there is no affiliation between or among the owners of the

Licensees. The presumption that two or more Licensees are ``Commonly

Controlled'' is not precluded solely because of the absence of any

affiliation between or among their respective owners, or any interlock

of their respective officers and/or directors, or general partners or

Control Persons. Subject to the right of any Licensee to present

evidence or arguments in rebuttal, Licensees shall be presumed to be

under ``Common Control'' under the terms of the proposed rule if day-

to-day management is contracted out to a single entity, or to two or

more affiliated entities.

The fact of common ownership need not compel the conclusion of

Common Control if it can be satisfactorily demonstrated to SBA that,

for example, two or more Licensees under common ownership operate under

entirely different management teams, are located in different regions,

and pursue different investment plans. On the other hand, the

presumption of Common Control would not be rebutted by a showing that

two or more Licensees are separately owned and that each has a separate

board of directors or general partner, if it also appeared that each

board or general partner had effectively delegated operational control

to a common adviser/manager.

Although public comment was generally favorable, one comment

considered the $90 million Leverage ceiling for a single Licensee to be

excessive. It is apparent from other provisions of Public Law 102-366

that Congress intended to make as much as $90 million available to

qualifying Licensees.

Another comment urged that two or more Licensees with different

ownership and different directors and/or general partners not be

considered under Common Control solely because the day-to-day

management has been delegated to a common manager.

SBA believes that any definition of ``Common Control'' that did not

cover the case of a common manager would be too narrow, especially with

regard to a company whose investors were led to believe that their

company would be run by a particular management team.

Yet another comment objected to the use of the words ``or

otherwise'' in the first sentences of the respective definitions of

``Control'' and ``Common Control.'' In each case, ``or otherwise''

appears at the end of a list of the means by which one might obtain or

exercise control over a business. Concern was expressed that an

institutional investor intending ultimately to form its own wholly

owned Licensee might be reluctant to become a 10 percent limited

partner in another Licensee lest SBA consider both Licensees to be

under common control, thus limiting the amount of Leverage available to

the wholly owned Licensee.

SBA understands these concerns, which are believed to arise not so

much from the definitions of Common Control and Control as from the

definition of Control Person, which has also been revised.

With regard to Common Control and Control, the point of both

definitions is to address the factual issue of whether A controls

Licensee X, without distinction as to how A came to control X. SBA does

not wish to leave open the possibility that someone might control a

Licensee and yet not be covered by these definitions; and it is not

confident that an enumeration consisting only of ``ownership,

management, [or] contract'' represents all the ways by which A might

control X. For example, if A were a 10 percent limited partner in

Licensee X, and the general partner received no salary or management

fee from X, but was instead an at-will employee of A, A's control of

the general partner's salary might justify a conclusion that A actually

controls X, even though A is only a 10 percent limited partner.

Control Person

The proposed amendment is adopted with changes to meet some of the

concerns touched upon in the discussion of Common Control and Control.

Some of these concerns have already been touched upon in discussing the

change in the definition of ``Associate of a Licensee''.

The term ``Control Person'' is concededly a misnomer as applied to

some of the persons described in the definition. For many years SBA's

regulations have defined the term ``Associate of a Licensee'' to

include any person with an equity interest of 10 percent or more in a

Licensee; it was thought that a person with a 10 percent interest or

more would have a significant, even if sometimes informal, influence

over the Licensee's operations. When SBA decided to allow Licensees

organized as limited partnerships to have a corporate general partner,

it was necessary to coin a term to cover those persons that might

control, or at least influence, the Licensee's corporate general

partner and thus the Licensee itself even though they themselves might

have no direct relationship to the Licensee. The term chosen to

describe such persons was ``Control Person'', even though it is defined

in language that includes persons that could only be described as

potentially having an influential, but not controlling, voice in the

Licensee's affairs. On the one hand, SBA's intention was to bring such

persons within the definition of ``Associate of a Licensee'' in order

to prevent self-dealing by or in favor of such persons. On the other

hand, it was never SBA's intention to create a presumption that an

ownership interest of 10 percent or more in an entity that serves as a

general partner of the Licensee would, by itself, constitute control

over the Licensee, even though the language of the proposal may have

given that impression. Accordingly, the final regulation draws a

distinction between a Person that has an interest in a corporation or

partnership, including a limited partnership interest, that serves

directly or indirectly as a general partner of a Licensee, and also

participates in that entity's operations and thus ultimately in the

Licensee's investment decisions; and, in contrast, a passive investor

in the same kind of entity. In the case of a participant in the

entity's affairs, an interest of 10 percent or more will bring such

Person within the definition of Control Person. A passive investor with

an interest of less than 33 percent in an entity that serves directly

or indirectly as a general partner of a Licensee is now excluded from

the definition of Control Person.

Cost of Money (COM)

SBA proposed three regulatory changes intended to increase the

income a Licensee might derive from Loans and Debt Security Financings.

The first proposal, amending the definition of COM to allow

Licensees to impose upon Small Concerns certain additional fees and

charges that would be excluded from the computation of COM, is adopted

as final without change. The other two regulatory proposals intended to

allow a Licensee to charge more for Financial Assistance will be

discussed hereafter.

All comments were favorable, though some expressed the view that

SBA had not gone far enough. One comment urged that the definition of

COM explicitly exclude, in addition to any other excluded fees, charges

and fees paid to non-Associate consultants, accountants, and lawyers.

SBA does not believe that any further amendment to the definition

is needed to accomplish the objective sought by this comment. COM is

defined in terms of payments to a Licensee and its Associates. Thus,

payments to non-Associates for technical and professional services are

already excluded from the definition.

Another comment had urged that a Licensee be allowed to charge a

fee, excluded from COM calculation, for arranging financing from an

Associate of that Licensee regularly engaged in investment banking.

While SBA considers this proposal to be worthy of serious

consideration, SBA declines to adopt it at this time.

The amended definition of COM no longer excludes commitment fees.

Instead, the definition permits Licensees to charge a processing fee of

up to 3 percent of the requested amount of Financing, without including

it in COM; and to collect this fee, in full or in part, before

processing the Small Concern's application. In other words, a Licensee

may charge interest at the maximum permissible rate, and collect an

additional processing fee, not to exceed 3 percent of the amount of the

Financing. If the Financing closes, the Licensee may collect or retain

the full amount of the processing fee, even if no commitment was

extended, and no part of this fee will be included in the computation

of COM. On the other hand, if the Licensee has collected a processing

fee equal to 3 percent of the requested Financing, any additional fee,

whether based on the extension of a commitment, or otherwise, will be

included in computation of COM.

Although the regulatory changes will permit a Licensee to require a

processing fee before processing an application for Financing,

Sec. 107.402 makes it clear that it is not intended that any Licensee

will derive a profit from a rejected application. In such a case, the

Licensee must return the entire amount of any processing fee collected

in excess of certain specified out-of-pocket costs. See Sec. 107.402,

as adopted. If the application is rejected, the Small Concern will have

no obligation to reimburse the Licensee for any additional expenses the

Licensee may have incurred, even if the Licensee has previously charged

a smaller advance processing fee than it might have charged, or no

processing fee at all.

If the Licensee does provide Financing, the Small Concern also may

be required to reimburse the Licensee for out-of-pocket conveyance and/

or recordation fees, taxes, and reasonable closing costs. Such

reimbursement, which may be required in addition to the processing fee,

is not to be included in the computation of COM.

The definition of COM also would allow Licensees to impose upon

Small Concerns three other charges, in addition to presently-excluded

charges, that would be excluded from the computation of COM.

By agreement with a Small Concern, a Licensee may receive a

reasonable fee for its efforts in arranging financing from non-SBIC

non-Associate sources, and the amount of such fee, whether or not the

Licensee itself participates in the financing, is excluded from the

computation of COM.

A Licensee may require the Small Concern to reimburse it for the

reasonable and necessary costs incurred by the Licensee in monitoring

the Financing, and the amount of such reimbursement is excluded from

computation of COM.

A Licensee that has a ``watchdog'' director serving on the board of

a Small Concern pursuant to Sec. 107.903(f) may receive reasonable

director's fees, not in excess of those paid to outside directors; and

such fees are not to be included in computing COM.

Finally, the language presently found in the definition of COM that

requires a Licensee, in the event of prepayment under certain

circumstances, to refund unearned front-end charges has been moved to

Sec. 107.402(f), and will be discussed later.

Disadvantaged Concern

The definition is revised to reflect SBA's current position, but

SBA expects to undertake a separate rule-making in the near future on

this subject.

Institutional Investor

Section 410 of Public Law 102-366 added a definition of ``private

capital'' to the Act that, among other things, requires SBA to

recognize ``unfunded commitments from Institutional Investors that meet

criteria established by the Administration'' as part of a Licensee's

Private Capital for certain purposes. Accordingly, SBA proposed a

definition of ``Institutional Investor'' which is now adopted with a

number of changes.

The most important change entails the imposition, with one

exception, of a minimum net worth requirement on all entities or

persons that which to be considered Institutional Investors, so that

their unfunded commitments may be recognized by SBA as a part of a

Licensee's Private Capital for regulatory purposes. The net worth

requirement does not affect any Person that actually makes an equity

investment in a Licensee, but only SBA's recognition of an unfunded

commitment for regulatory purposes.

Even though SBA does not extend Leverage against unfunded

commitments, the inability of an investor to fund a commitment may

adversely affect SBA's risks with respect to Leverage previously

extended. Although it was SBA's intention to define ``Institutional

Investor'' broadly and inclusively it is also important that there be a

substantial probability that the commitment recognized by SBA will be

fully funded when the time comes. This probability does not necessarily

exist with respect to every institution that falls within the proposed

definition of Institutional Investor. Accordingly, SBA has determined

to impose a $1 million minimum net worth test upon all entities that

seek to qualify as Institutional Investors, and a $2 million minimum

net worth standard upon all persons that seek to qualify. However,

while the final rule exempts individuals who are Accredited Investors

from the $2 million net worth test, such individuals will be considered

Institutional Investors only if such person's commitment is backed by a

letter of credit from another Institutional Investor.

At this point it is appropriate to note that while an Accredited

Investor with a net worth of less than $2 million is the only kind of

individual who will be required to provide a letter of credit in order

to be considered an Institutional Investor, it does not follow that SBA

will automatically recognize as a part of a Licensee's Private Capital

the full amount of the commitment made by every individual

Institutional Investor with a net worth of $2 million or more.

Unless an individual Institutional Investor has a net worth of $10

million or more, a letter of credit from another Institutional Investor

will be required to back up that part of the commitment that exceeds 10

percent of the Institutional Investor's net worth. See the definition

of Private Capital.

Another change relates to the requirement of a letter of credit. A

number of comments had pointed out that compliance with the proposed

requirement that an individual investor's (unfunded) commitment be

backed by a letter of credit from a qualified Institutional Investor

was not feasible in the case of a commitment that was not to be fully

funded within one year; banks and similar Institutional Investors

normally do not issue letters of credit with terms in excess of one

year.

Upon reflection, SBA will recognize a commitment backed by a one-

year letter of credit as long as the letter of credit is renewed or

replaced at its expiration with another letter equal to the unfunded

amount of the commitment, expiring on the anniversary of its issuance

or on the date the commitment is to be fully funded, whichever shall

first occur. An unfunded commitment not backed by a current letter of

credit shall cease to be recognized as a part of Regulatory Capital as

of the date the letter of credit expires, which may cause the Licensee

to be in violation of any regulatory restrictions or requirements that

are expressed in terms of the Licensee's Regulatory Capital.

Another change represents a response to certain inquiries

concerning foreign investors. SBA never intended that an individual

investor who meets the standards set forth in the definition of

``Institutional Investor'' should be excluded from the definition

solely because he or she was not a permanent resident of the United

States, as long as he or she irrevocably designates an agent in the

United States for service of process. The definition is amended to

reflect this intention.

Private Capital

With one significant change, and with three changes of an editorial

nature, the definition of Private Capital is adopted as proposed.

The proposed definition had allowed ``funds invested which are

income derived from the investment of grants that have been made by a

state or local government agency or instrumentality into a nonprofit

corporation or institution exercising discretionary authority with

respect to such funds; and funds invested by a State financing agency,

or similar agency or instrumentality, to the extent such funds are

derived from such agency's income and not from appropriated State or

local funds'' to be included in the Regulatory Capital of a Section

301(d) Licensee, subject to the limitation that the aggregate amount of

such funds and funds invested in the Licensee directly by any State or

local government or instrumentality might not exceed 40 percent of that

Licensee's Regulatory Capital. This 40 percent limit is not in the

final version. Thus, a Section 301(d) Licensee may be capitalized

entirely with such indirect funds.

However, it does not follow that a State or local governmental

entity supplying such funds to a section 301(d) Licensee can control

the Licensee. Section 301(b) of the Act requires SBA to make a positive

determination as to the probability of successful operation by any

applicant before it may issue a license, specifically considering the

applicant's prospects of ``adequate profitability''. In making this

determination, SBA considers it essential that control of a Licensee be

in hands other than the representatives of public sector investors.

One editorial change has been made to reflect the fact that, while

the law requires unfunded binding commitments to invest in a Licensee

to be treated as a part of the Licensee's Regulatory Capital for some

purposes, fundamental accounting principles forbid the inclusion of

unfunded commitments in ``paid-in capital and paid-in surplus.''

The proposed definition of Private Capital included a paragraph (4)

providing in relevant part that for the purpose of determining whether

a Licensee was in compliance with certain cited regulations, the term

Private Capital used in each such regulation should be considered to

mean ``Regulatory Capital''. For ease of reference, the term Regulatory

Capital has been substituted in each cited regulation and the

corresponding language of paragraph ((4) is deleted.

To encourage license applicants to assist Small Concerns as soon as

they are able, even before they receive a license, language has been

added to make it clear that securities of eligible Small Concerns

Financed by an applicant or by the applicant's investors after the date

its license application has been physically received by the Office of

Investment, but before the license is issued, will be regarded as a

part of Regulatory Capital for Licensing and other purposes, subject to

SBA approval. The added language reflects SBA's present practice.

Section 301(d) Licensee

The proposed definition is adopted with editorial changes that

conform to the changes in the definition of Disadvantaged Concern.

Limited Partnerships

The proposed rule is adopted with one significant change. The

requirement that the funds of a corporate or limited partnership

general partner not invested in the Licensee be either co-invested with

those of the Licensee or invested in ``idle funds'' investments is

eliminated. SBA has never Leveraged such funds, and SBA does not hold

general partners as such personally liable for the repayment of

Leverage obligations. No purpose is served by treating such general

partners differently from unleveraged Licensees.

Operational Requirements

Except as hereafter noted, SBA adopts as final its proposal to

amend Sec. 107.101 regarding operational requirements in order both to

increase the chances of successful operation on the part of Licensees,

and to minimize SBA's exposure to loss.

A company that applies for a license, or a Licensee that applies

for leverage, must demonstrate to SBA that its management has something

more than general business experience. Such applicant or Licensee must

show that management has experience making the sizes and types of loans

or investments in Small Concerns of the sizes and types contemplated in

the Licensee's Plan of Operations.

SBA's experience has shown that companies entering the SBIC program

with only the statutory minimum amount of capital have little chance of

carrying on the ``successful operations'' and achieving the ``adequate

profitability'' required by section 301(c) of the Act. Accordingly,

every applicant will be required to have sufficient capital in excess

of the minimum to operate soundly and profitably within the context of

its plan of operations as approved by SBA. Each prospective Licensee

must have sufficient capital so that it will be able to pay its

expenses without dissipating its Regulatory Capital. Based on SBA's

experience, given Licensees' fixed expenses for management and rent,

and their costs of due diligence, even in the case of straight loans,

SBA believes that a stand-alone company bearing the full expense of

rent, management, accounting services, etc. has only a limited prospect

of profitability if its Regulatory Capital is less than $5 million.

Accordingly, SBA would prefer that applicants have minimum capital of

$5 million before admission to the program. It does not follow, though,

that SBA will never hereafter license a company with Regulatory Capital

of less than $5 million. In appropriate cases, consideration will be

given to the possibility that the applicant's overhead expenses may be

substantially less than customary because they will be shared with

other companies having similar investment policies, or underwritten by

the applicant's investors.

SBA's experience also has shown that the portfolio valuation

process is a weakness of some Licensees. Accordingly, SBA has taken

steps to improve the process and the valuation standards. Each Licensee

is required to adopt a policy for the valuation of its portfolio

investments, to evaluate portfolio investments in accordance with such

policy, and to report such evaluations to SBA. For their guidance, SBA

adds an Appendix III to Part 107 setting forth the basis upon which

valuation guidelines should be framed. Appendix III as adopted differs

somewhat from its proposed form because of SBA's response to comments

it has received.

With the widespread use of computers in virtually all businesses,

SBA is in the process of developing systems to enable SBICs to perform

their reporting requirements through electronic transmission from the

most commonly used types of personal computers. SBA will provide SBICs

with custom software that will enable SBICs to perform their reporting

tasks more easily, more accurately, and more quickly. To this end, SBA

is requiring all SBICs to have personal computers, to run SBA-provided

software, and to report electronically as directed by SBA by June 30,

1994.

The final version of Sec. 107.101 adopted today includes a new

paragraph (i) that was not a part of the original proposal. The

combination of the tendency within the Small Business Investment

Company industry toward the formation of larger companies and increases

in the size standards applicable to the industry (see 58 FR 40603,

proposed July 29, 1993 and adopted as final simultaneously herewith)

raises the possibility that the flow of investment capital into smaller

concerns may be substantially reduced. Accordingly, SBA will require

Licensees to ensure that a percentage of the Financings they extend in

the future go to Smaller Concerns--concerns that qualify as Small

either under the standard set forth in 13 CFR Sec. 121.802(a)(2)(i) as

in effect on January 1, 1993, or under the industry size standard in

effect at the time of the Financing--as defined in Sec. 107.3. A

Licensee that fails to meet the goal set forth in this regulation may

make no Financings of concerns that do not qualify as Smaller Concerns

until it has brought itself into compliance.

At the end of each Licensee's first full fiscal year following the

adoption of this rule, at least 10 percent of the dollar amount of all

Financings made by the Licensee between those dates shall have been

extended to such Smaller Concerns. At the end of each subsequent fiscal

year following the adoption of this rule, the cumulative dollar amount

of Financings extended to such Smaller Concerns by each Licensee since

the adoption of this rule must equal at least 20 percent of the

cumulative total of Financings over the same period. For the purpose of

determining whether a Licensee has achieved these objectives, a change

of ownership Financing pursuant to Sec. 107.711 in which the resulting

concern qualifies as a Smaller Concern will be counted as a Financing

of such Smaller Concern.

The purpose of this rule is to insure a continued flow of Financial

Assistance to Smaller Concerns despite the adoption of a new size

standard. Therefore the rule does not mean that a certain percentage of

the Licensee's portfolio as of the end of any (full) fiscal year

following the adoption of this rule must consist of investments in

Smaller Concerns. In the case of any present Licensee, 100 percent of

its portfolio on the date of this final rule would consist of

investments in Smaller Concerns. Thus, such Licensee would be free to

operate for a number of years without Financing any Smaller Concerns if

the rule were addressed to a specific percentage of portfolio as of the

close of a fiscal year. Such a result would be inconsistent with the

previously-declared purpose of the rule, which is aimed at future

investments. Given the purpose of the rule, events such as prepayments,

the sale or exchange of portfolio securities, or the write-down or

write-off of portfolio securities will not affect the Licensee's

compliance.

Nor does the rule necessarily require a specific percentage of

Financings to Smaller Concerns within any given fiscal year; the object

of the rule is a cumulative percentage as of the end of a period. The

wording of the rule is intended to imply a carry-forward from one

fiscal year to the next, of Financings to Smaller Concerns made after

the effective date of the rule.

Calculation of Cost of Money Ceiling

The proposal to allow Licensees to calculate an alternative Cost of

Money Ceiling based on their own weighted average cost of money is

adopted with a number of significant changes.

Until now, the maximum permissible rate of interest that any

Licensee might impose upon any Small Concern was calculated with

reference to the rate of interest on the SBA-guaranteed debentures

underlying the most recent offering of trust certificates to the

public. While the existing rule facilitated the determination of a

uniform ceiling throughout the industry, it ignored the actual interest

expense on the debenture leverage drawn down by any individual

Licensee.

SBA had originally proposed to amend Sec. 107.302 to allow

Licensees that have been leveraged through the sale of debentures to

use their own weighted average cost of funds borrowed from SBA, or with

SBA's guarantee, as the case may be, as an alternative basis for

calculating their respective interest rate ceilings. Although companies

licensed under section 301(d) of the Act that sell debentures to SBA

(or to the public with SBA's guarantee) may enjoy the benefits of a

subsidized interest rate for the first five years of the debenture's

term, this subsidy is to be disregarded in the calculation of the

alternative interest rate ceiling. On the other hand, Licensees that

have sold Preferred Securities (stock or limited partnership interests)

or Participating Securities may not include dividends or distributions

on such securities in the calculation of their alternative interest

rate ceilings.

The entire focus of the proposal was on Leveraged Licensees, partly

because section 305 of the Act, as amended by section 411 of Public Law

102-366, spoke only of ``companies which have issued debentures

pursuant to this Act'', and partly because it was assumed that non-

Leveraged Licensees did not utilize borrowed funds. The final

regulation reflects the numerous comments that informed SBA that non-

Leveraged Licensees do indeed have borrowings, albeit from other

sources. Accordingly, the final rule will allow a Licensee to utilize

Weighted Average Cost of Qualified Borrowings (including SBA-guaranteed

Debentures) rather than Weighted Average Cost of Leverage as an

alternative basis for the calculation of its Cost of Money limit.

The use of the term ``Qualified Borrowings'', defined in

Sec. 107.3, is intended to discourage a Licensee's acceptance of

extremely high (above-market) interest loans, presumably from

Associates, for the purpose of maximizing the COM that the Licensee may

then impose upon a Small Concern.

It should be understood that under the terms of the regulation as

proposed and adopted, the Weighted Average Cost of Qualified Borrowings

that is to be used by a Licensee is its cost over the Licensee's

preceding fiscal year, certified to SBA when the Licensee's Annual

Report (Form 468) is transmitted. However, it is also SBA's intention

to make this alternative method available as soon as possible to any

Licensee that may wish to use it without waiting until the end of its

fiscal year.

Following the publication of this final rule, any Licensee may

promptly certify its Weighted Average Cost of Qualified Borrowings to

SBA as if this regulation had been in effect prior to the close of the

Licensee's preceding fiscal year. Solely for the purposes of

determining whether the notification is timely within the meaning of

Sec. 107.302(f), SBA will regard the effective date of this rule as the

closing date of the Licensee's fiscal year. In other words, if the

Licensee's fiscal year ends on December 31, and this rule is adopted as

final on the following May 1, a Licensee may certify a Weighted Average

Cost of Borrowed Funds based on the fiscal year that closed on the

preceding December 31, and the required notification to SBA will be

considered timely if made within 30 days after May 1.

If a Licensee does not make a timely certification of its Weighted

Average Cost of Qualified Borrowings, it will be presumed that its

Weighted Average Cost of Borrowed Funds for the preceding fiscal year

is zero, so that the COM ceiling applicable to its Financings will be

that based on the current Debenture Rate. It should be understood

clearly that the interest rate ceiling based on the Debenture Rate

remains the only permissible ceiling applicable to Loans or Debt

Security Financings committed or disbursed prior to the certification

of the Licensee's Weighted Average Cost of Qualified Borrowings.

Since each Licensee may have its own individual COM ceiling, SBA

proposed a solution to the question of the applicable ceiling when two

or more Licensees participate in a joint financing. See Sec. 107.302(g)

as proposed. In response to comments, SBA has determined to adopt a

simpler final rule. The applicable COM limit for a joint financing is

the highest of any of the three following ceilings:

(1) A ceiling based on the current Debenture Rate, which is the

same for all Licensees at any given time;

(2) A ceiling determined with reference to the lead lender's

Weighted Average Cost of Qualified Borrowings; or

(3) A ceiling equal to the weighted average of the highest ceiling

available to each participating Licensee. If a Licensee has not

certified a Weighted Average Cost of Qualified Borrowings to SBA at the

time it participates in a joint financing, or has no Qualified

Borrowings, the ``highest ceiling available'' to such Licensee is, of

course, a ceiling based on the current Debenture Rate. SBA acknowledges

that on occasion some participating Licensees may be able to collect

interest and/or other charges for the use of money in excess of the

limit that would apply if they had done the Financing separately; but

SBA considers that such situations will arise only rarely, and the

excess cost to the Small Concern will be minimal.

SBA had proposed to adopt a new rule that would limit both the

amount of default penalty that a Licensee may impose, and the

circumstances under which a penalty might be imposed. Based upon the

comments received, SBA now believes that a rule limiting post-default

interest to the maximum rate permitted by the Cost of Money ceiling in

effect at the time of default may be insufficient to deter deliberate

default. Accordingly, the final rule will permit a Licensee to impose

and collect a default penalty not to exceed 7 percentage points over

the rate specified in the Note or Loan Agreement, for as long as the

default shall continue.

As proposed, the rule would have allowed a default penalty to be

imposed only if the Small Concern failed to make payment in accordance

with the terms of its obligation. The final rule will also allow a

default penalty to be imposed for failure to furnish required reports

or other information. Inasmuch as SBA will require Licensees to furnish

information concerning the economic impact of the loans and investments

they make, and to verify the use of Financing proceeds by Small

Concerns; and to obtain the necessary documentation pertaining to such

use and to economic impact generally, SBA considers the Licensee's

ability to impose a monetary sanction on the Small Concern both an

inducement to the Licensee to force compliance by the Small Concern and

an indispensable tool for that purpose.

Regulatory Relief for Unleveraged Licensees

As directed by section 408 of Public Law 102-366, SBA reviewed and

proposed to revise those regulations ``intended to provide for the

safety and soundness of'' leveraged Licensees with a view toward

exempting unleveraged Licensees from compliance with such regulations,

or promulgating different rules for unleveraged Licensees. SBA's

proposal to exempt unleveraged Licensees from compliance with

Sec. 107.303 (overline limitation) is adopted as proposed.

SBA's proposal to relieve unleveraged Licensees from compliance

with Sec. 107.708 (idle funds) is also adopted without change. SBA's

proposal to amend Sec. 107.708 as it applies to Leveraged Licensees

will be discussed later.

The language of Sec. 107.708 now reflects SBA's position with

respect to a Licensee's deposit of idle funds in an Associate bank,

which has always been that such a deposit does not constitute the

Financing of an Associate unless the Licensee is receiving a lower

interest rate than the Associate gives the public. In the case of an

unleveraged Licensee, SBA will not consider the deposit of funds with

an Associate bank to constitute self-dealing, even if the Licensee

accepts a lower interest rate than the Associate gives the public.

SBA does not intend that any Licensee shall simultaneously be

leveraged and exempted from compliance with Secs. 107.303 and 107.708,

or with any other regulations that may later be made inapplicable to

unleveraged Licensees. Accordingly, no Leverage is to be made available

to any unleveraged Licensee that is not, at the time of the request for

Leverage, in compliance with regulations applicable to Licensees with

outstanding Leverage.

Economic Impact

SBA had proposed to add a paragraph (c) to Sec. 107.304 to require

that each Portfolio Financing Report (Form 1031) set forth the economic

impact expected to result from the financing in terms of job creation

or retention, expanded business activity, or other identified

indicators of economic impact. In response to comments, SBA has

determined that it would be more appropriate to require the Licensee to

include in its own annual reports to SBA additional information

reflecting the actual economic impact of its Financing on each

Portfolio Concern, instead of requiring the Licensee to submit its

predictions of economic impact.

Verification of Use of Proceeds

SBA's proposal to require Licensees to take reasonable steps to

verify the use of Financing proceeds by portfolio concerns is adopted

with certain changes intended to clarify what is expected of Licensees.

The purpose of this regulation is to reduce the possibility that

Licensee funds may be used for purposes beyond the contemplation of the

Act or for purposes forbidden by the regulations; it is intended to

make existing prohibitions more effective.

For example, Sec. 107.901(c) has long forbidden the extension of

Financing to concerns engaged in the operation of rental real estate,

but the scope of the prohibition is not limited to concerns that openly

hold themselves out (to the Licensee, at least) as being engaged in the

operation of rental real estate. Also prohibited is the use of Licensee

funds to acquire or improve rental real estate even if the Small

Concern's primary business (at least immediately before the Financing)

is classifiable other than as a prohibited Major Group 65 activity. SBA

seeks to make it as difficult as possible for a Small Concern to divert

funds from the legitimate purpose represented to the Licensee and

reported to SBA on the Form 1031. As the preceding sentence suggests,

SBA considers the diversion-of-proceeds problem to be one primarily

involving innocent Licensees that have been wrongfully induced by a

Small Concern to make a Financing.

Certainly a Small Concern's representations pertaining to the

eligibility of the end use of its funds are as material as those

pertaining to the value of its assets or its revenues. Nor should a

Small Concern be able to deceive Licensees with impunity as to the

ultimate intended use of Financing proceeds. While the cooperation of

Licensees is necessary to prevent such deceit, the real obligation

should fall upon the Small Concerns themselves. Accordingly, the

regulation adopted today clarifies the Licensee's duty to verify that

the use of funds was in accordance with the representations made to the

Licensee. To assist the Licensee in obtaining such information, SBA has

adopted other regulations that will permit a Licensee to impose a

substantial default penalty on a Small Concern that fails to furnish

required post-financing information (see Sec. 107.302(h)) and that

allow a Licensee to recover from the Small Concern the reasonable and

necessary out-of-pocket expenses incurred in monitoring the Financing

(see paragraph (7) of the definition of Cost of Money).

Accordingly, Licensees will be required to enter in their own

files, and to maintain therein, the expected date of a post-closing

review for the purpose of monitoring use of proceeds, which shall be

not later than 90 days after the scheduled use of the funds.

In conducting a post-closing review or monitoring the subsequent

activities of a portfolio concern, Licensees should be alert to the

possibility of diversion of proceeds. If post-Financing financial

statements from the Small Concern, or visits to the Small Concern,

disclose substantial amounts of newly-created non-trade receivables or

investment assets, suspicion is warranted.

Similarly, since ``working capital'' is always understood to mean

money for use in the portfolio concern's business, as represented to

the Licensee and reported on the Form 1031, a request for a ``working

capital'' loan that seems wholly out of proportion for an enterprise of

the Small Concern's size in the same line of business should be a

warning signal.

Prepayment Penalties

Most of the substance of the proposed Sec. 107.402 has already been

discussed in connection with the proposed definition of Cost of Money.

However, the proposed Sec. 107.402 reflected a new approach to the

treatment of prepayment penalties by a Licensee that has also charged

front-end fees. Under the rule adopted today, which is substantially as

proposed, every Licensee may charge a reasonable prepayment penalty for

voluntary prepayment without regard to front-end charges, but a

Licensee that charges an excessive prepayment penalty shall be required

to refund the entire amount of the penalty to the Small Concern.

A number of comments had sought some guidance as to what SBA would

consider a reasonable prepayment penalty. Accordingly, the regulation

clarifies that SBA will presume that a prepayment penalty equal to 5

percent of the outstanding balance in the first year of the Financing's

term, and declining by one percentage point per year until the fifth

year, is a reasonable prepayment penalty. The formula is that employed

in the case of prepayment of SBA-guaranteed Debentures. SBA considers

this a more precise and useful standard than one referring to a penalty

``customary for financial institutions in the geographic area in which

the financing is being made.''

If a Licensee has imposed front-end charges that are not

specifically excluded from computation of COM (such as points,

discounts, or processing fees in excess of 3 percent) such charges

shall be prorated over the stated term of the Financing and if the sum

of interest and unearned front-end charges exceeds the applicable COM

limit, the excess shall be repaid to the Small Concern.

Special Situations for Short-Term Financing

The proposal to amend Sec. 107.403(b)(1) by adding a narrow

exception to the general requirement that all Financings have a term of

at least five years is adopted without change. The new exception is

created in favor of Small Concerns that have received government

contracts under Federal, State, or local set-aside programs for

``minority'' or ``disadvantaged'' concerns, so that Licensees may

provide the short-term contract financing that the Small Concern needs

to perform the contract.

Although such Financing would only go to firms receiving contracts

under set-aside programs wherein eligibility had been established by

the contracting agency, Licensees extending short-term contract

Financing would have a responsibility to assure that the Small Concern

in question is a ``Disadvantaged Concern'', as defined in Sec. 107.3.

Consideration for Issuance of Licensee's Securities

The proposal to amend Sec. 107.705 to allow a Licensee to issue its

securities in exchange for non-cash assets approved by SBA is adopted

with an editorial change.

Paragraph (4) of the definition of ``Private Capital'', as

originally proposed, had included a warning concerning future

Financings of, and/or assumptions of Control over, concerns whose

securities were exchanged with the Licensee for stock or partnership

interests therein. The intended gist of the warning was that if the

legality of a certain action or Financing depends upon the need to

protect a Licensee's investment, a Licensee that has only issued its

stock or partnership interests in exchange for securities of a Small

Concern is not considered to have any investment to protect. This

warning language, adopted without change, will now be a part of

Sec. 107.705 as adopted; it is transferred from paragraph (4) of the

definition of Private Capital. However, this restriction will not apply

to securities of eligible Small Concerns that SBA has approved for

inclusion in Regulatory Capital.

Retention of Investments

The final version of Sec. 107.706 differs substantially from the

proposed version. Section 107.706 originally had addressed the right of

a Licensee to retain its investment in, and to provide additional

Financing to, a concern that had ceased to be a Small Concern. SBA had

proposed to broaden the scope of the regulation to cover the case in

which a concern's eligibility is lost, either because it ceases to be

an alter ego of another eligible concern, or because it has shifted its

activity into an ineligible line of business. The policy decision,

previously discussed, to defer adoption of an alter ego rule required

the elimination of all such references in the proposed rule. The other

changes, discussed below, respond to comments received from the public.

The proposed rule would have left untouched the present rule

restricting the right of Licensees to provide additional Financing to

concerns whose growth and expansion was such as to take them out of the

definition of Small Concern. After further consideration, SBA is

persuaded that growth and expansion are desirable processes that should

neither restrict the access of the successful portfolio concern to

additional Financing from the Licensees that Financed it when it was

small, or the right of the Licensees to take additional advantage of an

unusually promising investment opportunity. Accordingly, paragraph (a)

has been revised to allow a Licensee with a pre-existing investment in

a concern that is no longer small to make additional investments until

the portfolio concern makes a public offering of its securities; and,

even after that, to exercise options, warrants or other rights to

acquire Equity Securities of the portfolio concern.

The regulation adopted this day with respect to additional

Financing of concerns that have become ineligible by reason of a change

in business operations represents the reconciliation of two conflicting

policy considerations. On the one hand, if SBA regulations declare

Small Concerns engaged in certain lines of business to be ineligible,

it makes no sense to allow Licensees to Finance an initially-eligible

concern so that it can shift its business activities into an ineligible

area. On the other hand, SBA recognizes that subsequent and unforeseen

occurrences may require a Small Concern to shift its activities into an

ineligible area.

Accordingly, the final regulation distinguishes between the case of

a concern that becomes ineligible by reason of a change in its business

activities within one year after the Licensee's Financing and that of a

concern that changes its business activities more than a year after the

Licensee's Financing. The regulation provides that if the concern moves

into an ineligible line of business within one year from the date of

the Licensee's Financing, a rebuttable presumption will arise that the

change in business activity was contemplated by the Small Concern at

the time of the Licensee's Financing. Accordingly, the Licensee shall

have the right to treat such change as a default or other breach of

covenant on the Small Concern's part, and to sue for any resulting

damages. See Sec. 107.305. The Licensee may also divest itself of the

investment if it considers such action to be in its best interests.

However, the Licensee's retention of such an investment in its

portfolio is a matter of balancing of program integrity against

possible loss to the Licensee, which is something that can only be done

on a case-by-case basis. Accordingly, requests for retention of the

investment should be accompanied by evidence tending to rebut the

presumption of bad faith on the part of the Small Concern by a showing

that the change in the Small Concern's business was prompted by a

change in circumstances subsequent to the date of the Licensee's

Financing and not reasonably foreseeable by the Small Concern.

If the change in business activity takes place more than one year

or more after the Licensee's Financing, of if the presumption of

regulatory violation has been rebutted, the Licensee may provide

additional Financing, but only to the extent necessary to prevent loss

of its original investment. SBA intends to allow only the most narrow

exception to its policy forbidding the Financing of concerns engaged in

ineligible business activities.

A change that takes place within one year gives the Licensee the

option to treat the event as a default and to accelerate the maturity

of all obligations. If the Licensee wishes to retain its investment in

the portfolio concern, it must obtain SBA's approval; and to obtain

such approval, it must rebut the presumption that the change was within

the contemplation of the parties, and, hence, in violation of the

applicable regulation, at the time of the Licensee's Financing. The

Licensee may rebut this presumption with evidence that the change was

the result of changed circumstances, unforeseen at the time of the

Licensee's Financing.

A change that takes place more than a year after the Licensee's

Financing may be treated by the Licensee as a default, but there is

neither a presumption that the change was within the contemplation of

the parties at the time of the Licensee's Financing, nor a requirement

of SBA approval should the Licensee decide to retain its investment.

Purchase of Portfolio Securities From SBA or From Licensees in

Liquidation

SBA's proposal to amend Sec. 107.707 to clarify the authority of

Licensees to purchase securities of Small Concerns from SBA, as either

the receiver or the assignee of another Licensee, is adopted without

change.

Licensees are reminded that Sec. 107.403(b)(3) presently allows

them to purchase securities of a Small Concern, including its

promissory notes, from any (non-Associate) non-issuer (including the

receiver of a failed financial institution), provided such acquisition

``constitutes a reasonably necessary part of the overall sound

financing of such concern.'' In contrast, Sec. 107.707 contains no such

restriction and is therefore narrowly drawn. SBA has determined that no

benefit to the Program or to small business would result from

broadening the scope of Sec. 107.707 to allow the purchase of a Small

Concern's Notes from the liquidators of a failed lending institution

when such purchase is made for its own sake, and not as a ``reasonably

necessary part of the overall sound financing of such concern.''

Idle Funds Investments

So far as this proposal deals with unleveraged Licensees, its

effects have already been discussed. That part of the proposal dealing

with investments of idle funds by Leveraged Licensees is adopted with

certain changes.

The final regulation clarifies in two ways the authority of

Leveraged Licensees to invest in repurchase agreements (repos).

The subject matter of the repo may only be obligations of, or

obligations guaranteed as to principal and interest by, the United

States; it is not enough that such Federal or Federally-guaranteed

obligations serve as collateral security for the performance of a repo

whose subject is some other kind of security.

The securities underlying the repo must be maintained in a

custodial account at a Federally-insured institution. They may not

remain in the hands of a party that is not itself Federally-insured;

and they may not be held as commingled assets of the custodial

institution.

The proposed regulation would not have allowed Licensees to

maintain idle funds deposits in excess of the insurance limit. The

final regulation permits Licensees to maintain idle funds in a

Federally-insured institution in excess of the insurance limit, but

only if that institution is ``well capitalized'' in accordance with the

standard set forth in 12 CFR 325.103(b)(1), as amended from time to

time.

Financing Changes of Ownership

The proposed rule is adopted with three changes.

The effect of the only significant substantive change is to allow

non-Leveraged Licensees to Finance changes of ownership if the debt-to-

equity ratio of the resulting concern is no higher than 8 to 1. As

proposed, the ratio had been 7 to 1.

The focus of Sec. 107.711 as proposed and adopted is the concern

that would emerge from the transfer of ownership, giving effect to all

financings, mergers and reorganizations contemplated by the parties. In

fact, the term ``contemplated'' has been substituted for ``agreed to''

to cover the case in which two or more parties agree in principle on a

general course of conduct, but have not reached definitive agreement on

all points.

If the concern resulting from the consummated acquisition will have

no more than 500 full-time equivalent employees, the Licensee may

finance the acquisition. If the concern resulting from the consummated

acquisition will have more than 500 full-time equivalent employees, the

Licensee may still finance the acquisition if, and only if, the

resulting concern also meets either one of two alternative debt/equity

ratio tests. If the Licensee in question has outstanding Leverage, the

resulting concern's debt/equity ratio may not exceed 5:1; in the case

of an unleveraged Licensee, the applicable debt/equity ratio may not

exceed 8:1.

The regulation contains a paragraph (b)(2)(iii) that excludes

certain classes of debt and other obligations from the category of

``debt'' for the purpose of determining the resulting concern's debt/

equity ratio. To preclude confusion, the paragraph has been slightly

modified to include contingent liabilities within the definition of

``debt''.

It should be understood that Sec. 107.711 does not constitute an

amendment of the size standards. The standards to be set forth in

Sec. 107.711 are applicable only in the context of financing a change

of ownership.

Minimum Capital Requirements

The proposal to amend Sec. 107.712(c) is adopted without change;

the amendment is a clerical one, mandated by statute.

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

the Regulatory Flexibility and Paperwork Reduction Acts

This final rule will be a significant regulatory action for

purposes of Executive Order 12866 because it will have an annual effect

on the economy of more than $100 million, and, for purposes of the

Regulatory Flexibility Act, 5 U.S.C. 601, et seq., it is likely to have

a substantial impact upon a number of small entities.

Much of this final rule is adopted pursuant to a statutory mandate

(section 415 of Pub. L. 102-366) that requires SBA to promulgate

regulations implementing The Small Business Equity Enhancement Act of

1992.

Among the statutory provisions to be implemented by regulation is a

definition of ``Private Capital'' that includes funds invested by State

and local governments and their instrumentalities, and by pension funds

managed by State or local government officials. Another provision

mandates the recognition of unfunded commitments of institutional

investors as a part of ``Private Capital'' for certain purposes. The

effect of these provisions is to encourage the investment of additional

capital in the Small Business Investment Company program; and the

amount of such new capital, together with SBA Leverage, is expected to

be substantially in excess of $100 million per year.

The potential benefits of this regulation have been set forth under

Supplementary Information. The potential cost of this regulation cannot

be quantified or estimated.

Executive Order 12612

SBA certifies that this regulation will not have federalism

implications warranting the preparation of a Federalism Assessment in

accordance with Executive Order 12612.

Executive Order 12278

For the purposes of Executive Order 12278, SBA certifies that this

rule is drafted, to the extent practicable, in accordance with the

standards set forth in section 2 of that Order.

Paperwork Reduction Act

This final rule will impose only minimal additional recordkeeping

and reporting requirements on Licensees and on the Small Concerns

Financed by them. SBA believes that much of the information needed to

ensure that funds advanced by Licensees are used by Small Concerns in

accordance with the Act and regulations, or to verify the effect of the

program in terms of job creation and additional tax purposes, or to

verify that Licensee Financing of changes of ownership serves a public

purpose by encouraging the preservation or creation of jobs, is

customarily provided by Small Concerns as part of their business plan

projections, or developed by Licensees as part of its due diligence.

(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, Small businesses.

For the reasons set forth above, part 107 of title 13, Code of

Federal Regulations is hereby 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., as amended; 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 of

``Control'', ``Control Person'', ``Cost of Money'', ``Disadvantaged

Concern'' ``Private Capital'', and ``Section 301(d) Licensee'' and by

adding definitions of ``Commitment'', ``Common Control'',

``Institutional Investor'', ``Leverageable Capital'', ``Qualified

Borrowing'', ``Regulatory Capital'', ``Section 301(c) Licensee'', and

``Smaller Concern'' in the appropriate alphabetical order and by

revising paragraph (b) of the definition of ``Associate of a

Licensee'', to read as follows:

Sec. 107.3 Definition of terms.\2\

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\2\Terms defined in this section are capitalized hereafter.

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* * * * *

Associate of a Licensee means:

* * * * *

(b)(1) Any Person owning or controlling, directly or indirectly,

ten percent or more of any class of stock of a Corporate Licensee; or

(2) any Person owning or controlling, directly or indirectly, a limited

partner's interest representing ten percent or more of the partnership

capital of an Unincorporated Licensee; Provided, however, That if a

Person described in the preceding paragraph (b)(2) of this definition

is an Institutional Investor and the amount of such Person's investment

in a Licensee, including commitments, does not exceed 5 percent of that

Person's net worth, then such Person shall not be considered an

Associate unless the amount of such Person's limited partnership

interest represents 33 percent or more of partnership capital.

* * * * *

Commitment means a written agreement between a Licensee and a Small

Concern that obligates the Licensee to provide Financing (except a

guarantee) to a Small Concern (whose eligibility has already been

determined by the Licensee) in a fixed or determinable sum, by a fixed

or determinable future date. In this context the term ``agreement''

means that there has been agreement on the principal economic terms of

the Financing; Provided, however, that the terms of the Commitment may

include reasonable conditions precedent not within the control of the

Licensee to the Licensee's obligation to fund the Commitment.

* * * * *

Common Control means a condition where two or more Licensees either

through ownership, management, contract, or otherwise, are under the

Control of one group or Person. Two or more Licensees are presumed to

be under Common Control if they are affiliates of each other by reason

of common ownership or common officers, directors, or general partners;

or if they are managed or their investments are significantly directed

either by a common independent investment advisor or managerial

contractor, or by two or more such contractors that are affiliates of

each other. This presumption may be rebutted by evidence satisfactory

to SBA. The term ``affiliate'' is defined in Sec. 121.401 of this

title.

Control means the possession, direct or indirect, of the power to

direct or cause the direction of the management and policies of a

Licensee or a Small Concern, whether through the ownership of voting

securities, by contract, or otherwise.

Control Person means (a) A general partner of an Unincorporated

Licensee, including all general partners of a partnership serving

either as a general partner of an Unincorporated Licensee or as a

general partner of any other (intervening) partnership, limited or

general, that serves directly or indirectly as a general partner of an

Unincorporated Licensee;

(b) Any officer, director, agent or employee of a corporate general

partner of an Unincorporated Licensee, or of any corporation that is a

general partner in a partnership serving as a general partner of an

Unincorporated Licensee, or as a general partner of any other

(intervening) partnership, limited or general, that serves directly or

indirectly as a general partner of an Unincorporated Licensee;

(c) Any Person that participates in the investment decisions of the

general partner of an Unincorporated Licensee and owns or controls,

directly or indirectly, an interest of 10 percent or more as a

stockholder in, or limited partner of, any corporation or limited

partnership that serves directly or indirectly as a general partner of

such Unincorporated Licensee;

(d) Any Person that does not participate in the investment

decisions of the general partner of an Unincorporated Licensee and owns

or controls, directly or indirectly, an interest of 40 percent or more

as a stockholder in, or limited partner of, any corporation or limited

partnership that serves directly or indirectly as a general partner of

such Unincorporated Licensee.

* * * * *

Cost of Money generally includes all consideration that a Small

Concern and/or its affiliates is (are) contractually obligated to pay

to a Licensee and/or the Associates of such Licensee in connection with

Financial Assistance from such Licensee, such as interest, discounts,

points, fees, commissions, and any other thing of value, except as

hereinafter set forth.

(a) The following fees and charges are not to be included in

calculating Cost of Money:

(1) Processing fees determined in accordance with Sec. 107.402;

(2) Out-of-pocket conveyance and/or recordation fees and taxes;

(3) Reasonable closing costs;

(4) A reasonable fee for arranging financing from non-SBIC non-

Associate sources of capital, whether or not the Licensee participates

in such financing, if there is a written agreement in advance with the

Small Concern to pay such fee;

(5) Fees for management consulting services, but only if calculated

on a per hour, commercially reasonable basis for services actually

rendered,

(6) Prepayment penalties pursuant to Sec. 107.402;

(7) Reasonable and necessary out-of-pocket expenses incurred in

monitoring the financing; and

(8) Board of Director fees not to exceed those paid to other

outside directors and pursuant to Sec. 107.903(f).

(b) All other fees and charges shall be included in calculating

Cost of Money.

* * * * *

Disadvantaged Concern means a Small Concern that is at least 50

percent owned, and controlled and managed, by a person or persons whose

participation in the free enterprise system is hampered because of

social or economic disadvantages.

* * * * *

Institutional Investor means any of the following classes of

entities having a net worth of not less than $1 million; or of persons

having a net worth of not less than $2 million, exclusive of the value

of the equity in his or her most valuable residence, unless otherwise

specified:

(a) Entities. (1) Any State or National bank, trust company,

savings bank, or savings and loan association, including any such

institution investing the funds of others in a fiduciary capacity;

(2) Any insurance company

(3) Any 1940 Act Investment Company or Business Development

Company, as defined in the Investment Company Act of 1940, as amended;

(4) Any holding company of the foregoing;

(5) Any employee benefit or pension plan established for the

benefit of employees of the Federal government or any State, their

political subdivisions, or any agency or instrumentality thereof;

(6) Any employee benefit or pension plan, as defined in the

Employee Retirement Income Security Act of 1974, as amended;

(7) Any trust, foundation or endowment exempt from Federal income

taxation under the Internal Revenue Code, as amended;

(8) Any corporation, partnership, or other entity with a net worth

in excess of $10,000,000;

(9) Any State, its respective political subdivisions, or any agency

or instrumentality thereof;

(10) Any entity whose primary purpose is to manage and invest non-

Federal funds on behalf of any of the foregoing Institutional

Investors; or

(11) Any other entity that SBA shall determine to be an

Institutional Investor.

(b) Persons. (1)(i) Any individual with a personal net worth of

less than $2 million who is an Accredited Investor as defined by the

Securities Act of 1933, as amended, and whose commitment to the

Licensee is backed by a letter of credit from a qualified Institutional

Investor;

(ii) Any individual whose personal net worth (exclusive of the

value of his or her most valuable residence) is equal to not less than

ten times the amount of his or her commitment; or

(iii) Any individual whose personal net worth (exclusive of the

value of any equity in his or her most valuable residence) equals or

exceeds $10 million: Provided, however, That the commitment of any

individual who is not a permanent resident of the United States shall

also be backed by an irrevocable appointment of an agent within the

United States for the service of process.

(2) See paragraph (b) of the definition of Private Capital for

restrictions on the amount of an Institutional Investor's commitment

that will be recognized by SBA as a part of a Licensee's Private

Capital. See also the definition of Regulatory Capital in Sec. 107.3,

and Sec. 107.241(c).

* * * * *

Leverageable Capital means Regulatory Capital, excluding unfunded

commitments and qualified non-private funds whose source is Federal

funds.

* * * * *

Private Capital--(a) General. Private Capital means the combined

private (non-governmental) paid-in capital and paid-in surplus of a

Corporate Licensee, or the private (non-governmental) partnership

capital of an Unincorporated Licensee, plus unfunded binding

commitments by an Institutional Investor (including commitments

evidenced by a promissory note) to purchase stock or limited

partnership interests in, or to make capital contributions to a

Licensee. The private paid-in capital and paid-in surplus of a

Corporate Licensee, or the private partnership capital of an

Unincorporated Licensee, may include funds invested by a public or

private pension fund; and qualified nonprivate funds as described in

paragraph (c) of this definition. Notwithstanding the foregoing, non-

cash assets purchased by a license applicant and non-cash assets

contributed to a Licensee or a license applicant will not be considered

part of Private Capital, except as permitted by Sec. 107.705(a) (1)

through (6), or unless approved by SBA.

(b) Exclusions. Private Capital shall not include:

(1) Funds borrowed by a Licensee from any source,

(2) Leverage funds obtained as a result of SBA's purchase or

guarantee of securities,

(3) Funds obtained directly or indirectly from any Federal, State,

or local government, or agency or instrumentality thereof, unless such

funds are qualified nonprivate funds, or

(4) That part of a commitment from an Institutional Investor with a

net worth of less than $10 million that exceeds 10 percent of such

Institutional Investor's net worth, except to the extent that such

excess is backed by a letter of credit from another Institutional

Investor.

(c) Qualified nonprivate funds. ``Qualified nonprivate funds''

means:

(1) Funds directly or indirectly invested in any Licensee on or

before August 16, 1982 by any Federal agency except SBA, pursuant to a

statute explicitly mandating the inclusion of such funds in ``Private

Capital'';

(2) Funds directly or indirectly invested in any Licensee by any

Federal agency pursuant to a statute that is enacted after September 4,

1992, explicitly mandating the inclusion of such funds in ``Private

Capital'';

(3) Funds invested in any Licensee by any State or local government

entity, including the amount of any guarantee extended by such entity;

and

(4) In any section 301(d) Licensee or such applicant, funds

invested which are income derived from the investment of grants that

have been made by a state or local government agency or instrumentality

into a nonprofit corporation or institution exercising discretionary

authority with respect to such funds; and funds invested by a State

financing agency, or similar agency or instrumentality, to the extent

such funds are derived from such agency's income and not from

appropriated State or local funds; Provided, however, that for any

Licensee or applicant, the funds described in paragraph (c)(3) of this

definition shall not exceed 33% of Regulatory Capital.

* * * * *

Qualified Borrowing means a loan to a Licensee bearing interest at

a rate not in excess of the usual rate charged on the date of the loan

by banks in the locality in which the Licensee's principal office is

located; and/or a Debenture purchased or guaranteed by SBA. See

Sec. 107.302.

* * * * *

Regulatory Capital.--(a) General. Regulatory Capital means Private

Capital, excluding non-cash assets contributed to a Licensee or a

license applicant and non-cash assets purchased by a license applicant

unless such assets have been converted to cash or have been approved by

SBA for inclusion in Regulatory Capital. For purposes of this

definition, sales of contributed non-cash assets with recourse or

borrowing against such assets shall not constitute a conversion to

cash.

(b) Exclusions. The amount of a commitment, the collectibility of

which SBA determines to be questionable, shall also be excluded from

Regulatory Capital.

* * * * *

Section 301(c) Licensee means an SBIC organized as a for-profit

corporation, a limited liability company or a limited partnership

organized in accordance with Sec. 107.4, and licensed pursuant to

section 301(c) of the Act.

Section 301(d) Licensee means an SBIC organized as a for-profit

corporation, a non-profit corporation, a limited liability company or a

limited partnership organized in accordance with section 107.4, and

licensed pursuant to section 301(d) of the Act. Such Licensees are

permitted to provide assistance only to Disadvantaged Concerns.

* * * * *

Smaller Concern means a concern that together with its affiliates

does not have net worth in excess of $6.0 million, and does not have

average net income after Federal income taxes (excluding any carry-over

losses) for the preceding two years in excess of $2.0 million; or a

concern that together with its affiliates, meets the size standard in

effect at the time of the Financing for the industry in which it is

then primarily engaged, and excluding its affiliates meets the size

standard in effect at the time of the Financing for the industry in

which it is then primarily engaged.

* * * * *

4. Section 107.4 is amended by revising paragraphs (b) (1), (2) and

(3)(i), by revising the fourth sentence in paragraph (c), and by adding

a new paragraph (f), to read as follows:

Sec. 107.4 Limited Partnership SBIC.

* * * * *

(b) Application. * * *

(1) Number of General Partners. A Licensee shall have as its

general partners at least two individuals; or one or more corporations

(including limited liability corporations), or one or more partnerships

(including limited partnerships), or any combination of individuals,

and/or corporations, and/or partnerships. General partners of a general

partner of an Unincorporated Licensee shall be considered for all

purposes to be general partners of such Licensee. For the status of

limited partners of a limited partnership that serves as a general

partner of a Licensee, see the definition of Control Person in

Sec. 107.3.

(2) General Partner. A general partner which is a corporation,

limited liability company or limited partnership (an ``Entity General

Partner'') shall be organized under state law solely for service as

such and its Articles or Certificate of Incorporation or Limited

Partnership Agreement or other similar governing instrument (which, in

each case, shall accompany the license application) shall specify that

no person shall serve as an officer, director or general partner

without SBA's approval. No Entity General Partner may serve as such for

any other Licensee and where an Entity General Partner is a limited

partnership, such partnership shall be subject to the number of general

partners defined in paragraph (b)(1) of this section. An Entity General

Partner is subject to the same examination and reporting requirements

as a Licensee under Sec. 310(b) of the Act. The restrictions and

obligations imposed upon a Licensee by Secs. 107.210 through 107.263,

and 107.601, 107.603, 107.701, 107.702, 107.703, 107.709, 107.801,

107.802, 107.803, 107.1001, 107.1002, and 107.1004 apply also to an

Entity general partner of a Licensee.

(3) Articles of Partnership. * * *

(i) The partnership shall have a minimum duration of not less than

the longer of ten years or two years following the maturity of the

last-maturing security issued by the partnership evidencing Leverage

from SBA. After 10 years and provided all Leverage has been repaid or

redeemed and provided that all amounts due SBA, its agency, or trustee

have been paid, the partnership may be terminated by a vote of the

Licensee's partners. (For purposes of this provision SBA shall not be

considered a partner.)

* * * * *

(c) Obligations of a Control Person. * * * The conditions specified

in Secs. 107.210 through 107.263 shall apply to all general partners;

the conditions specified in Sec. 107.210(e) shall apply to all Control

Persons. * * *

* * * * *

(f) Special Leverage requirement. Prior to the extension of any

Leverage, an Unincorporated Licensee shall furnish SBA with evidence

that it qualifies as a partnership for tax purposes, either by a ruling

from the Internal Revenue Service, or by any opinion of counsel.

5. Section 107.101 is amended by revising paragraph (a), by

redesignating paragraphs (d) and (e) as paragraphs (e) and (f), by

adding a new paragraph (d), by revising the introductory text of newly

designated paragraph (e), and by adding new paragraphs (g), (h) and

(i), to read as follows:

Sec. 107.101 Operational requirements.

* * * * *

(a) Management. Each Licensee shall have and maintain qualified

management (or an Investment Adviser/Manager pursuant to Sec. 107.709)

in charge of its operations who will be available during normal

business hours to the public. Any manager of a Licensee shall be deemed

an officer thereof. When applying for a license or for Leverage, a

Licensee must demonstrate, to the satisfaction of SBA, that its

management has the knowledge, experience and capability necessary for

investing in the types of businesses contemplated by the Act, these

regulations, and Licensee's Plan of Operations. Neither management, nor

any board of directors, nor any general partner shall be controlled

either directly or indirectly by investors of qualified non-private

funds.

* * * * *

(d) General capital requirements. Each company shall have at

licensing, and thereafter shall maintain Regulatory Capital adequate to

assure a reasonable prospect that the company will be operated soundly

and profitably over the long term, and managed actively and prudently

in accordance with its articles or partnership agreement and within the

context of its Plan of Operations, as approved by SBA. In this regard,

SBA shall determine the ability of the company to be economically

viable, both prior to licensing and prior to approving any request for

financing, taking into consideration the income and losses which the

company anticipates on its Loans and Investments, and the experience

and qualifications of the company's owner's and managers. Compliance

with these requirements shall be determined within the context of

capital impairment and other regulations that relate to safety and

soundness.

(e) Minimum Capital. Any company licensed after April 8, 1994 shall

have Regulatory Capital in U.S. dollars sufficient to meet the

requirements of paragraph (d) of this section, but in no case shall a

Licensee have Regulatory Capital (not including commitments to invest

in a Licensee) less than the following minimum levels:

* * * * *

(g) Valuation guidelines and responsibility. (1) Each Licensee

shall adopt a written Valuation Policy for its use in determining the

value of its Loans and Investments, and each applicant for a License

shall submit such Policy as part of its application. Such Policy shall

adhere to the provisions of Appendix III. The boards of directors of

corporations and the general partners of partnerships shall have sole

responsibility for adopting the Licensee's valuation policy and,

pursuant thereto, for valuing Loans and Investments of such Licensee.

Loans and Investments shall be valued individually and in the aggregate

by the Board of Directors or General Partners at least semiannually--as

of the end of the second quarter of Licensee's fiscal year and as of

the end of Licensee's fiscal year, Provided however, That Licensees

without Leverage need only perform valuations as of the end of the

fiscal year. On a case-by-case basis, SBA may require valuations to be

made more frequently.

(2) Licensee shall forward valuation reports to SBA within 90 days

of the end of the fiscal year in the case of annual valuations, and

within thirty days following the close of other reporting periods.

Material changes in valuations shall be reported not less often than

quarterly within thirty days following the close of the quarter.

(3) Only valuations performed as of the fiscal year-end are

required to be reviewed by the Licensee's independent public

accountant. Such accountant shall have responsibility to review the

Licensee's valuation procedures and the implementation of such

procedures, including adequacy of documentation. Such accountant also

shall have reporting responsibilities regarding the results of this

review (see Appendix I, section III and section V, paragraphs I and J).

(4) Any Licensee that adopts the exact wording of those parts of

section III of Appendix III, entitled ``Valuation Policy'', that are

set in bold type, without any additions or changes will be presumed to

have an acceptable Valuation Policy. A Licensee may write a policy

which differs from the bold type, but must have such policy approved by

SBA, in writing. Applicants for either a 301(c) or 301(d) license must

submit their Valuation Policies for approval as part of the licensing

application process.

(h) Computer requirements. By June 30, 1994 all Licensees shall

have a personal computer facility with modem capable of running

software provided by SBA and person(s) trained in the use of SBA-

provided software and shall electronically transmit information and

reports as required by SBA. Such Licensees shall use such software for

the purpose of reporting specific financial information required by

SBA.

(i) Financing of Smaller Concerns. As of the close of the

Licensee's first full fiscal year commencing on or after April 8, 1994,

at least 10 percent of the cumulative dollar amount of Financing

extended during the period between April 8, 1994 and the close of such

fiscal year shall consist of Financings of Smaller Concerns. As of the

close of each subsequent fiscal year, the cumulative dollar amount of

Financing extended to Smaller Concerns shall be no less than 20 percent

of the total dollar amount of Financing extended since April 8, 1994.

Unless a Licensee is in compliance with the requirements of this

paragraph, Financing may be extended only to a Smaller Concern. A

Financing extended pursuant to Sec. 107.711 in which the resulting

concern qualifies as a Smaller Concern will be considered a Financing

of a Smaller Concern.

6. Section 107.103 is revised to read as follows:

Sec. 107.103 Public notice.

SBA shall publish notice of the license application in the Federal

Register. It shall include such appropriate information as the name and

location of the proposed Corporate Licensee, its area of operation, the

names and addresses of its officers, directors, and owners of, or

persons controlling 10 or more percent of its voting stock; and in the

case of an Unincorporated Licensee, its name, location, and area of

operation, and the names and addresses of its Control Persons. If any

Control Person is a corporation, the notice shall set forth the names

and addresses of any officers, directors, and owners of, or persons

controlling 10 percent or more of the stock of such corporation. In the

case of an Unincorporated Licensee, the notice shall also include the

name and address of each owner of 10 percent or more of the Licensee's

Regulatory Capital. The public shall be afforded reasonable opportunity

for the submission of written comments. The proposed Licensee shall

publish a similar notice in a newspaper of general circulation in the

city or proposed area of operation, and shall furnish a certified copy

to SBA within 10 days of the date of publication.

7. Section 107.302 is revised to read as follows:

Sec. 107.302 Cost of money; loans and debt securities.

Subject to lower ceilings prescribed by local law, Cost of Money on

Loans and Debt Securities shall not exceed the higher of the following:

(a) Loans. The higher of either the Licensee's certified Weighted

Average Cost of Qualified Borrowings, computed in accordance with

paragraph (e) of this section, or the current Debenture Rate, plus, in

either case, 7 percentage points, rounded off to the next lower eighth

of one percent; Provided, however; That if the current Debenture Rate

is 8 percent per annum or lower, a Licensee is permitted to charge up

to 15 percent.

(b) Debt securities. The higher of either the Licensee's certified

Weighted Average Cost of Qualified Borrowings, computed in accordance

with paragraph (e) of this section, or the current Debenture Rate,

plus, in either case, 6 percentage points, rounded off to the next

lower eighth of one percent; Provided, however; That if the current

Debenture Rate is 8 percent per annum or lower, a Licensee is permitted

to charge up to 14 percent.

(c) Maximum Cost of Money. The maximum Cost of Money on any

specific Financing shall be determined with reference to either the

Licensee's certified Weighted Average Cost of Qualified Borrowings or

the Debenture Rate in effect as of the day the Licensee collects a

processing fee or enters into a Commitment, or makes the first

disbursement, whichever shall first occur.

(d) Effective date. The Cost of Money limitation in effect on April

24, 1994 shall remain applicable to all Financings committed or

disbursed on or before that date.

(e) Computation of Weighted Average Cost of Qualified Borrowings.

Licensee's Weighted Average Cost of Qualified Borrowings (as a percent)

shall be computed as follows:

TR08AP94.000

where:

W=Weighted Average Cost of Qualified Borrowings

A=Dollar amount of Interest on Qualified Borrowings still outstanding

at the end of the prior fiscal year, as found on Form 468. (SSBICs are

presumed to have paid interest at the coupon rate, without regard to

any subsidy payments by SBA)

P=Outstanding principal amount of Qualified Borrowings at the end of

the prior fiscal year, net of related fees

D=Days outstanding for prior fiscal year

i=Individual Note, Debenture, or other debt instrument

n=Number of Notes, Debentures, or other debt instruments outstanding at

end of fiscal year

=sum of

This equation is read as: Multiply the principal balance (net of

Leverage fees) of each Note, Debenture, or other debt instrument still

outstanding at the end of the preceding fiscal year by the number of

days that the instrument was outstanding in that fiscal year and divide

this product by 365; take the sum of these amounts and divide that sum

into total interest expense for those Qualified Borrowings still

outstanding at the end of the fiscal year; finally multiply the

resulting number by 100.

(f) Notification of Weighted Average Cost of Qualified Borrowings.

A Licensee that wishes to utilize its Weighted Average Cost of

Qualified Borrowings as the basis of an alternative COM ceiling for its

next succeeding fiscal year shall transmit a written certification of

its Weighted Average Cost of Qualified Borrowings to SBA as a part of

its Annual Financial Report (SBA Form 468) for the prior fiscal year;

provided however, that where such licensee provides Financing using the

Weighted Average Cost of Qualified Borrowings before submitting its

Annual Financial Report, such Licensee shall submit its certified

Weighted Average Cost of Qualified Borrowings as an attachment to the

SBA Form 1031 for each such financing. Such Weighted Average Cost of

Qualified Borrowings shall be reviewed by the Licensee's independent

public accountant, who shall provide a certification that the Weighted

Average Cost of Qualified Borrowings was calculated in accordance with

SBA's regulations. Failure to submit timely a certified Weighted

Average Cost of Qualified Borrowings in such manner shall constitute a

binding waiver of Licensee's right to use its Weighted Average Cost of

Qualified Borrowings as the basis for an alternative Cost of Money

limitation for the remainder of the Licensee's fiscal year, unless for

good cause shown, SBA grants written approval for its use.

(g) Application of Weighted Average Cost of Qualified Borrowings to

Financings Involving Multiple Licensees. (1) If two or more Licensees

participate in the same Financing of a Small Concern, the basis for

determining the applicable COM ceiling shall be the highest of any of

the following:

(i) The current Debenture Rate; or

(ii) The certified Weighted Average Cost of Qualified Borrowings of

the lead Licensee in the Financing; or

(iii) The weighted average of the Weighted Average Cost of

Qualified Borrowings of all Licensees participating in the Financing.

(2) For the purposes of the calculation in paragraph (q)(1)(iii) of

this section, the Weighted Average Cost of Qualified Borrowings of a

Licensee that has not certified such cost to SBA or that has no

outstanding Qualified Borrowings shall be the Debenture Rate in effect

at the time of the Financing.

(h) Default Penalties. In the event of a monetary default by a

Small Concern or a failure to provide any post-Financing report or

other document required by the terms of the Loan Agreement or SBA

regulations, Licensees may, by way of default penalty and without

regard to any Cost of Money limit that may otherwise be applicable,

raise the interest rate by as much as seven percentage points over the

rate specified in the Financing, until such time as the default shall

be cured.

8. Section 107.303 is amended by revising paragraph (a), by

redesignating paragraph (b) as paragraph (c), by adding a new paragraph

(b), and by revising the newly designated paragraph (c) introductory

text, (c)(6) and the example that follows newly designated paragraph

(c)(7), to read as follows:

Sec. 107.303 Overline limitation.

(a) Leveraged Licensees. Without written SBA approval, the

aggregate amount of funds disbursed for securities acquired (exclusive

of write-down), and of Commitments and guaranties issued for a Small

Concern (including affiliated concerns as defined in Sec. 121.401 of

this chapter) shall not exceed twenty percent of a Licensee's

Regulatory Capital: Provided, however, That for section 301(d)

Licensees the limitation shall be thirty percent.

(b) Non-Leveraged Licensees. Any Licensee that does not have

outstanding Leverage shall be exempt from this section; Provided,

however, that no Leverage will be extended to any Licensee until such

Licensee is in compliance with paragraph (a) of this section.

(c) Increased Limit. For purposes of this section only, Regulatory

Capital may include the net unrealized gains of a Licensee represented

by marketable securities and support an additional overline limitation

(increased limit) subject to the following conditions:

* * * * *

(6) By availing itself of this increased limit, Licensee agrees

that, in the event the net unrealized gains show a reduction on the

first business day of any calendar quarter and for at least thirty days

thereafter, below seventy percent of the net unrealized gains, Licensee

will (not later than ninety (90) days from such date) cause to be

injected sufficient Regulatory Capital to restore support for the

increased limit or reduce the increased limit of its investments to a

point at which no investment exceeds 20 percent of the sum of its

Regulatory Capital plus the remaining net unrealized appreciation

represented by marketable securities.

* * * * *

Example: On January 15, 1995 the Licensee documents net

unrealized gains of $100,000. Licensee adds $100,000 to its

Regulatory Capital and increases its overline limitation

accordingly. Licensee now makes one or more investments in reliance

on this increased limit. Hereafter, on each subsequent first

business day of April, July, October, and January, Licensee must

document net unrealized gains of a least $100,000. On April 15, 1996

Licensee can document further net unrealized gains for an aggregate

of $150,000 and invest pursuant to an increased limit of $30,000

(20% of $150,000). Following the first business day of April, 1997,

Licensee documents net unrealized gains of only $120,000. All

investments within the increased limit remain undiminished in the

portfolio. Licensee is now required to cause to be injected

sufficient cash into Regulatory Capital before July 1, 1997, so that

the sum of the remaining net unrealized gains and the added cash

equals at least five times the increased limit of its largest

investment. In the alternative, Licensee must reduce before July 1,

1997, its overline investments made in reliance on this subsection

so that none will exceed 20 percent of Regulatory Capital plus

$24,000. Any further reduction of net unrealized gains will require

additional proportionate injection of cash or reduction of

investments.

* * * * *

9. Section 107.304 is amended by revising the heading and

paragraphs (a)(1) and (b) and by adding paragraph (c) to read as

follows:

Sec. 107.304 Size status, financial report, and non-discrimination.

(a) * * *

(1) The Licensee has determined that the concern being assisted is

a Small Concern based on the financial size standards set forth in

Sec. 121.802(a)(3)(i) or the single industry standard covering the

industry in which the applicant Small Concern is, or will be, primarily

engaged as set forth in Sec. 121.802(a)(3)(ii); or SBA has determined

at the request of the Licensee or of such concern that the latter is a

Small Concern. The Licensee and the Small Concern shall execute SBA

Form 480, Size Status Declaration, including Licensee's representation

that applicable size standards have been met, unless the size

determination has been made by SBA.

* * * * *

(b) Financial reports.--(1) Initial Financing decision. In

considering any Financing for a Small Concern the Licensee shall

require the concern to submit such financial statements, plans of

operation (including intended use of financing proceeds), cash flow

analyses and projections as are necessary to support the Licensee's

investment decisions, considering the size and type of the business and

the amount of the Financing being considered. Such materials shall be

in English and shall be retained by, and become a part of the permanent

record of, the Licensee.

(2) Subsequent reports. The terms of the Financing shall require

each assisted Small Concern to forward to the Licensee, at least

annually, such financial statements (including verification of the use

of financing proceeds) as are necessary to verify not only the

financial condition of the Small Concern for the purpose of valuing the

Licensee's investment therein, but also the continued eligibility of

such Small Concern. Such statements shall be in English and be

certified by the chief financial officer, general partner, or

proprietor of such Small Concern and shall be retained by, and become a

part of the permanent records of, the Licensee. If the Licensee shall

deem it appropriate, considering the size and type of the business

involved, the Licensee may accept, for financial and valuation purposes

only, a complete copy of the Federal income tax return, including all

appropriate schedules thereto, filed by the business or by the

proprietor, as the case may be. The foregoing requirements shall not

apply, however, when the Licensee acquires the securities from an

underwriter in a public offering (see 107.404), in which event the

Licensee shall keep copies of all reports furnished by such Small

Concern to the holders of its securities.

(c) Economic impact. When a Licensee's Form 468 is forwarded to SBA

it shall be accompanied by an assessment of the economic impact of each

Financing, specifying the full-time equivalent jobs created or

retained, the impact of the financing on the business in terms of

expanded revenue and taxes, and other appropriate economic benefits

including, but not limited to, technology development or

commercialization, minority business development, urban or rural

business development, expansion of exports and assistance to

manufacturing firms (SIC Major Groups 20-39)

.10. Part 107 is amended by adding a new Sec. 107.305 before the

heading ``Equity Capital'' to read as follows:

Sec. 107.305 Use of proceeds.

Proceeds of financings by a Licensee shall be used by the Small

Concern for its sound financing and for its growth, modernization, or

expansion and such use shall be reported on SBA Form 1031. Accordingly,

Licensees shall obtain sufficient information to give reasonable

assurance that the proposed financing will be used for purposes

intended by the Act and this Part of the regulations. Financing

documents shall contain provisions which require the Small Concern to

provide information specified in Sec. 107.304(b), and which give the

Licensee and/or SBA access to the Small Concern's records to confirm

such use of proceeds. The Licensee shall conduct a reasonable post

closing review within 90 days after disbursement of the proceeds to

assure that proceeds were used for the intended purposes. The financing

documents shall also provide that any diversion by a Small Concern of

financing proceeds from their reported use without the Licensee's prior

written consent shall constitute an event of default when the Licensee

has made a loan or a violation of a covenant with the Licensee when the

Licensee has made an investment. The financing documents also shall

specify that such event of default or covenant violation shall give the

Licensee the right to demand immediate repayment of the financing.

Nothing in this paragraph shall be construed to restrict the Licensee's

right to sue the Small Concern for any additional damages it may

sustain as a result of the improper diversion of funds or to bring suit

against the individuals responsible for such diversion of funds. Any

unauthorized diversion that comes to the attention of a Licensee shall

be reported promptly to SBA for such action against the Small Concern

as SBA may consider proper. See also Sec. 107.906(b).

11. Section 107.401(a)(5) is revised to read as follows:

Sec. 107.401 SBIC guaranty of loans.

(a) * * *

(5) The total guaranties issued and outstanding for all Small

Concerns shall not exceed one hundred percent of Regulatory Capital.

* * * * *

12. Section 107.402 is amended by revising paragraphs (a) and (d)

and adding paragraphs (e), (f), and (g) to read as follows:

Sec. 107.402 Commitments.

(a) General. A Licensee is authorized to enter into a written

Commitment to furnish Financing to a Small Concern.

* * * * *

(d) Processing fees. A Licensee is authorized to charge a

processing fee, in no event to exceed three percent of the amount of

Financing requested: Provided, however, That if the amount of Financing

offered in response by the Licensee and agreed to by the Small Concern

is a lesser amount, the maximum processing fee may not exceed three

percent of such lesser amount. A processing fee that does not exceed

the foregoing limits shall not be considered part of the Small

Concern's Cost of Money. A processing fee that exceeds the foregoing

limits shall, to the extent of such excess, be considered part of the

Small Concern's Cost of Money.

(1) Collection of processing fee. (i) The processing fee may be

collected, in full or in part, when the Licensee accepts the Small

Concern's application for financing, or such fee may be deducted from

Financing proceeds. When the application is accepted for processing,

however, the Licensee shall furnish the applicant Small Concern with a

written statement setting forth:

(A) The maximum Cost of Money determined with reference to

Licensee's certified Weighted Average Cost of Qualified Borrowings, if

any, or the present Debenture Rate, as appropriate;

(B) A date by which Licensee will notify the applicant of its

decision; and

(C) The specific processing services to be performed by the

Licensee.

(ii) Failure to furnish such statement shall cause the amount of

any processing fee to be included in Cost of Money if the requested

Financing closes, or shall obligate Licensee to refund the entire

amount of the processing fee if the request for Financing is denied.

(2) Partial refund of processing fee when Financing does not close.

(i) No Commitment extended. If the Licensee has not provided a

Commitment and the Small Concern and the Licensee do not close the

Financing, that part of the processing fee in excess of Eligible Costs,

hereafter enumerated, that were incurred by the Licensee shall be

refunded within thirty days to the Small Concern, together with a

detailed accounting of the Eligible Costs incurred by the Licensee.

(ii) Commitment extended. If the Licensee has provided a Commitment

and the Small Concern and the Licensee do not close the Financing, any

refund of the processing fee, in whole or in part, is dependent upon

which party caused the Financing not to close, as follows:

(A) Failure to close attributable to Small Concern. If the

Financing does not close due to actions of the Small Concern, the

Licensee is entitled to retain the processing fee, not to exceed three

percent of the amount of the Licensee's Commitment. If Eligible Costs

exceed the processing fee, Licensee may obtain reimbursement for such

excess Eligible Costs only if the Small Concern has entered into a

contractual agreement providing for such reimbursement. If no such

contractual agreement exists, a Small Concern shall not be required to

pay an additional processing fee, even if the amount of the Licensee's

Eligible Costs exceed the amount of the processing fee advanced by the

Small Concern.

(B) Failure to close attributable to Licensee. If the failure to

close is attributable to actions of the Licensee, that part of the

processing fee in excess of Eligible Costs incurred by the Licensee

shall be refunded to the Small Concern within thirty days, together

with a detailed accounting of the Eligible Costs incurred by the

Licensee.

(3) Eligible costs. As used in this Section, Eligible Costs means:

(i) Actual computed costs incurred in the segregation of money to fund

a Commitment, if one was extended;

(ii) Ordinary and reasonable out-of-pocket expenses necessary to

process the application and perform due diligence, and

(iii) Actual costs paid to non-Associates of the Licensee for

specialized application processing services which are not ordinarily

performed by the Licensee.

(e) Additional fees. If the Small Concern and the Licensee close

the Financing, Licensee is authorized to deduct from the proceeds the

unpaid remainder of any processing fee previously agreed upon, not to

exceed 3 percent of the total Financing provided at the closing, and,

in addition, to charge the Small Concern for Eligible Costs incurred by

the Licensee and reasonable closing costs. Such fees and charges shall

not be included in the calculation of Cost of Money.

(f) Prepayment penalties. A Licensee may charge a reasonable

penalty for prepayment of a Financing which shall be excluded from the

Cost of Money calculation. If such prepayment penalty is considered by

SBA to be unreasonable, however, Licensee shall not be entitled to such

prepayment penalty, and if the penalty has been collected, shall refund

the entire prepayment penalty to the Small Concern. A prepayment

penalty equal to 5 percent of the outstanding balance during the first

year of any Financing, declining by one percentage point per year

through the fifth year, will be considered a reasonable penalty.

(g) Front-end charges. If a Licensee has imposed front end charges

such as points, discount, loan origination fee, a processing fee to the

extent it exceeds three percent, or other such charges, regardless of

the label the Licensee may apply, that are not specifically excluded

from Cost of Money, such charges shall be prorated over the stated term

of the Financing. In that case, the sum of interest and unearned front-

end charges shall not exceed the Cost of Money limit in effect at the

time of the Financing; and in the event of prepayment, any resulting

excess Cost of Money shall be returned to the Small Concern.

13. Section 107.403 is amended by revising paragraph (b)(1), to

read as follows:

Sec. 107.403 Other Permissible Financing.

* * * * *

(b) * * *

(1) Short-term Financing. Financing with a term of less than five

years when it constitutes:

(i) Interim financing in contemplation of long-term Financing of a

Small Concern by the Licensee or a group including the Licensee and

others in an amount at least equal to such total interim financing:

Provided, however, That the maximum aggregate period for short-term

Financing in contemplation of long-term Financing shall not exceed one

year; or

(ii) Protection of prior investments; or

(iii) Financing ownership change pursuant to Sec. 107.711; or

(iv) Financing required by a Small Concern to perform a contract

that it has been awarded under any Federal, State, or local government

set-aside program for ``minority'' or ``disadvantaged'' contractors.

This paragraph (b)(1) supplements the authority to make short term

investments in Disadvantaged Concerns under Sec. 107.301(a).

* * * * *

15. Section 107.501(c) is amended by revising the last sentence

thereof, to read as follows:

Sec. 107.501 Management services.

* * * * *

(c) Management Services Corporation. * * * Licensee's investments

in and receivables from such corporation shall not exceed 3 percent of

the Licensee's Regulatory Capital.

15. Section 107.601 is amended by revising the first sentence of

paragraph (g) and by revising paragraph (h)(1), to read as follows:

Sec. 107.601 Changes in ownership or control of Licensee.

* * * * *

(g) Public notice. SBA shall publish notice in the Federal Register

concerning the application for approval of a proposed transfer of

Control over a Licensee, including such appropriate information as the

name and location of the Licensee and of the proposed transferees who

will own ten or more percent of any class of its Regulatory Capital. *

* *

(h) Standards governing SBA approval. (1) SBA may, as a condition

of approving a proposed transfer of Control, require an increase in

Licensee's Regulatory Capital.

* * * * *

16. Section 107.705 is amended by adding a new paragraph (a)(8) to

read as follows:

Sec. 107.705 Consideration for issuance of Licensee securities.

(a) * * *

(8) With SBA's prior written approval, contributed non-cash assets:

Provided, however, That for the purposes of Secs. 107.403(b),

107.706(b), and 107.710, under which the legality of certain Financings

is conditional upon a need to protect the Licensee's investment, and

for the purpose of Sec. 107.801, under which assumption of control over

a Small Concern is permitted only to protect the Licensee's investment,

Licensees are not considered to have any investment to protect in such

contributed assets unless such assets are included in Regulatory

Capital.

* * * * *

17. Section 107.706 is revised to read as follows:

Sec. 107.706 Retention of investments.

(a) Change in size. A Licensee may retain its investment in a

concern which qualified as small at the time of initial financing, but

which subsequently became large. Subject to Sec. 107.303, additional

Financing may be provided at any time before such concern makes a

public offering of its securities. In addition, stock options,

warrants, or other rights to purchase Equity Securities of such

concern, if acquired while the concern qualified as a Small Concern,

may be exercised even after a public offering has been made.

(b) Change in business activity or ownership--(1) Change within one

year of Licensee Financing. Without SBA's written approval, a Licensee

may not retain its investment in a Portfolio Concern, small or

otherwise, that has become ineligible by reason of a subsequent change

in such concern's business activity within one year from the date of

the Licensee's initial Financing. Any such change shall be presumed to

have been within the contemplation of the Small Concern at the time of

the Licensee's Financing, and shall constitute a default or breach of

the terms of the Licensee's Financing by the Small Concern, thereby

giving the Licensee the right to demand immediate repayment of all

indebtedness and redemption of all equity investments in such concern.

See Sec. 107.305. A Licensee's request to SBA for approval to retain

its investment shall be accompanied by evidence sufficient to rebut

this presumption that the Small Concern's change to an ineligible

business activity within one year of the Licensee's Financing was

within the contemplation of the Small Concern at the time the Licensee

provided Financing and, hence, in violation of applicable regulations.

Such presumption may be rebutted by a showing that the change in

business activity was prompted by an unforeseen change in

circumstances.

(2) Change more than one year after Financing; additional

Financing. If SBA has granted approval for the retention of an

investment as provided in paragraph (b)(1) of this section, or if the

change to an ineligible business has taken place more than one year

after the Licensee's initial Financing, additional Financing may be

provided to the extent necessary to protect the Licensee against the

loss of the amount of its original investment.

18. Section 107.707 is revised to read as follows:

Sec. 107.707 Purchases of securities from another Licensee or from

SBA.

A Licensee may exchange with or purchase for cash from another

Licensee, or from SBA as the receiver or assignee of another Licensee

or former Licensee, Portfolio securities (or any interest therein), but

only on a non-recourse basis, and only if:

(a) The Licensee shall not have at any time more than one-third of

its total assets (valued at cost) invested in such securities; and

(b) The Licensee, if it has previously sold Portfolio securities

(or any interest therein) on a recourse basis, shall include the amount

for which it may be contingently liable in its overline limit under

Sec. 107.303.

19. Section 107.708 is revised to read as follows:

Sec. 107.708 Deposits and investments of idle funds.

(a) General. Except as set forth in paragraphs (b) and (c) of this

section, all funds of a Licensee (other than a petty cash fund of up to

$2,000) shall be deposited without delay in an account in a federally

insured financial institution.

(b) Leveraged Licensees. (1) Funds of a Licensee with outstanding

Leverage, or that has applied for Leverage, that are not invested in

Small Concerns and not reasonably needed for its day-to-day operations

shall be invested in:

(i) Direct obligations of, or obligations guaranteed as to

principal and interest by the United States, the remaining maturities

of which do not exceed fifteen months; or

(ii) In repurchase agreements with federally insured institutions,

the maturity of which does not exceed seven days, in which the

securities being sold and repurchased shall only be direct obligations

of, or obligations guaranteed as to principal and interest by the

United States, such securities to be maintained in a custodial account

at a federally insured institution; or

(iii) In certificates of deposit maturing within one year or less

issued by a federally insured institution, up to the amount of

insurance; or

(iv) In a deposit account in a federally insured institution, up to

the amount of the insurance, subject to a withdrawal restriction not to

exceed one year;

(2) Provided, however, That funds in excess of the insured amount

may be maintained in certificates of deposit or a deposit account in a

federally insured institution which is deemed to be ``well

capitalized'' in accordance with the definition set forth in

regulations of the Federal Deposit Insurance Corporation, as amended

(12 CFR 325.103); and Provided, further, That nothing in this paragraph

shall be interpreted to forbid the temporary deposit, not to exceed 30

days, of Licensee's funds in excess of the insured amount in a

federally insured institution in a transfer account established to

facilitate the receipt and disbursement of funds or to hold funds

necessary to honor Commitments issued by the Licensee. For the purposes

of this paragraph (b) a deposit in, or repurchase agreement with, a

federally insured institution that is an Associate of the Licensee

shall not be considered a Financing of such Associate if the terms of

such deposit or repurchase agreement are the same, or more favorable,

than those available to the general public.

(c) Non-Leveraged Licensees. Funds of an unleveraged Licensee that

are not invested in Small Concerns and not reasonably needed for its

day-to-day operations and exempt from the provisions of paragraph (b)

of this section, but nothing contained in this paragraph shall be

deemed to authorize any Licensee to Finance an Associate in violation

of Sec. 107.903, or to engage in any other activity prohibited by this

part. No Leverage will be extended to any Licensee until such Licensee

is in compliance with paragraph (b) of this section. For purpose of

this paragraph, a Licensee's deposit of funds in a federally insured

institution that is an Associate of the Licensee is not considered a

Financing of an Associate under Sec. 107.903.

20. Section 107.710 is amended by revising paragraph (b)(3), to

read as follows:

Sec. 107.710 Assets in liquidation.

* * * * *

(b) Preservation of assets. * * *

(3) In addition to the amounts authorized by paragraphs (a) and (b)

of this section, a Licensee may make the following required

expenditures allocable to such assets in an aggregate amount which,

together with its total investment attributable thereto, and its

expenditures pursuant to paragraphs (a) and (b) of this section do not

exceed 35 percent of its Regulatory Capital, except as specifically

approved in writing by SBA: Prior mortgage interest; principal

payments; taxes and necessary insurance coverage.

* * * * *

21. Section 107.711 is revised to read as follows:

Sec. 107.711 Financing changes of ownership.

(a) General. A Licensee may finance a change of ownership in a

Small Concern when it will promote the sound development or preserve

the existence of the Small Concern; or will assist in creation of a

Small Concern as a result of a corporate divestiture, or facilitate

ownership in a Disadvantaged Concern.

(b) Special size standard; debt/equity ratios. In determining

whether the existence of a Small Concern has been preserved, or whether

a Small Concern has been created as a result of a divestiture, the

Licensee must make an assessment of the concern as though the change of

control had been accomplished, giving effect to all contemplated

financings, mergers, and acquisitions.

(1) Concerns with not more than 500 employees. Such Financings

shall be permitted where the resulting concern has been determined to

be small (see Sec. 107.304(a)(1)) and its full-time equivalent

employment does not exceed 500 employees.

(2) Concerns with more than 500 employees. If the full-time

equivalent employment exceeds 500 employees, the Financing will only be

permitted when the concern meets one of the following debt/equity ratio

tests:

(i) If the Financing is provided by a Licensee with outstanding

Leverage, the Concern's ratio of debt to equity is no more than 5 to 1;

(ii) If the Financing is provided by a Licensee with no outstanding

Leverage, the Concern's ratio of debt to equity is no more than 8 to 1.

(iii) As used herein, ``debt'' means long-term debt, including

contingent liabilities, but exclusive of accounts payable, short-term

working capital loans which require that the Concern have no

outstanding balance for at least 30 consecutive days during its fiscal

year, operating leases, letters of credit and subordinated notes

payable to the seller, and any other liabilities approved by SBA on a

case-by-case basis; and ``equity'' means common and preferred stock in

the case of a corporation, or contributed capital in the case of a

partnership.

22. Section 107.712 is amended by revising the first sentence of

paragraph (c) to read as follows:

Sec. 107.712 Section 301(d) Licensee wholly or partly owned by

Licensee companies.

* * * * *

(c) Capital contribution. The capital contribution of a participant

Licensee in excess of the minimum capital ($1,500,000, which shall be

in cash or cash equivalents, in U.S. dollars) of the section 301(d)

Licensee, may (notwithstanding Sec. 107.705(a)) be represented by

securities of Small Concerns eligible for investment by a section

301(d) Licensee, at cost or value, whichever is lower. * * *

* * * * *

23. Section 107.901(a) is amended by revising the last sentence

thereof to read as follows:

Sec. 107.901 Prohibited uses of funds.

No funds may be provided to a Small Concern:

(a) Relending, reinvesting, etc. * * * Without SBA's prior written

approval, all Financings pursuant to this proviso shall not exceed the

Licensee's Regulatory Capital as of the close of any full fiscal

year.\8\

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

\8\1940 Act Companies are reminded that sections 12(d) (2) and

(3) of that Act impose additional restrictions on certain

investments otherwise permitted by this Sec. 107.901(a).

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

* * * * *

24. Part 107 is amended by adding, at the end thereof, a new

Appendix III, to read as follows:

Appendix III to Part 107--Valuation Guidelines for SBICs

I. Introduction

This appendix describes the policies and procedures to which

Licensees (SBICs and SSBICs) must conform in valuing their Loans and

Investments and provides guidance as to the techniques and standards

which are generally applicable to such valuations.

The need for clearly defined valuation policies and procedures

and understandable techniques arises in connection with the

requirement that Licensees report the worth of their portfolios to

investors and SBA. This information assists SBA in its assessment of

the overall operational performance and financial condition of

individual Licensees and of the industry.

II. Overall Guidelines

A. Definitions

1. Asset Value means the amount that the general partners or

board of directors of an SBIC have established as a current value in

accordance with its Valuation Policy.

2. Marketable Securities means securities for which market

quotations are readily available and the market is not ``thin'',

either in absolute terms, or relative to the potentially saleable

holdings of the Licensee and other investors with saleable blocks of

such securities. These securities are valued as follows:

(a) For over-the-counter stocks, taking the average of the bid

price at the close for the valuation date and the preceding two

days, and

(b) For listed stocks, taking the average of the close for the

valuation date and the preceding two days. This classification does

not include securities which are subject to resale restrictions,

either under securities laws or contractual agreements, although

other securities of the same class may be freely marketable.

3. Other Securities means all Loans and Investments not defined

in paragraph A.(2) of this section. Such securities shall be valued

at Asset Value. Most SBIC and SSBIC investments will fall in this

classification.

4. Valuation Policy means the official document of a Licensee

that definitively sets forth the Licensee's methods of valuing Loans

and Investments in accordance with the requirements of Sec. 101(g)

and this appendix.

B. Objective

The goal of a Licensee's valuation process is to value its Loans

and Investments. However, the very nature of Licensees' investments

sometimes makes the determination of fair market value

problematical. In most cases there is no market for the investment

at the time of valuation. Therefore, except where market quotations

are readily available and the markets are not ``thin'', the Boards

of Directors or General Partners are necessarily responsible for

determining in good faith the value of Loans and Investments.

Determination of value will depend upon the circumstances in

each case. No exact formula can be devised that will be generally

applicable to the multitude of different valuation issues that will

arise. This is especially true for semiannual valuation updates of

relatively new investments for which current results either exceed

or do not meet the Small Concern's forecasts. A sound valuation

should be based upon all of the relevant facts, with common sense

and informed judgment influencing the process of weighing those

facts and determining their significance in the aggregate.

C. General Considerations

The Asset Value of Loans and Investments will depend upon the

circumstances of each individual case and will be based upon the

nature of the asset and the stage of a company's existence.

In negotiating the terms and conditions of an investment with a

Small Concern, the Licensee, in effect, establishes an initial

valuation for the investment, which is cost. Cost shall be the Asset

Value until there is a basis to increase or decrease the valuation.

Unrealized appreciation should be recognized when warranted, but

should be limited to those investments that have a sustained

economic basis for an increase in value. Temporary market

fluctuations or a temporary increase in earnings should not be the

cause or sole reason for appreciation.

Unrealized depreciation should be recorded when portfolio

companies show sustained unfavorable financial performance.

Continuous close scrutiny of Loans and Investments will provide

insight into the business cycles and problems encountered by small

business concerns. This insight will allow the Licensee to

differentiate between a temporary downturn or setback and a long-

term problem indicating a measurable decline in Asset Value.

When a decline in Asset Value appears permanent, a complete or

partial write-off of the asset (i.e., recording a realized loss

rather than unrealized depreciation) should occur. Some of the more

obvious indications of permanent impairment of an investment include

the termination of business operations, a petition for bankruptcy

protection or liquidation, or the absence of a verifiable forwarding

address of the business or its proprietor(s). Less obvious

situations may include the loss of major revenue accounts, the shut

down of a critical distribution channel, an adverse legal or

regulatory ruling, or the expiration of a priority claim on

collateral in a distressed Small Concern. These and other possible

circumstances should be assessed on a case-by-case basis, with

supporting documentation on file.

D. Valuation Responsibility

As specified in 13 CFR 107.101(g), the Licensee's Board of

Directors or General Partners have the sole responsibility for

determining Asset Value. In determining Asset Value, the Board of

Directors or General Partners must satisfy themselves that all

appropriate factors relevant to a good faith valuation have been

considered and that the methods used are reasonable and prudent and

are consistently applied. Although the Board of Directors or General

Partners have the ultimate responsibility for determining Asset

Value, they may appoint management or other persons to assist them

in such determinations and to provide supporting data and make the

necessary calculations pursuant to the Board's or General Partner's

direction. It is essential that a careful, conservative, yet

realistic approach be taken by Licensees in determining the Asset

Value of each Loan and Investment.

As part of the annual audit of the Licensee's financial

statements, the Licensee's independent public accountant has

responsibility to review the Licensee's valuation procedures and

implementation of such procedures including adequacy of

documentation. The independent public accountant also has reporting

responsibility regarding the results of this review. (See appendix I

to this part, section III and section V, paragraphs I and J).

E. Frequency of Valuation

Loans and Investments shall be valued individually and in the

aggregate by the Board of Directors or General Partners at least

semiannually--as of the end of the second quarter of Licensee's

fiscal year and as of the end of Licensee's fiscal year, Provided

however, That Licensees without Leverage need only perform

valuations once a year. On a case-by-case basis, SBA may require

valuations to be made more frequently. Only valuations performed as

of the fiscal year-end are required to be reviewed by the Licensee's

independent public accountant, as discussed in paragraph D. of this

section. Each Licensee shall forward a valuation report to SBA

within 90 days of the end of its fiscal year in the case of annual

valuations, and within thirty days following the close of other

reporting periods. Material changes in valuations shall be reported

not less often than quarterly within thirty days following the close

of the quarter. Since the valuations will only be as sound as the

timeliness of the financial information upon which they are based,

Licensees shall require frequent financial statements from Small

Concerns. Monthly financial statements are normally appropriate.

F. Written Valuation Policy

Each Licensee shall establish a written Valuation Policy

approved by its Board of Directors or General Partners that includes

a statement of policies and procedures that are consistent with

section III of this appendix.

G. Documentation

Each Licensee shall prepare and retain in its permanent files a

valuation report as of each valuation date documenting, for each

portfolio security, the cost, the current Fair Value and the

previous Fair Value, plus the methodology and supporting data used

to determine the value of each such portfolio security. The minutes

of meetings of Boards of Directors or General Partners at which

valuations are determined will contain a resolution confirming that

the valuations of each portfolio security were determined in

accordance with Licensee's duly adopted valuation procedures and

will incorporate by reference the valuation report signed by each

Director or General Partner along with any dissenting valuation

opinions.

H. Instructions

In section III below, certain sentences are in bold type and

others are in regular type. Those sentences that are in bold type

generally should be included in the Valuation Policy of each

Licensee. However, this exact wording is not mandatory and may be

modified, substituted, added to, or omitted. Sentences in regular

type are commentary provided by SBA that need not be included in a

Licensee's Valuation Policy, but may be adapted, if desired.

I. Approval

1. Any Licensee that utilizes the exact wording of Section III

that is set in bold type, without any additions, deletions, or

changes will be presumed to have an acceptable Valuation Policy.

However, it is acknowledged that this wording may not be directly

applicable to all Licensees, and if a Valuation Policy by an

existing Licensee is written which differs from the bold type,

approval by SBA, in writing, of the Valuation Policy must be

obtained. If changes from the bold type are minor, it is suggested

that the Licensee indicate deletions with a caret (caret) and

underline additions.

2. Applicants for either a 301(c) or 301(d) License must submit

their Valuation Policies for approval as part of the licensing

application process.

III. Valuation Policy

A. General

1. The Board of Directors [General Partners] have sole

responsibility for determining the Asset Value of each of the Loans

and Investments and of the portfolio in the aggregate.

2. Loans and Investments shall be valued individually and in the

aggregate at least semi-annually--as of the end of the second

quarter of the fiscal year-end and as of the end of the fiscal year.

[* * * at least annually--as of the end of the fiscal year.] Fiscal

year-end valuations are audited as set forth in 13 CFR part 107

appendix III, section II, paragraph D.

3. This Valuation Policy is intended to provide a consistent,

conservative basis for establishing the Asset Value of the

portfolio. The Policy presumes that Loans and Investments are

acquired with the intent that they are to be held until maturity or

disposed of in the ordinary course of business.

B. Interest-Bearing Securities

1. Loans shall be valued in an amount not greater than cost with

Unrealized Depreciation being recognized when value is impaired. The

valuation of loans and associated interest receivables on interest-

bearing securities should reflect the portfolio concern's current

and projected financial condition and operating results, its payment

history and its ability to generate sufficient cash flow to make

payments when due.

2. When a valuation relies more heavily on asset versus earnings

approaches, additional criteria should include the seniority of the

debt, the nature of any pledged collateral, the extent to which the

security interest is perfected, the net liquidation value of

tangible business assets, and the personal integrity and overall

financial standing of the owners of the business. In those instances

where a loan valuation is based on an analysis of certain

collateralized assets of a business or assets outside the business,

the valuation should, at a minimum, consider the net liquidation

value of the collateral after reasonable selling expenses. Under no

circumstances, however, shall a valuation based on the underlying

collateral, be considered as justification for any type of loan

appreciation.

3. Appropriate unrealized depreciation on past due interest

which is converted into a security (or added to an existing

security) should be recognized when collection is doubtful.

Collection is presumed to be in doubt when one or both of the

following conditions occur:

(i) Interest payments are more than 120 days past due; or

(ii) The small concern is in bankruptcy, insolvent, or there is

substantial doubt about its ability to continue as a going concern.

a. Licensees may rebut this presumption by providing evidence of

collectibility satisfactory to SBA. Such evidence may include the

existence of collateral, the value of which has been verified

through an appraisal by an independent professional appraiser

acceptable to SBA. Such an appraisal shall be at liquidation value

(net of liquidation costs) and shall have been performed within the

12 months immediately preceding the valuation date. In considering

whether collateral provides an appropriate basis for valuations, SBA

will review the Licensee's operating history for evidence concerning

its willingness and ability to pursue available remedies (including

foreclosure) in default situations.

b. For those Licensees primarily involved in making loans, the

use of a loan classification system is strongly encouraged to help

manage portfolios and determine Asset Values, with loans that

warrant extra attention being flagged by SBIC management. Such a

``watch list'' can also be used to report to the Board of Directors

or General Partner(s). For each loan placed on the watch list, a

reason or statement should describe the particular situation. Danger

signals that should alert the SBIC to potential problems include

delinquency, a lack of profitability, weak or decreasing equity,

increasing debt load, a deteriorating cash position, an abnormal

increase in accounts payable, inaccurate financial information,

insurance cancellation, judgments and tax liens, family problems,

loss of employees, collateral problems, slowdown in inventory

turnover, poor maintenance of plant and equipment, and heavy

reliance on short term debt.

c. Upon careful consideration of all the relevant factors, the

Board of Directors or General Partners shall determine which loans

require recognition of Unrealized Depreciation. It is a good rule of

operation for an SBIC to perform downward valuations earlier rather

than later. When the quality of a loan recovers, a higher Asset

Value may subsequently be assigned.

4. The carrying value of interest bearing securities shall not

be adjusted for changes in interest rates.

5. Valuation of convertible debt may be adjusted to reflect the

value of the underlying equity security net of the conversion price.

a. Accepted methods for valuing convertible debentures generally

involve one of two approaches. The first approach views the

debenture as a debt obligation. Under this approach, the SBIC or

SSBIC should utilize the loan valuation techniques described in this

section above. The second approach considers the conversion of all

convertible securities of the same class into their common stock

equivalent, taking into account dilution, and a subsequent valuation

of the SBIC's or SSBIC's proportionate equity interest. Valuation of

this equity interest should follow the equity valuation techniques

described in Paragraph C. of this section.

b. Normally, the reported value is the higher of these two

alternatives. However, Licensees should disregard higher equity

values and retain lower debt-based valuations if there are

circumstances which make conversion undesirable. When equity

considerations govern the Asset Value assigned, all underlying

factors should be disclosed.

C. Equity Securities--Private Companies

1. Investment cost is presumed to represent value except as

indicated elsewhere in these guidelines.

2. Valuation should be reduced if a company's performance and

potential have significantly deteriorated. If the factors which led

to the reduction in valuation are overcome, the valuation may be

restored.

3. The anticipated pricing of a Small Concern's future equity

financing should be considered as a basis for recognizing Unrealized

Depreciation, but not for Unrealized Appreciation. If it appears

likely that equity will be sold in the foreseeable future at a price

below the Licensee's current valuation, then that prospective

offering price should be weighed in the valuation process.

4. Valuation should be adjusted to a subsequent significant

equity financing that includes a meaningful portion of the financing

by a sophisticated, unrelated new investor. A subsequent significant

equity financing that includes substantially the same group of

investors as the prior financing should generally not be the basis

for an adjustment in valuation. A financing at a lower price by a

sophisticated new investor should cause a reduction in value of

prior securities.

5. If substantially all of a significant equity financing is

invested by an investor whose objectives are in large part

strategic, or if the financing is led by such an investor, it is

generally presumed that no more than 50% of the increase in

investment price compared to the prior significant equity financing

is attributable to an increased valuation of the company.

6. Where a company has been self-financing and has had positive

cash flow from operations for at least the past two fiscal years,

Asset Value may be increased based on a very conservative financial

measure regarding P/E ratios or cash flow multiples, or other

appropriate financial measures of similar publicly-traded companies,

discounted for illiquidity. Should the chosen valuation cease to be

meaningful, the valuation may be restored to a cost basis, or in the

event of significant deterioration in performance or potential, to a

valuation below cost to reflect impairment.

a. Under these conditions, valuation factors that may be

considered, include:

(1) The utilization of a multiple of earnings, cash flow, or

revenues, which are commensurate with the multiples which the market

currently accords to comparable companies in similar businesses and

industries, with an appropriate discount for conditions such as

illiquidity or a minority position. Care should be taken to use only

comparable companies, including not only business similarities but

also similarities as to size, financial condition, and earnings

outlook. However, in order for comparative market prices to be

meaningful, data for a representative sample or similar companies

must be available.

(2) Among the more important factors to be considered in a

particular case are (i) The nature of the business, (ii) the risk

involved, and (iii) the growth, stability or irregularity of

earnings and cash flows. A company with a positive earnings trend

and a favorable outlook may command a capitalization factor

(multiplier) in the marketplace that will result in a stock

valuation well above book value. When the gross value of a small

concern is computed by applying a capitalization rate to pre-

interest, pre-tax earnings, the value of equity securities is

derived by subtracting the outstanding debt of the concern from the

gross value. While capitalization rates do vary, an appropriate rate

can be determined by analyzing rates for comparable companies in the

same industry. Investigating similar companies in the same industry

or geographic area can be done directly or through published

material from sources such as the Value Line, Standard and Poor's,

Robert Morris and Associates, or any other of the numerous sources

available for comparative industry data.

(3) Another method discounts the present value of estimated

future proceeds to a Licensee including dividend income and sales of

securities, using a discount rate that reflects the degree of risk

of the equity interest.

(4) One may also utilize the recent sale prices of comparable

blocks of the issuer's securities in arm's length transactions.

b. Equity interests or limited partnership interests without the

benefit of stock certificates and which generally define a certain

percentage of the profits to be allocated to each of the investors

based on its relative contributions should be valued in a manner

similar to the valuation methods described in this section.

7. With respect to portfolio companies that are likely to face

bankruptcy or discontinue operations for some other reason,

liquidating value may be employed. This value may be determined by

estimating the realizable value (often through professional

appraisals or firm offers to purchase) of all assets and then

subtracting all liabilities and all associated liquidation costs.

a. Liquidation value will depend on the decreasing value of

wasting assets, the costs experienced by the business being

liquidated, the expenses borne by the Licensee in order to be able

to realize any liquidating value, the elapsed time until such net

proceeds can be realized, the ranking of the Licensee's claims

relative to other security interests and subordination agreements,

and the probability of any ultimate realization of value.

b. Incorporating this approach as a normal step in valuation can

provide improved understanding of the downside of an investment.

c. Licensees should recognize unrealized appreciation or

depreciation, as appropriate, on Assets Acquired in liquidation of

Loans and Investments. In order to recognize Unrealized

Appreciation, asset values must be verified by an appraisal which

meets all the conditions specified in the preceding paragraph;

provided, however, that if the assets acquired constitute a going

concern, such assets may be appraised as a going concern rather than

at liquidation value. Unrealized Appreciation may not be recognized

if the Licensee does not benefit from such appreciation. For

example, an asset acquired through foreclosure should not be carried

at a value greater than the defaulted loan balance plus any expenses

and penalties to which the Licensee is entitled.

8. Warrants should be valued at the excess of the value of the

underlying security over the exercise price.

a. Valuation of debt with detachable warrants can be done

similarly to convertible debt by treating the debt and warrants as a

unit, or, alternatively, the debt can be valued on its own basis as

a debt instrument, and the warrants separately. If the warrants are

valued separately, the following factors must be taken into account:

(1) Current value of issued shares.

(2) The differential between the exercise price and the

underlying share values if the current share values are higher than

the exercise price.

(3) Time until expiration dates are reached or dates of changes

in terms of exercise prices.

(4) Number of shares into which the warrants are exercisable on

various dates.

(5) Restrictions on sale of the underlying stock.

(6) Restrictions on the transferability of the warrants.

(7) Registration rights for the warrants or the underlying

shares.

(8) Financial ability of the Licensee to perform the exercise of

its rights or to sell it warrants.

(9) The ultimate desirability, if any, of exercising the rights

given by the warrants.

D. Equity Securities--Public Companies

1. Public securities should be valued as follows:

(a) For over-the-counter stocks, take the average of the bid

price at the close for the valuation date and the preceding two

days, and

(b) For listed stocks, take the average of the close for the

valuation date and the preceding two days.

a. However, securities are not deemed to be freely marketable in

those situations wherein such securities are very thinly or

infrequently traded, or may be lacking in truly representative

market quotations, or where the market for such securities cannot

absorb the quantity of shares which the Licensee and similar

investors may want to sell.

b. In such cases, Asset Value must be determined by the Board of

Directors or General Partners.

2. The valuation of public securities that are restricted should

be discounted appropriately until the securities may be freely

traded. Such discounts typically range from 10% to 40%, but the

discounts can be more or less, depending upon the resale

restrictions under securities laws or contractual agreements.

3. When the number of shares held is substantial in relation to

the average daily trading volume, the valuation should be discounted

by at least 10%, and generally by more.

Dated: March 1, 1994.

Erskine B. Bowles,

Administrator.

[FR Doc. 94-7844 Filed 04-07-94; 8:45 am]

BILLING CODE 8025-01-M