Small Business Investment Companies

SMALL BUSINESS ADMINISTRATION

13 CFR Part 107

Small Business Investment Companies

AGENCY: Small Business Administration.

ACTION: Proposed rule.

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SUMMARY: Title II of Public Law 104-208 (September 30, 1996), entitled

the ``Small Business Programs Improvement Act of 1996'', made a number

of changes to the Small Business Investment Act of 1958, as amended.

For the Small Business Investment Company program, these changes

include provisions affecting capital requirements, Leverage eligibility

and fees, and the status of Section 301(d) Licensees. This proposed

rule would implement the statutory provisions; in addition, it would

make various technical corrections and clarifications, as well as

changes intended to improve the fairness and flexibility of the

regulations.

DATES: Comments must be submitted on or before November 13, 1997.

ADDRESSES: Written comments should be addressed to Don A. Christensen,

Associate Administrator for Investment, U.S. Small Business

Administration, 409 3rd Street, S.W., Suite 6300, Washington, D.C.

20416.

FOR FURTHER INFORMATION CONTACT: Leonard W. Fagan, Investment Division,

at (202) 205-7583.

SUPPLEMENTARY INFORMATION: This proposed rule would implement the

provisions of Title II of Public Law 104-208 (September 30, 1996) which

relate to small businesses investment companies (SBICs). This rule

would also make certain other substantive changes, clarifications and

technical corrections to the regulations governing SBICs, including

those concerning portfolio diversification, Cost of Money, and the

computation of distributions to be made by SBICs that have issued

Participating Securities.

Section 301(d) Licensees

Prior to October 1, 1996, an SBIC program applicant could be

licensed under either section 301(c) or section 301(d) of the Small

Business Investment Act of 1958, as amended (Act). A Section 301(d)

Licensee, also known as a ``specialized SBIC'' or ``SSBIC'', agreed to

invest only in businesses owned and controlled by socially or

economically disadvantaged individuals. In return, a Section 301(d)

Licensee received certain benefits not available to other SBICs, such

as eligibility for certain types of subsidized Leverage (as defined in

Sec. 107.50).

Effective October 1, 1996, section 208(b)(3) of Public Law 104-208

repealed section 301(d) of the Act. However, the repeal provision was

accompanied by the following language: ``The repeal * * * shall not be

construed to require the Administrator to cancel, revoke, withdraw, or

modify any license issued under section 301(d) of the Small Business

Investment Act of 1958 before the date of enactment of this Act.''

This proposed rule would revise several sections in part 107 to

implement this statutory change. The revisions would eliminate

provisions relating to the licensing of new SSBICs while retaining

rules governing the operations of existing SSBICs.

Thus, in Sec. 107.50, a ``Section 301(d) Licensee'' would be

defined as ``a company licensed prior to October 1, 1996 under section

301(d) of the Act as in effect on the date of licensing, that may

provide Assistance only to Disadvantaged Businesses.'' Current

Sec. 107.110, which deals with organization of a section 301(d) license

applicant, would be removed. Similarly, Sec. 107.120 would be revised

by

[[Page 53254]]

eliminating references to the licensing of an SSBIC to operate as the

subsidiary of another Licensee or group of Licensees. Any existing

SSBIC which was licensed as a subsidiary would be permitted to continue

its operations under the same conditions as before; however, the

proposed rule would not allow an existing SSBIC that is not already a

subsidiary of another Licensee to become one. SBA has noted no demand

on the part of existing Licensees to reorganize in this fashion.

The proposed revision of Sec. 107.230(d)(4) would eliminate future

use of the provision which allowed Section 301(d) Licensees to include

in their Private Capital, without limitation, funds indirectly obtained

from State or local government sources. Under the proposed rule, such

funds would be included in Private Capital only if they were invested

in or committed in writing to the Licensee prior to October 1, 1996.

Otherwise, Section 301(d) Licensees would be limited to State and local

government funds equal to 33 percent of their Regulatory Capital under

current Sec. 107.230(d)(3), which applies to all Licensees. This change

is necessary to bring the regulations into conformity with the Act as

amended by Public Law 104-208.

Other proposed changes reflect amendments to the Act which

eliminated subsidized SBA Leverage. Such Leverage was previously

available to SSBICs in the form of Debentures with an interest rate

subsidy or Preferred Securities with a 4 percent dividend. Although

subsidized Leverage can no longer be issued, the Act does not require

SSBICs to prepay or redeem such Leverage prior to its scheduled

maturity. In addition, an SSBIC may apply for any type of non-

subsidized Leverage (Debentures or Participating Securities) for which

it is eligible.

To implement these changes, current Secs. 107.1100 and 107.1110

would be condensed into proposed Sec. 107.1100. The proposed section

would eliminate the separate descriptions of the types of Leverage

available to Section 301(c) and Section 301(d) Licensees and would

eliminate all references to subsidized Leverage.

SBA is also proposing revisions to Sec. 107.1160 in order to

conform with the Act. The entire section, which sets forth conditions

governing the issuance of Leverage by a Section 301(d) Licensee, would

apply only to Leverage issued on or before September 30, 1996. After

that date, a Section 301(d) Licensee would be eligible to apply for

Leverage under Sec. 107.1150, subject to the same terms and conditions

as other Licensees.

Similarly, the proposed revisions to the definition of ``Preferred

Securities'' in Sec. 107.50 and to Secs. 107.1400, 107.1420 and

107.1430 reflect the fact that SBA's authority under the Act to

purchase Preferred Securities ceased as of October 1, 1996. The

appropriation of funds for such securities actually ended as of October

1, 1995, but some Preferred Securities were issued in fiscal year 1996

by Licensees drawing against SBA's commitments of fiscal year 1995

funds.

Finally, the provisions of current Sec. 107.1350 which allow a

Section 301(d) Licensee to retire certain Debentures by issuing

Preferred Securities would be eliminated. The remainder of the section,

dealing with the retirement of Debentures through the issuance of

Participating Securities, would be redesignated as Sec. 107.1585 and

would apply to both SBICs and SSBICs.

Common Control

``Common Control'' as defined in Sec. 107.50 currently means ``a

condition where two or more Licensees, either through ownership,

management, contract, or otherwise, are under the Control of one group

or Person.'' However, the defined term as used in paragraphs (4) and

(5) of the definition of ``Associate'' is clearly intended to refer to

Persons other than Licensees. To accommodate this usage, the proposed

rule would revise the Common Control definition to refer to ``two or

more Persons'' rather than ``two or more Licensees''. The portion of

the definition under which certain circumstances establish a

presumption of Common Control would continue to apply only to two or

more Licensees.

Management and Ownership Diversity

Section 208(c)(3) of Public Law 104-208 amended the Act to require

that new SBICs have diversity between management and ownership. For any

SBIC licensed on or after September 30, 1996, SBA must ensure that the

management ``is sufficiently diversified from and unaffiliated with the

ownership of the licensee in a manner that ensures independence and

objectivity in the financial management and oversight of the

investments and operations of the licensee.'' SBA has required

diversity between management and ownership since 1994 for Participating

Securities issuers and since 1996 for other new leveraged Licensees.

Therefore, in response to the new statutory requirement, SBA is

proposing only minor changes to improve the effectiveness of

Sec. 107.150.

Under current Sec. 107.150(a), a Licensee or license applicant can

demonstrate diversity if at least 30 percent of its Regulatory Capital

is held by at least three shareholders or limited partners (or one

acceptable Institutional Investor) unrelated to management.

Specifically, these investors cannot be Associates of the Licensee or

applicant, or Affiliates of any of its Associates. The proposed rule

would retain these concepts, but would eliminate the phrase ``Affiliate

of an Associate''. Instead, proposed Sec. 107.150(a) would specify that

to qualify for diversity purposes, an investor must not be an Associate

of the Licensee or applicant and must not ``Control, be Controlled by,

or be under Common Control with'' an Associate. SBA does not intend for

this language to be substantively different from the current language,

but believes that readers may find it easier to understand. In

addition, the proposed rule would address certain other characteristics

of ``diversity investors'' which are not covered in the current

regulation, but which SBA considers important.

Proposed Sec. 107.150(a) would specify that the investors relied

upon to satisfy the diversity requirement cannot be Affiliates of one

another. SBA believes that if such investors are related parties, the

requirement that there be at least three of them is rendered

essentially meaningless. The proposed rule also would give SBA

discretion to reject for diversity purposes an investor whose ownership

interest is not significant, either in terms of absolute dollars or

percentage of ownership. This provision underscores the purpose of the

diversity rules, which is to encourage the presence of investors who

are likely to have a serious interest, similar to SBA's, in the fair

and prudent management of the SBIC.

The proposed changes reflect policies which SBA has been developing

in its review of license applications. In particular, SBA has used

informal internal guidelines to evaluate whether a proposed investor's

interest is substantial enough to qualify for diversity purposes. SBA

is continuing to refine these guidelines and expects to incorporate

them into its standard operating procedures.

Capital Requirements

Under the Act as amended by section 208(c) of Public Law 104-208,

SBICs licensed on or after October 1, 1996 must meet increased minimum

capital requirements. Previously, the statutory minimum capital

requirement was $2.5 million. The new requirements would be implemented

in proposed Sec. 107.210, which combines and revises elements of

current Secs. 107.210 and 107.220. Proposed Sec. 107.210(a)(1) would

require

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a company that does not wish to be eligible to issue Participating

Securities to have Regulatory Capital of at least $5,000,000. As an

exception to this general rule, SBA would be able to license an

applicant with Regulatory Capital of at least $3,000,000, but only if

the applicant meets certain conditions set forth in the proposed

regulation. As mandated by the Act, this exception is limited to those

instances where ``special circumstances and good cause'' can be shown.

Proposed Sec. 107.210(a)(2) contains essentially the same language

as the current Sec. 107.220(a). It would require a company licensed on

or after October 1, 1996, that wishes to be eligible to apply for

Participating Securities to have Regulatory Capital of at least

$10,000,000, with a permitted exception for an applicant which

demonstrates to SBA's satisfaction that it can be financially viable

over the long term with a lower amount (but under no circumstances less

than $5,000,000). SBA regulations have required this level of

Regulatory Capital for Participating Securities issuers since 1994.

The proposed rule would not permit prospective Participating

Securities issuers to be licensed pursuant to the exception available

to other applicants, under which a license may be granted with

Regulatory Capital as low as $3,000,000. For applicants planning to

issue Participating Securities, SBA believes that the ability to meet

the standard minimum capital requirement is an important indicator of

the credibility of management. SBA also doubts that any such applicant

can demonstrate financial viability with Regulatory Capital of only

$3,000,000, even on a temporary basis.

In addition to the Regulatory Capital requirements described above,

proposed Sec. 107.210(a) would also require any company licensed on or

after October 1, 1996, to have Leverageable Capital of at least

$2,500,000. Leverageable Capital is a subset of Regulatory Capital;

while both include capital actually contributed to a Licensee by its

private investors, the major difference between them is that Regulatory

Capital also includes the Licensee's unfunded binding commitments from

Institutional Investors. The proposed rule, which is consistent with

SBA's current licensing policy, reflects the Agency's belief that the

presence of a certain minimum level of Leverageable Capital

demonstrates an applicant's seriousness and readiness to operate

actively as an SBIC.

The proposed rule would not require SBICs licensed before October

1, 1996 to increase their capital. Under proposed Sec. 107.210(b), such

companies would have to meet the applicable minimum capital

requirements under the regulations in effect on September 30, 1996 (see

Secs. 107.210 and 107.220 as in effect on that date). These

requirements vary depending upon the date a company was licensed and

the type of SBA Leverage it has issued or wants to issue.

See also the section of this preamble entitled ``Eligibility for

Leverage and Leverage Commitments''.

Valuations

Section 208(f)(2) of Public Law 104-208 included one provision

related to the valuation of portfolio securities held by Licensees

which was not already reflected in the regulations. Under this

provision, as part of the annual audit of a Licensee's financial

statements, the independent auditor must provide to SBA a statement

that the Licensee's valuations were performed in accordance with its

SBA-approved valuation policy, as required by section 310(d)(2) of the

Act. SBA has included this requirement in proposed Sec. 107.503(e). SBA

is also proposing various non-substantive wording changes in

Sec. 107.503 to improve the clarity of the section.

Reports To Be Filed With SBA

Current Sec. 107.660 requires an SBIC to provide SBA with copies of

reports given to its investors or filed with the Securities and

Exchange Commission, and to notify SBA when it becomes a party to

litigation or other proceedings. Proposed Sec. 107.660(d) would add a

requirement for a Licensee to notify SBA if an officer, director,

general partner or other Control Person is charged with or convicted of

any criminal offense other than a misdemeanor involving a minor motor

vehicle violation. Key personnel associated with a license applicant

currently must provide this type of information as part of the personal

history statement included in the SBIC license application. The purpose

of the proposed rule is to give SBA a mechanism for updating such

information as needed to ensure the integrity of the SBIC program.

Financing of Smaller Enterprises

Since April 1994, SBICs have been required to direct a certain

percentage of their investment activity to businesses which fall

significantly below the maximum size permitted for a Small Business.

These businesses were originally referred to as ``Smaller Businesses'',

a term which was changed to ``Smaller Enterprises'' in a final rule

published in the Federal Register on March 13, 1997 (62 FR 11759).

Under proposed Sec. 107.710, the basic requirement for a Licensee

to invest at least 20 percent of the total dollar amount of its

Financings in Smaller Enterprises would remain unchanged. However,

proposed Sec. 107.710(c) would add a new requirement to implement

section 208(c)(2) of Public Law 104-208. This provision applies to

SBICs licensed on or before September 30, 1996, which issue Leverage

after that date and which do not meet the current minimum capital

requirement (Regulatory Capital of at least $5,000,000 for Debentures

or at least $10,000,000 for Participating Securities). For such

Licensees, at least 50 percent of the aggregate dollar amount of their

Financings extended after September 30, 1996 must be invested in

Smaller Enterprises. As a practical matter, SBA has found that

Licensees to which this requirement applies typically invest almost

exclusively in Smaller Enterprises.

Like the current regulation, the proposed rule would measure

compliance with the requirements to finance Smaller Enterprises as of

the end of a Licensee's fiscal year. Under current Sec. 107.710(e), a

Licensee which has not achieved the required percentage of investments

in Smaller Enterprises is allowed one additional year to bring its

portfolio into compliance. The proposed rule would retain this

provision. However, such a Licensee would not be eligible for

additional Leverage until it reaches the required percentage. See also

the section of this preamble entitled ``Eligibility for Leverage and

Leverage Commitments''.

Passive Businesses

SBICs are generally prohibited from investing in passive

businesses. However, an exception is provided for holding companies

which pass through the financing proceeds to an active subsidiary. The

precise nature of this exception has changed over time. Prior to 1996,

the general prohibition did not apply ``to any Small Concern wholly

owning another eligible Small Concern engaged in a regular and

continuous business operation.'' Under current Sec. 107.720(b)(2),

which became effective January 31, 1996, an SBIC may finance a passive

business ``if, for all Financings extended, it passes substantially all

the proceeds through to the same eligible Small Business that is not

passive.''

The goal of the 1996 revision was to eliminate the requirement for

the passive business to be the 100 percent owner of the operating

business, while still ensuring some substantial relationship between

the two by

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allowing funds to be passed through to only one active entity. SBA now

believes that the latter provision may unnecessarily restrict some

Small Businesses. For example, a holding company may be established

with two operating subsidiaries, one engaged in manufacturing and the

other in distribution of the manufactured product. Under the current

regulation, if the holding company received financing from an SBIC, it

could pass through the proceeds to only one subsidiary, even though

both subsidiaries are essentially components of the same business.

At the same time, SBA continues to believe that there must be a

significant relationship between a financed passive business and the

active business which ultimately receives the proceeds. To satisfy this

goal, proposed Sec. 107.720(b)(2) would permit financing of a passive

Small Business if it passes substantially all the proceeds through to

one or more ``subsidiary companies'', defined as companies in which the

financed passive business owns at least 50 percent of the voting

securities. The current provision limiting the pass-through of proceeds

to only one Small Business would be eliminated.

Co-Investment With Associates

Licensees may co-invest with Associates, subject to the conditions

in Sec. 107.730(d). This section sets forth certain circumstances under

which the terms of a co-investment are presumed to be fair and

equitable to the SBIC, so that no specific demonstration of equity is

required. Under current Sec. 107.730(d)(3)(iv), this presumption

applies to co-investments by two non-leveraged SBICs. The proposed rule

would apply the same presumption to co-investments by a non-leveraged

SBIC and its non-SBIC Associate. The rationale behind the presumption

is the same in both cases: SBA has no financial exposure, and is

therefore unconcerned that a Licensee may be disadvantaged relative to

its Associate.

Portfolio Diversification Requirements

Under current Sec. 107.740, a leveraged SBIC may not have more than

20 percent of its Regulatory Capital invested in or committed to a

single Small Business or group of related businesses, unless SBA gives

its prior written approval (for SSBICs, the limit is 30 percent of

Regulatory Capital). The purpose of this ``overline'' limit is to avoid

excessive risk by ensuring a certain degree of portfolio

diversification.

Since the beginning of the Participating Securities program, SBA

has been aware that the current regulation may have an unintended

effect. Participating Securities issuers operate under detailed rules

governing distributions to SBA as well as to their private investors.

These regulations permit a Licensee to return capital to its non-SBA

partners under certain conditions, thereby reducing its Regulatory

Capital and overline limit. SBA is concerned that a Licensee in these

circumstances may suddenly have multiple violations of the overline

regulation, even though its portfolio was sufficiently diversified

based on its original Regulatory Capital.

To address this problem, proposed Sec. 107.740(a) would base a

Licensee's maximum permitted investment in or commitment to a Small

Business on its Regulatory Capital at the time the investment or

commitment is made. The limit would apply to the total amount of

Financings and Commitments extended to the Small Business by the

Licensee. For example, if a Licensee had invested $1,000,000 in a Small

Business and wanted to provide follow-on financing at a time when its

Regulatory Capital was $8,000,000, the amount of the follow-on

financing could not exceed $600,000 (20 percent of $8,000,000, minus

the $1,000,000 already invested).

It should be noted that the proposed rule would require a Licensee

to be in compliance at the date of a Commitment and at the date of a

Financing. Thus, a Licensee preparing to fund a Commitment it had made

to a Small Business must ensure that it has sufficient Regulatory

Capital as of the closing date to support the completed Financing.

Proposed Sec. 107.740(a) would continue to permit overline

investments with the prior written approval of SBA.

Cost of Money

Current Sec. 107.855 sets forth limits on interest rates and other

charges that SBICs may impose on Small Businesses. SBA is proposing

three changes to these ``Cost of Money'' rules. The first change

reflects section 208(d)(6) of Public Law 104-208, under which SBICs

must pay to SBA an additional charge of 1 percent per year on any

Leverage issued after September 30, 1996 (except for draws against

commitments made by SBA in fiscal year 1996). The proposed rule would

allow a Licensee to include this charge in its base rate when computing

its Cost of Money ceiling. The base rate would be equal to either the

current Debenture Rate plus the 1 percent charge (see Sec. 107.855(c)),

or the Licensee's own Cost of Capital with the 1 percent charge treated

as additional interest expense in the computation (see

Sec. 107.855(d)). Although this change may increase the cost of

borrowing for some Small Businesses, SBA believes that it is warranted

because it reflects the increase in Licensees' cost of funds. There

would be no change in the basic Cost of Money limitations of 19 percent

for Loans and 14 percent for Debt Securities which Licensees may use

regardless of the level of prevailing interest rates.

For Section 301(d) Licensees which elect to compute a Cost of Money

ceiling based on their own Cost of Capital, proposed Sec. 107.855(d)(4)

would clarify that interest expense on a subsidized SBA-guaranteed

debenture may be computed using the debenture's face (unsubsidized)

interest rate. This provision was inadvertently deleted when the

regulations were revised in January 1996, but has since remained in

effect as a matter of SBA policy.

Finally, SBA is proposing to clarify the treatment of warrants with

respect to Cost of Money. The regulations governing Cost of Money apply

to Loans (which have no provision for obtaining equity in a Small

Business) and Debt Securities (which involve some type of equity

feature). SBA generally interprets these rules to exclude from Cost of

Money any returns realized on the equity portion of a Debt Security

because such returns normally are neither assured nor predictable.

However, SBA has become aware of certain situations under which the

current regulations may effectively require inclusion of the value of

warrants in Cost of Money.

This may occur when a Licensee lends cash to a Small Business, and

receives in return not only a note for the amount lent, but also

detachable warrants to acquire equity in the Small Business. Generally

accepted accounting principles require the Licensee to determine the

fair value, if any, of the warrants received and to record the warrants

at that value, while discounting the note by the same amount. The

discount is then amortized to interest income over the life of the

note. Under current Sec. 107.855(f), the income created through

amortization of the discount is included in Cost of Money.

SBA believes that this provision unduly disadvantages SBICs which

allocate substantial value to the warrants acquired, relative to SBICs

which assign zero or nominal value. Typically, SBICs invest in private

companies which have no readily ascertainable market value. Thus, the

value allocated to such companies' warrants is often determined through

negotiation rather than the application of precise methods. Given the

level of

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uncertainty associated with such valuations, SBA prefers to create a

level playing field in which all returns realized on detachable

warrants are excluded from Cost of Money.

Proposed Sec. 107.855(g)(1) would address this concern by allowing

a specific exclusion from Cost of Money for a discount on the loan

portion of a Debt Security, if the discount results solely from the

allocation of fair value to detachable stock purchase warrants as

required by generally acceptable accounting principles. Discounts in

general would still be included in Cost of Money. For example, if a

Licensee provided $1,000,000 to a Small Business and received a note

for $1,100,000, the amortization of the $100,000 discount over the life

of the note would be treated as additional interest income for Cost of

Money purposes.

Control

Proposed Sec. 107.865 contains two clarifications to the existing

regulation concerning Control of a Small Business by an SBIC. Under

current Sec. 107.865(c), a Licensee can rebut a presumption of Control

if certain criteria concerning the ownership of the Small Business and

the composition of its board of directors are satisfied. The proposed

rule would eliminate references to the rounding of percentages in

determining whether the board of directors meets the established

criteria. The current language is confusing because it is unclear how

the rounding is to be applied; SBA believes that removing it would

permit a plain reading of the regulation.

The second proposed clarification involves current Sec. 107.865(d),

which sets forth the conditions under which a Licensee may take

temporary Control of a portfolio company. The proposed rule would

permit such Control where reasonably necessary for the protection of a

Licensee's existing investment; the only revision is the addition of

the word ``existing''. The proposed language is not a substantive

change; it is intended simply to make explicit SBA's long-standing

interpretation of this provision.

Eligibility for Leverage and Leverage Commitments

Section 208 of Public Law 104-208 established certain requirements

which an SBIC must satisfy in order to obtain SBA Leverage. Proposed

Sec. 107.1120 (c) and (d) would implement these requirements. An SBIC

licensed after September 30, 1996, with Regulatory Capital of less than

$5,000,000 would be ineligible for Leverage until it reached the

$5,000,000 level. An SBIC licensed on or before September 30, 1996,

would not be required to increase its capital in order to obtain

additional Leverage; however, if its Regulatory Capital was less than

$5,000,000 ($10,000,000 for a company seeking to issue Participating

Securities), it would have to certify in writing that at least 50

percent of the aggregate dollar amount of its Financings extended after

September 30, 1996 would be provided to Smaller Enterprises (see also

proposed Sec. 107.710(c)). Finally, any Licensee seeking Leverage would

be required to certify in writing that it is in compliance with the

general requirement to provide 20 percent of its total Financings to

Smaller Enterprises under Sec. 107.710(b).

SBICs can obtain Leverage by applying directly for funding when it

is needed or by obtaining a Leverage commitment from SBA which it can

draw down over a period of time. SBA is proposing minor changes to the

current rules governing the commitment process. The proposed rule would

eliminate the minimum and maximum amounts for a Leverage commitment in

current Sec. 107.1200(c). SBA believes that these limits are

unnecessary. Under the proposed rule, commitment amounts would have to

be in multiples of $5,000 to accommodate requirements of the Leverage

funding process; in all other respects, the amount of a commitment

would be at SBA's discretion. Similarly, the current limitations in

Sec. 107.1230(b) on the amount that a Licensee can draw against its

commitment would be eliminated. The proposed rule would require draws,

like commitments, to be in multiples of $5,000; in addition, SBA would

have discretion to determine a minimum draw amount, and would publish

notice of any such determination in the Federal Register from time to

time.

Leverage Fees

SBA is proposing changes in Secs. 107.1130 and 107.1210 to

implement provisions of section 208(d)(6) of Public Law 104-208 which

affect the fees SBICs must pay in order to obtain SBA Leverage. These

fee changes were effective October 1, 1996, and were implemented on an

interim basis by SBA Policy Notice 1000-6.

Under proposed Sec. 107.1130, a Licensee would pay a nonrefundable

``leverage fee'' to SBA when Debentures or Participating Securities are

issued. The fee is 3 percent of the face amount of the Leverage issued,

replacing the 2 percent user fee and the 1 percent commitment fee

previously in effect. If a Licensee receives a Leverage commitment from

SBA, it must prepay the 3 percent fee at the time it receives the

commitment (see proposed Sec. 107.1210(a)); otherwise, the fee is

payable when the Leverage is issued.

Proposed Sec. 107.1130(d) would require a Licensee to pay to SBA an

additional ``Charge'' on Debentures and Participating Securities (see

also Sec. 107.50 for the definition of this proposed new term). For

both types of Leverage, the Charge is 1 percent per annum. The Charge

is payable under the same terms and conditions as the interest on

Debentures or the Prioritized Payments on Participating Securities, as

applicable. Thus, a Debenture issuer would pay the Charge in two semi-

annual installments together with its interest payments. In contrast, a

Participating Securities issuer would pay the Charge only when it had

profits and was distributing Prioritized Payments under Sec. 107.1540.

The Charge would not apply to Leverage drawn down against a commitment

obtained from SBA on or before September 30, 1996.

Participating Securities--General

SBICs began to issue Participating Securities in 1995. As Licensees

and SBA have gained experience with the program, there have been a

number of regulatory changes intended to correct errors and to

eliminate inconsistencies and confusing language. The proposed rule

continues this process of correction and clarification, and also

includes certain substantive changes.

Current Sec. 107.1500 sets forth general terms and conditions of

the Participating Security. One of these conditions, set forth in

Sec. 107.1500(b)(4), is that a Licensee must make Equity Capital

Investments equal to the amount of Participating Securities it issues,

and must maintain such investments in an amount equal to its

outstanding balance of Participating Securities. The proposed rule

would implement a provision of Public Law 104-208 by eliminating the

maintenance requirement. Thus, a Licensee would be responsible only for

investing the appropriate dollar amount in Equity Capital Investments,

and would not have to be concerned with the timing of the liquidation

of those investments. The same change would also be reflected in

proposed Sec. 107.1820, which sets forth conditions that an SBIC must

comply with in connection with its issuance of Participating

Securities. In this section, under paragraph (e)(9), the failure to

maintain a specified amount of Equity Capital Investments would be

eliminated from the list of Restricted Operations Conditions.

Proposed Sec. 107.1500(e), concerning amounts to be paid upon

redemption of Participating Securities, includes the

[[Page 53258]]

new 1 percent annual Charge on Leverage issued on or after October 1,

1996 (see the section entitled ``Leverage Fees'' in this preamble).

Proposed Sec. 107.1500(f), concerning the priority of Participating

Securities when a Licensee liquidates, reflects the same change. In

addition, this paragraph would clarify that only Earned Prioritized

Payments (that is, those Prioritized Payments which the Licensee has

sufficient profits to pay) have priority in liquidation; the Licensee

has no obligation to pay Accumulated Prioritized Payments (those not

covered by available profits).

Liquidity Requirements for Participating Securities

The proposed rule includes two minor changes to the liquidity

requirements in Sec. 107.1505. Currently, a Licensee must perform the

liquidity impairment computation at the end of its fiscal year, when it

applies for Leverage, and when it intends to make a Distribution. Under

proposed Sec. 107.1505(a)(2), SBA would be able to exempt a Licensee

applying for Leverage from the computation requirement. SBA has found

that many SBICs in the early stages of their existence are extremely

liquid; in these cases, the Agency believes that the formal liquidity

computation provides no additional useful information and need not be

performed.

The second proposed change involves the computation of the

liquidity ratio in Sec. 107.1505(b). Various components of the ratio

are assigned weights which reflect the ease and/or probability of their

conversion to cash. One of the components of ``Total Current Funds

Available'' (the numerator of the liquidity ratio) is Publicly Traded

and Marketable Securities, as reported on SBA Form 468. Under the

current regulation, a Licensee is given credit for 65 percent of the

reported value of these securities in the liquidity computation. In

contrast, the proposed rule would allow the Licensee to count 100

percent of the reported value as a source of liquidity. SBA is

proposing this change because Licensees are expected to take

appropriate discounts (for restrictions, large holdings relative to

trading volume, etc.) when valuing their securities, as required by

SBA's valuation guidelines for SBICs. Since these discounts are already

reflected in the portfolio valuations reported on Form 468, SBA

considers it unnecessary to discount these values further in the

liquidity computation.

Earmarked Profit (Loss)

Under Sec. 107.1510, Participating Securities issuers are required

to compute Earmarked Profit (Loss) as a preliminary step in determining

the amounts of various Distributions. SBA is proposing two changes to

this section. The first would affect only a Licensee holding assets not

subject to SBA Profit Participation (``non-Earmarked Assets''). For a

hypothetical SBIC in this situation (none are currently licensed), the

proposed rule would simplify the computation of the ``Earmarked Asset

Ratio''. This ratio is intended to measure the proportion of the total

portfolio which consists of Earmarked Assets, but is currently

complicated by the inclusion of a factor described as ``weighted

average uninvested proceeds of Participating Securities''. SBA believes

that this amount would be extremely difficult, if not impossible, to

compute in practice; even if it could be determined, it would have

little effect on the resulting ratio because it is included in both the

numerator and denominator. Therefore, SBA is proposing to eliminate

this factor entirely from the Earmarked Asset Ratio computation in

Sec. 107.1510(c). The proposed rule would also simplify the Earmarked

Asset Ratio formula by replacing ``weighted average'' Earmarked Assets

and ``weighted average'' Loans and Investments with simple averages.

The intent of this change is that the ``average'' amounts specified

would represent average monthly balances, as computed by the

Participating Securities software developed by SBA. The Agency believes

this method provides reasonable precision without requiring detailed

tracking of the number of days outstanding for each portfolio

investment, as the weighted average method requires.

The other proposed change affecting the Earmarked Profit (Loss)

computation is in Sec. 107.1510(d)(1)(ii), which deals with the

amortization of leverage fees paid to SBA and partnership syndication

costs incurred by an SBIC. Currently, for the purpose of computing

Earmarked Profit (Loss), such costs must be amortized over five years.

The proposed rule would require amortization over not less than five

years. This change would accommodate companies which amortize the fees

over a longer period for financial statement purposes and would prefer

not to make an additional adjustment when performing the required

profit computations.

Prioritized Payments

Section 107.1520 tells a Licensee how to compute Prioritized

Payments and how to determine whether it has profits which will cause

Prioritized Payments to become ``earned'' and therefore payable to SBA.

Three changes to this section are proposed. First, the proposed rule

would implement a provision of Public Law 104-208 by including

``Charges'' (the 1 percent annual fee discussed in this preamble under

the heading ``Leverage Fees'') on outstanding Participating Securities

in the required computations. Although Charges are not part of

Prioritized Payments, they are payable under the same terms and

conditions, as set forth in the proposed section.

Second, the computation of profit for the purposes of Sec. 107.1520

would be revised under proposed Sec. 107.1520(d). Under the current

regulations, a Licensee's ``profit'' equals its cumulative Earmarked

Profit minus its cumulative Earned Prioritized Payments from prior

periods. This computation ignores the fact that some or all of the

profit computed in this manner may have already been distributed under

other sections of the regulations, either to SBA as Profit

Participation or to the Licensee's private investors. SBA received no

comments addressing this concern when the regulations governing

Participating Securities were originally proposed in April 1994 or

revised in January 1996; nevertheless, the Agency is concerned that the

current regulation may, in effect, place duplicate claims on the same

income. The proposed rule would take prior profit distributions into

account in determining whether a Licensee has profits which can be used

to pay Prioritized Payments.

Third, proposed Sec. 107.1520(f) would provide additional detail

concerning the computation of Adjustments, a type of compounding of

unpaid Prioritized Payments. The current regulation is written in

general terms which do not explain exactly how certain amounts should

be calculated. The proposed rule follows the method which is currently

used in the software developed by SBA to perform the allocation and

distribution computations required for Participating Securities.

Profit Participation

An SBIC which has issued Participating Securities must allocate

Profit Participation to SBA when it has earned profits over and above

the amount necessary to pay its Prioritized Payments in full. Under

current Sec. 107.1530, Profit Participation is determined by computing

a ``Base'' and a ``Profit Participation Rate'', and multiplying the

Base by the Rate. The proposed rule would modify both the Base and the

Rate under certain circumstances.

[[Page 53259]]

The Base for Profit Participation represents a cumulative measure

of a Licensee's Earmarked Profit after Prioritized Payments,

Adjustments and Charges. A Participating Securities issuer must compute

its Base as of the end of each fiscal year, but may also compute the

Base for a period of less than one year in order to make an interim

distribution of profits. If an SBIC elects to make such a distribution,

it faces the possibility that the Profit Participation it pays to SBA

for the interim period will be greater than the Profit Participation it

would have been obligated to pay had it waited until the end of the

fiscal year. This can happen because the SBIC suffers losses during the

remainder of the year, or simply because additional Prioritized

Payments accumulate during that time; either or both of these factors

would reduce the SBIC's year-end Base. Under current Sec. 107.1530(c),

an SBIC which has paid ``excess'' Profit Participation under these

conditions can treat the excess as ``Unused Loss'' at year end, thereby

reducing the Base which it will use the next time it computes Profit

Participation. However, this approach captures only a part of the

SBIC's loss; the actual loss incurred between the interim distribution

date and the fiscal year end is equal to the difference between the

interim and year-end Bases, not just the Profit Participation computed

on that difference. For this reason, SBA is concerned that the current

regulation may impose a significant penalty on a Licensee which chooses

to make an interim distribution, and may unduly distort an SBIC's

decisions concerning the timing of distributions. Proposed

Sec. 107.1530(c) would allow a Licensee in the circumstances described

to treat the full amount of the difference between its interim and

year-end Bases as Unused Loss.

Most SBICs operate for a period of time before issuing

Participating Securities; in some cases, companies are already

investing actively even before they are licensed. In the computation of

the Base, the current regulations do not address the question of

whether net income or loss from fiscal years prior to the issuance of

Participating Securities may be included. Under proposed

Sec. 107.1530(c)(3), a Licensee would be permitted to include prior

losses in its Base with SBA approval, which would be required only once

when the Licensee computes the Base for the first time. SBA expects to

approve inclusion of prior losses in most cases, but is proposing the

approval requirement to cover unusual circumstances, such as a company

with non-Earmarked Assets or one which has operated for an extended

period of time before issuing Participating Securities. The proposed

rule does not discuss net income realized in prior fiscal years because

SBA has not seen this situation in practice; the Agency considers this

an unlikely occurrence which would be handled on a case by case basis.

The Profit Participation Rate is computed using a formula in which

the key variable is the ratio of Participating Securities to

Leverageable Capital (the ``PLC ratio''). Proposed Sec. 107.1530(e)

would retain the basic definition of the PLC ratio as the highest ratio

of outstanding Participating Securities to Leverageable Capital that an

SBIC has ever attained, as well as the exception which allows the ratio

to be reduced if Leverageable Capital increases above its highest

previous level, subject to certain conditions. Proposed

Sec. 107.1530(e)(2) (i) and (ii) would simplify the method for

recomputing the PLC ratio following an increase in Leverageable

Capital. The new PLC ratio would equal the highest dollar amount of

Participating Securities the SBIC has ever had outstanding, divided by

the SBIC's current Leverageable Capital. This computation would replace

the present three-step method which is not only quite complex, but also

can produce anomalous results when a Licensee's highest dollar amount

of Participating Securities outstanding does not coincide with its

highest ratio. SBA does not believe that any Licensee would be

disadvantaged by this change.

After computing the Base and the Profit Participation Rate, an SBIC

computes Profit Participation under Sec. 107.1530(h). In the proposed

rule, this paragraph has been reworded to improve its clarity. No

substantive changes are proposed.

Tax Distributions

Limited partnership SBICs which have paid their Prioritized

Payments in full and still have remaining Retained Earnings Available

for Distribution are permitted to make an annual ``tax distribution''

to their investors, with SBA also receiving a share. Both the Act and

Sec. 107.1550 of the regulations use the term ``tax distribution'',

based on the concept of allowing partnerships (or other flow-through

entities) to distribute cash that investors can use to pay their taxes

on the income allocated to them by the partnership. In practice, the

permitted tax distribution may or may not correspond to a particular

investor's actual tax liability, since the computation uses assumed

rather than actual tax rates and does not distinguish between taxable

and tax-exempt investors.

SBA is proposing one substantive change in Sec. 107.1550(a)(1),

which would be revised to include the 1 percent per annum Charge on

Participating Securities issued on or after October 1, 1996 (except for

those issued pursuant to a commitment obtained from SBA before that

date). Under Public Law 104-208, Charges are payable as a preferred

return to SBA under the same terms and conditions as Prioritized

Payments; therefore, a Licensee must pay all its Prioritized Payments,

Adjustments and Charges before it can make a distribution under

Sec. 107.1550.

The other proposed revisions in Sec. 107.1550 are clarifications

rather than substantive changes. In the formula used to compute a

Licensee's Maximum Tax Liability, proposed Sec. 107.1550(b)(1) would

specify that Prioritized Payments allocated to SBA are to be excluded

from the net ordinary income and capital gains allocated to partners.

Proposed Sec. 107.1550(b)(2) would clarify that while a Licensee may

use either individual or corporate tax rates to compute Maximum Tax

Liability, it must apply the same type of rate, either individual or

corporate, to both ordinary income and capital gains. Finally, proposed

Sec. 107.1550(b)(3) would specify that in computing combined Federal

and State tax rates to be used in the Maximum Tax Liability formula, a

Licensee must assume that State income taxes are deductible for Federal

income tax purposes. All of these changes are consistent with SBA's

interpretation of the current regulations.

Distributions Based on ``Retained Earnings Available for

Distribution''

As of the end of each fiscal year, if a Participating Securities

issuer has Retained Earnings Available for Distribution (``READ'')

remaining after paying all of its Prioritized Payments and making a tax

distribution (if applicable), it must distribute the balance of READ in

accordance with Sec. 107.1560. SBA is proposing two clarifications to

this section, as well as one minor substantive change.

Proposed Sec. 107.1560 (a)(4) and (b)(1) would both be revised to

clarify that the amount of READ to be distributed is determined after

giving effect to any preceding distributions of Prioritized Payments

under Sec. 107.1540 and tax distributions under Sec. 107.1550. The

current regulation may not be clear on this point, although SBA has

always interpreted it in a manner consistent with the proposed rule.

Current Sec. 107.1560(e) contains a table which gives SBA's

percentage share of

[[Page 53260]]

any distributions made under Secs. 107.1560 or 107.1570(a). The heading

of the first column refers to the Licensee's ``ratio of Leverage to

Leverageable Capital as of the fiscal year end''. This heading is

appropriate for distributions under Sec. 107.1560, which are always

computed as of the end of a fiscal year, but may be confusing for

interim distributions under Sec. 107.1570(a). If a Licensee makes an

interim distribution, the intent of the regulations is to measure the

ratio of Leverage to Leverageable Capital as of the end of the interim

period for which the distribution is made. The proposed rule would

clarify this point by replacing ``fiscal year'' with ``fiscal period''

in the column heading.

Proposed Sec. 107.1560(a)(1) would be revised to include the 1

percent per annum Charge on Participating Securities issued on or after

October 1, 1996. Under Public Law 104-208, Charges are payable as a

preferred return to SBA under the same terms and conditions as

Prioritized Payments; therefore, a Licensee must pay all its

Prioritized Payments, Adjustments and Charges before it can make any

other distribution under Sec. 107.1560.

Optional Distributions Not Based on READ

A Licensee which has no READ may be able to make distributions to

its private investors and SBA in accordance with Sec. 107.1570(b).

Distributions under this section are at the option of the SBIC and

essentially constitute returns of capital. The current regulation sets

forth conditions for making a distribution of this type. Under the

proposed rule, two of these conditions would be revised. First,

Sec. 107.1570(b)(1)(i) would require an SBIC to pay any earned Charges,

along with its Earned Prioritized Payments and earned Adjustments,

before distributing under Sec. 107.1570(b). This change is in

accordance with section 208(d)(6) of Public Law 104-208; similar

changes proposed in Secs. 107.1550 and 107.1560 are discussed earlier

in this preamble.

Second, under current Sec. 107.1570(b)(1)(ii), a Licensee must have

``distributed all Profit Participation computed under Sec. 107.1530''

before distributing under Sec. 107.1570(b). This language may present a

problem for an SBIC because of the following circumstances: Profit

Participation is computed only on the basis of realized income or loss;

however, the ability to distribute Profit Participation depends on the

availability of READ, which also takes into account unrealized losses

in a Licensee's portfolio. Thus, it is possible that a Licensee may

compute Profit Participation to be allocated to SBA, but may be unable

to pay it until some later date. Under these conditions, the Licensee

would be blocked from distributing under Sec. 107.1570(b). To remedy

this situation, the proposed rule would require a Licensee to

distribute Profit Participation only to the extent permitted based on

its READ. SBA believes that the language in section 303(g)(10) of the

Act, which requires payment of all Profit Participation ``due'' to SBA

before a Licensee can return capital, provides sufficient flexibility

to support this interpretation.

Notice of Participating Securities Distributions

The current regulations do not require SBICs with Participating

Securities to notify SBA before making distributions. In practice,

Licensees generally have sought SBA's assistance with the distribution

calculations and have given SBA sufficient opportunity to review the

results. Because of the complexity of some of the required

computations, and the difficulty of correcting errors after a

distribution takes place, SBA is proposing to formalize this practice.

The proposed rule would require an SBIC to notify SBA 10 business days

before a planned distribution under Secs. 107.1540 through 107.1570,

unless SBA permits otherwise. This language would give SBA the

flexibility to allow distributions on shorter notice, if the

circumstances warrant, without requiring Licensees to submit a formal

request for a written exemption. SBA believes that this provision would

not unreasonably constrain a Licensee's freedom of action and would

provide important protection for Licensees as well as the Agency.

Timing of Participating Securities Distributions

The current regulations permit Participating Securities issuers to

make distributions only on quarterly ``Payment Dates'' (February 1, May

1, August 1 and November 1 of each year). This structure was adopted to

coincide with the terms of the public fundings of Participating

Securities, under which investors receive interest payments and any

returns of principal to which they are entitled on these dates. In the

preamble to the final rule published on January 31, 1996 (61 FR 3177),

SBA stated that it intended to seek a solution that would provide

Licensees with greater flexibility in making distributions,

particularly distributions in the form of securities.

Proposed Sec. 107.1575 would allow an SBIC to make distributions

(either in cash or in kind) on dates other than Payment Dates with

SBA's prior written approval. SBA wishes to provide SBICs with as much

flexibility as possible; however, for administrative and oversight

purposes, the Agency feels strongly that it must have an opportunity to

review planned distributions in advance.

Distributions based on fiscal year end results, such as required

annual distributions of Prioritized Payments, would have to be made no

later than the second Payment Date following the Licensee's fiscal year

end. This requirement is consistent with the current regulation, which

requires such distributions to be made on either the first or second

Payment Date.

For any distribution made on other than a Payment Date, the

distribution date would be used as the cutoff date for all the required

computations (Earmarked Profits, Prioritized Payments, etc.). This

approach may require a Licensee to perform a mid-month closing of its

financial statements, which may not be as clean or convenient as a

month-end closing. However, SBA believes it is the only approach which

will accommodate all potential distributions, particularly

distributions of securities on which realized gain cannot be recognized

before the distribution date.

If a distribution to SBA includes a redemption of Participating

Securities, the proposed rule specifies that the effective date of the

redemption will be the next Payment Date following the distribution

date. This provision is necessary because Participating Securities are

funded through the purchase by investors of Trust Certificates, under

which principal can be returned only on Payment Dates. Because of this

structure, a Licensee will also be responsible for Prioritized Payments

through the next Payment Date on the amount of Participating Securities

to be redeemed.

In-Kind Distributions by Licensees

Participating Securities issuers are permitted to make

distributions to SBA in the form of securities under the conditions set

forth in Sec. 107.1580. The current regulation limits in-kind

distributions to those distributions required or permitted by

Secs. 107.1560 and 107.1570. Distributions of Prioritized Payments,

which are governed by Sec. 107.1540, must be made in cash. Because

Prioritized Payments precede any other distributions, this limitation

can have a potentially significant effect on the timing and value of

distributions in general. To alleviate this concern, proposed

Sec. 107.1580(a) would allow distributions

[[Page 53261]]

under Secs. 107.1540, 107.1560 and 107.1570 to be made in the form of

securities. Distributions under Sec. 107.1550 would continue to be

permitted on a cash-only basis, since the stated purpose of such

distributions is to provide investors in flow-through entities with

sufficient cash to pay their anticipated tax liabilities.

Characteristics of SBA's Leverage Guarantee

Section 303(b) of the Act authorizes SBA to guarantee the timely

payment of all principal and interest as scheduled on Debentures or

Participating Securities, pursuant to regulations issued by the Agency.

In the final rule published January 31, 1996 (61 FR 3177), the section

of the regulations which implemented this provision of the Act was

dropped inadvertently. Proposed Sec. 107.1720 would restore the

previous language setting forth the unconditional nature and other

characteristics of SBA's guarantee.

Capital Impairment

SBA is not proposing any substantive changes in the Capital

Impairment computations set forth in Secs. 107.1830 through 107.1850,

but is proposing one clarification. Current Sec. 107.1830(a) has caused

some confusion by stating that the current Capital Impairment

regulations apply to a Licensee if it has outstanding Leverage issued

on or after April 25, 1994. While this statement is true, it is

incomplete. This is because SBA Leverage is subject to the Capital

Impairment regulations in effect on the date the Leverage is issued.

Thus, a Licensee must comply with the current impairment rules if it

has Leverage issued on or after April 25, 1994; however, if it has

Leverage issued before that date as well, it must also comply with the

impairment rules in effect when such Leverage was issued. Proposed

Sec. 107.1830(a) would clarify this point by specifically linking the

applicability of the Capital Impairment regulations to the Leverage

issued. In the same paragraph, the proposed rule would also state that

a Licensee must comply with any specific conditions to which it has

agreed by contract with SBA. This is not a substantive change, but

simply makes explicit a Licensee's obligation to abide by the terms of

any agreement it has made with the Agency.

Miscellaneous Corrections and Editorial Changes

The definition of ``Commitment'' in Sec. 107.50 would be reworded

in the third person (i.e., to refer to ``a Licensee'' instead of

``you'') to conform to the style in which the other definitions are

written.

In current Sec. 107.720(c), the SIC code for Operative Builders is

incorrect. The proposed rule contains the correct 4-digit code (1531).

Proposed Sec. 107.1590 sets forth special rules applicable to

Participating Securities issuers licensed on or before March 31, 1993.

The proposed rule would eliminate the current paragraph (c), which

allows Licensees to repay outstanding Debentures with the proceeds of

newly issued Participating Securities, subject to certain conditions.

Since this paragraph properly applies to all Licensees, regardless of

licensing date, its content would be transferred to the new proposed

Sec. 107.1585. The substance of Sec. 107.1590 would remain unchanged.

In Sec. 107.1600, references to section 321 of the Act would be

changed to section 319, reflecting the amendment of the Act by Public

Law 104-208.

In the definition of Trust Certificate Rate and in Secs. 107.1240

and 107.1520(a)(1), certain technical changes have been proposed to

facilitate the interim Leverage funding mechanism currently under

consideration by SBA.

Limited Liability Companies

Section 208(b)(1) of Public Law 104-208 amended the Act to permit

SBICs to organize as limited liability companies (LLCs). SBA is

studying the legal and administrative issues which may arise in

connection with LLCs, and will publish a proposed rule to implement

this form of organization by SBICs at a later date.

Although SBA regulations do not yet provide for LLC Licensees, SBA

has the statutory authority to license such companies. SBA's current

policy is to accept a license application from an LLC only if the LLC

is organized under Delaware's Limited Liability Company Act and does

not intend to issue Participating Securities, which SBA has not yet

developed in a form suitable for use by an LLC. SBA may reconsider

these limitations as SBA acquires greater familiarity with the LLC form

of organization and as a body of case law is created under the various

state LLC laws. The adoption of a Uniform LLC Act by a significant

number of states also would induce SBA to reexamine its current

preference for Delaware law.

Until SBA regulations are revised to accommodate LLC Licensees,

such Licensees should understand that SBA regards the members of the

LLC to be equivalent to the general partners in a partnership Licensee

unless the LLC's operating agreement clearly indicates otherwise. Thus,

all members of an LLC Licensee will automatically be considered Control

Persons and Associates of the Licensee unless the LLC's operating

agreement vests management authority only in certain members of the

company.

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

Regulatory Flexibility Act (5 U.S.C. 601, et seq.), and the Paperwork

Reduction Act (44 U.S.C. Ch. 35)

SBA certifies that this proposed rule would not be a significant

regulatory action for purposes of Executive Order 12866 because it

would not have an annual effect on the economy of more than $100

million, and that it would not have a significant economic impact on a

substantial number of small entities within the meaning of the

Regulatory Flexibility Act, 5 U.S.C. 601, et seq. The purpose of the

proposed rule is to implement provisions of Public Law 104-208 which

relate to small business investment companies, and to make certain

other changes, primarily technical corrections and clarifications, to

the regulations governing SBICs.

For purposes of the Paperwork Reduction Act, 44 U.S.C. Ch. 35, SBA

certifies that this proposed rule, if adopted in final form, would

contain no new reporting or recordkeeping requirements that have not

already been approved by the Office of Management and Budget.

For purposes of Executive Order 12612, SBA certifies that this rule

would not have any federalism implications warranting the preparation

of a Federalism Assessment.

For purposes of Executive Order 12778, SBA certifies that this rule

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

set forth in Section 2 of that Order.

List of Subjects in 13 CFR Part 107

Investment companies, Loan programs-business, Reporting and

recordkeeping requirements, Small businesses.

For the reasons set forth above, SBA hereby proposes to amend Part

107 of Title 13 of the Code of Federal Regulations as follows:

PART 107--SMALL BUSINESS INVESTMENT COMPANIES

1. The authority citation for part 107 continues to read as

follows:

Authority: 15 U.S.C. 681 et seq., 683, 687(c), 687b, 687d, 687g

and 687m, Pub. L. 104-208.

2. Section 107.50 is proposed to be amended by revising the

definitions for

[[Page 53262]]

Commitment, Common Control, Preferred Securities, Section 301(d)

Licensee, and Trust Certificate Rate, and adding a definition of

Charge, to read as follows:

Sec. 107.50 Definitions of terms.

* * * * *

Charge means an annual fee on Leverage issued on or after October

1, 1996 (except for Leverage issued pursuant to a commitment made by

SBA before October 1, 1996), which is payable to SBA by Licensees,

subject to the terms and conditions set forth in 107.1130(d).

* * * * *

Commitment means a written agreement between a Licensee and an

eligible Small Business that obligates the Licensee to provide

Financing (except a guarantee) to that Small Business 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. The agreement may

include reasonable conditions precedent to the Licensee's obligation to

fund the commitment, but these conditions must be outside the

Licensee's control.

Common Control means a condition where two or more Persons, 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 advisors or contractors that are

Affiliates of each other. This presumption may be rebutted by evidence

satisfactory to SBA.

* * * * *

Preferred Securities means nonvoting preferred stock or nonvoting

limited partnership interests issued to SBA prior to October 1, 1996,

by a Section 301(d) Licensee. Such securities were issued at par value

in the case of preferred stock, or at face value in the case of

preferred limited partnership interests.

* * * * *

Section 301(d) Licensee means a company licensed prior to October

1, 1996 under section 301(d) of the Act as in effect on the date of

licensing, that may provide Assistance only to Disadvantaged

Businesses. A Section 301(d) Licensee may be organized as a for-profit

corporation, as a non-profit corporation, or as a limited partnership.

* * * * *

Trust Certificate Rate means a fixed rate determined by the

Secretary of the Treasury at the time Participating Securities or

Debentures are pooled, taking into consideration the current average

market yield on outstanding marketable obligations of the United States

with maturities comparable to the maturities of the Trust Certificates

being guaranteed by SBA, adjusted to the nearest one-eighth of one

percent.

* * * * *

Sec. 107.110 [Removed]

3. Section 107.110 is proposed to be removed.

4. Section 107.120 is proposed to be revised to read as follows:

Sec. 107.120 Special rules for a Section 301(d) Licensee owned by

another Licensee.

A Section 301(d) Licensee which was licensed to operate as the

subsidiary of one or more Licensees (participant Licensees) may

continue to do so, subject to the following:

(a) Each participant Licensee must continue to own at least 20

percent of the voting securities of the Section 301(d) Licensee.

(b) A participant Licensee must continue to treat its entire

capital contribution to the subsidiary as a reduction of its

Leverageable Capital. The participant Licensee's remaining Leverageable

Capital must be sufficient to support its outstanding Leverage.

(c) A participant Licensee may not transfer its Leverage to a

subsidiary Section 301(d) Licensee.

5. In Sec. 107.150, the introductory text of paragraph (a)(1) is

proposed to be revised to read as follows:

Sec. 107.150 Management and ownership diversity requirement.

* * * * *

(a) Requirement one. * * *

(1) At least 30 percent of your Regulatory Capital and Leverageable

Capital must be owned by Persons unrelated to management. To satisfy

this requirement, such Persons must not be your Associates (except for

their status as your shareholders or limited partners) and must not

Control, be Controlled by, or be under Common Control with any of your

Associates. You must have as investors at least three such Persons who

are not Affiliates of one another and whose investments are significant

in both dollar and percentage terms, as determined by SBA. As an

alternative, you may substitute one investor who is an acceptable

Institutional Investor for the three investors who are otherwise

required. For purposes of this paragraph (a)(1), the following

Institutional Investors are acceptable:

* * * * *

6. Section 107.210 is proposed to be revised to read as follows:

Sec. 107.210 Minimum capital requirements for Licensees.

(a) Companies licensed on or after October 1, 1996. A company

licensed on or after October 1, 1996 must have Leverageable Capital of

at least $2,500,000 and must meet the applicable minimum Regulatory

Capital requirement:

(1) Licensees other than Participating Securities issuers. A

Licensee that does not wish to be eligible to apply for Participating

Securities must have Regulatory Capital of at least $5,000,000. As an

exception to this general rule, SBA in its sole discretion and based on

a showing of special circumstances and good cause may license an

applicant with Regulatory Capital of at least $3,000,000, but only if

the applicant:

(i) Has satisfied all licensing standards and requirements except

the minimum capital requirement, as determined solely by SBA;

(ii) Has a viable business plan reasonably projecting profitable

operations; and

(iii) Has a reasonable timetable for achieving Regulatory Capital

of at least $5,000,000.

(2) Participating Securities issuers. A Licensee that wishes to be

eligible to apply for Participating Securities must have Regulatory

Capital of at least $10,000,000, unless it demonstrates to SBA's

satisfaction that it can be financially viable over the long term with

a lower amount. Under no circumstances can the Licensee have Regulatory

Capital of less than $5,000,000.

(b) Companies licensed before October 1, 1996. A company licensed

before October 1, 1996 must meet the minimum capital requirements

applicable to such company, as required by the regulations in effect on

September 30, 1996. See Sec. 107.1120(c)(2) for Leverage eligibility

requirements.

Sec. 107.220 [Removed]

7. Section 107.220 is proposed to be removed.

8. Section 107.230 is proposed to be amended by revising the

introductory

[[Page 53263]]

text of paragraph (d)(4) to read as follows:

Sec. 107.230 Permitted sources of Private Capital for Licensees.

* * * * *

(d) Qualified Non-private Funds. * * *

(4) Funds invested in or committed in writing to any Section 301(d)

Licensee prior to October 1, 1996, from the following sources: * * *

* * * * *

9. In Sec. 107.503, paragraphs (a), (b) and (e), and the heading

and first sentence of paragraph (c), are proposed to be revised to read

as follows:

Sec. 107.503 Licensee's adoption of an approved valuation policy.

(a) Valuation guidelines. You must prepare, document and report the

valuations of your Loans and Investments in accordance with the

Valuation Guidelines for SBICs issued by SBA. These guidelines may be

obtained from SBA's Investment Division.

(b) SBA approval of valuation policy. You must have a written

valuation policy approved by SBA for use in determining the value of

your Loans and Investments. You must either:

(1) Adopt without change the model valuation policy set forth in

section III of the Valuation Guidelines for SBICs; or

(2) Obtain SBA's prior written approval of an alternative valuation

policy.

(c) Responsibility for valuations. Your board of directors or

general partner(s) will be solely responsible for adopting your

valuation policy and for using it to prepare valuations of your Loans

and Investments for submission to SBA. * * *

* * * * *

(e) Review of valuations by independent public accountant. (1) For

valuations performed as of the end of your fiscal year, your

independent public accountant must review your valuation procedures and

the implementation of such procedures, including adequacy of

documentation.

(2) The independent public accountant's report on your audited

annual financial statements (SBA Form 468) must include a statement

that your valuations were prepared in accordance with your approved

valuation policy established in accordance with section 310(d)(2) of

the Act.

10. Section 107.660 is proposed to be amended by redesignating

paragraph (d) as paragraph (e) and by adding a new paragraph (d) to

read as follows:

Sec. 107.660 Other items required to be filed by Licensee with SBA.

* * * * *

(d) Notification of criminal charges. If any officer, director,

general partner or other Control Person is charged with or convicted of

any criminal offense other than a misdemeanor involving a minor motor

vehicle violation, you must report the incident to SBA within 5

calendar days. Such report must fully describe the facts which pertain

to the incident.

* * * * *

11. Section 107.710 is proposed to be amended by adding a sentence

at the end of paragraph (e) and by revising paragraphs (b) and (c) to

read as follows:

Sec. 107.710 Requirement to finance Smaller Enterprises.

* * * * *

(b) Smaller Enterprise Financings. (1) General rule. At the close

of each of your fiscal years, at least 20 percent of the total dollar

amount of the Financings you extended since April 25, 1994 must have

been invested in Smaller Enterprises. If you were licensed after April

25, 1994, the 20 percent requirement applies to the total dollar amount

of the Financings you extended since you were licensed plus any pre-

licensing investments approved by SBA for inclusion in your Regulatory

Capital.

(2) Phase-in for new Licensees. At the close of your first full

fiscal year after licensing, at least 10 percent of the total dollar

amount of the Financings you extended, including any pre-licensing

investments approved by SBA for inclusion in your Regulatory Capital,

must have been invested in Smaller Enterprises. At the close of each

fiscal year thereafter, you must meet the requirement in paragraph

(b)(1) of this section.

(c) Special requirement for certain leveraged Licensees. (1) This

paragraph (c) applies if you were licensed on or before September 30,

1996, and you issued Leverage after that date, and you have Regulatory

Capital of:

(i) Less than $10,000,000 if such Leverage was Participating

Securities; or

(ii) Less than $5,000,000 if such Leverage was Debentures.

(2) At the close of each of your fiscal years, at least 50 percent

of the total dollar amount of the Financings you extended after

September 30, 1996 must have been invested in Smaller Enterprises.

* * * * *

(e) Non-compliance with this section. * * * However, you will not

be eligible for additional Leverage until you reach the required

percentage (see Sec. 107.1120 (c) and (d)).

12. In Sec. 107.720, paragraph (b)(2) and the introductory text of

paragraph (c)(1) are proposed to be revised to read as follows:

Sec. 107.720 Small Businesses that may be ineligible for Financing.

* * * * *

(b) Passive businesses. * * *

(2) Exception for pass-through of proceeds to subsidiary. You may

finance a passive business if it is a Small Business and it passes

substantially all the proceeds through to one or more subsidiary

companies, each of which is an eligible Small Business that is not

passive. For the purpose of this paragraph (b)(2), ``subsidiary

company'' means a company in which at least 50 percent of the

outstanding voting securities are owned by the Financed passive

business.

(c) Real estate businesses. (1) You are not permitted to finance

any business classified under Major Group 65 (Real Estate) or Industry

No. 1531 (Operative Builders) of the SIC Manual, with the following

exceptions: * * *

* * * * *

13. In Sec. 107.730, paragraph (d)(3)(iv) is proposed to be revised

to read as follows:

Sec. 107.730 Financings which constitute conflicts of interest.

* * * * *

(d) Financings with Associates. * * *

(3) Exceptions to paragraphs (d)(1) and (d)(2) of this section. * *

*

(iv) Both you and your Associate are non-leveraged Licensees, or

you are a non-leveraged Licensee and your Associate is not a Licensee.

* * * * *

14. In Sec. 107.740, paragraph (a) is proposed to be revised to

read as follows:

Sec. 107.740 Portfolio diversification (``overline'' limitation).

(a) General rule. This Sec. 107.740 applies if you have outstanding

Leverage or want to be eligible for Leverage. Without SBA's prior

written approval, you may provide Financing or a Commitment to a Small

Business only if the resulting amount of your aggregate outstanding

Financings and Commitments to such Small Business and its Affiliates

does not exceed:

(1) 20 percent of your Regulatory Capital as of the date of the

Financing or Commitment if you are a Section 301(c) Licensee; or

(2) 30 percent of your Regulatory Capital as of the date of the

Financing or Commitment if you are a Section 301(d) Licensee.

* * * * *

[[Page 53264]]

15. Section 107.855 is proposed to be amended by revising

paragraphs (c)(1), (c)(4)(i) and (d)(4), redesignating paragraphs

(g)(1) through (g)(10) as paragraphs (g)(2) through (g)(11), and adding

a new paragraph (g)(1) to read as follows:

Sec. 107.855 Interest rate ceiling and limitations on fees charged to

Small Businesses (``Cost of Money'')

* * * * *

(c) How to determine the Cost of Money ceiling for a Financing. * *

*

(1) Choose a base rate for your Cost of Money computation. The base

rate may be either the Debenture Rate currently in effect plus the

applicable Charge determined under Sec. 107.1130(d)(1), or your own

``Cost of Capital'' as determined under paragraph (d) of this section.

* * * * *

(4) * * *

(i) The current Debenture Rate plus the applicable Charge

determined under Sec. 107.1130(d)(1);

* * * * *

(d) How to determine your Cost of Capital. * * *

(4) For all qualified borrowings outstanding at your last fiscal

year or fiscal quarter end, determine the aggregate interest expense

for the past four fiscal quarters, excluding amortization of loan fees.

For the purposes of this paragraph (d)(4):

(i) Interest expense on Debentures includes the 1 percent Charge

paid by a Licensee under Sec. 107.1130(d)(1); and

(ii) Section 301(d) Licensees with outstanding subsidized

Debentures are presumed to have paid interest at the rate stated on the

face of such Debentures, without regard to any subsidy paid by SBA.

* * * * *

(g) Charges excluded from the Cost of Money. * * *

(1) Discount on the loan portion of a Debt Security, if such

discount exists solely as the result of the allocation of value to

detachable stock purchase warrants in accordance with generally

accepted accounting principles.

* * * * *

16. In Sec. 107.865, the first sentence of paragraph (c)(2) and

paragraph (d)(1) are proposed to be revised to read as follows:

Sec. 107.865 Restrictions on Control of a Small Business by a

Licensee.

* * * * *

(c) Rebuttals to presumption of Control. * * *

(2) The management of the Small Business can elect at least 40

percent of the board members of a corporation, general partners of a

limited partnership, or managers of a limited liability company, as

appropriate, and the Investor Group can elect no more than 40 percent.

* * *

* * * * *

(d) Temporary Control permitted. * * *

(1) Where reasonably necessary for the protection of your existing

investment;

* * * * *

17. Section 107.1100 is proposed to be revised to read as follows:

Sec. 107.1100 Types of Leverage and application forms.

(a) Types of Leverageable available. You may apply for Leverage

from SBA in one or both of the following forms:

(1) The purchase or guarantee of your Debentures.

(2) The purchase or guarantee of your Participating Securities.

(b) Application forms. Use SBA Form 1022 to apply for Debentures

and SBA Form 1022B to apply for Participating Securities.

(c) Where to send your application. Send all Leverage applications

to SBA, Investment Division, 409 Third Street, S.W., Washington, DC

20416.

Sec. 107.1110 [Removed]

18. Section 107.1110 is proposed to be removed.

19. Section 107.1120 is proposed to be amended by revising

paragraph (c), redesignating paragraphs (d) through (f) as paragraphs

(e) through (g), and adding a new paragraph (d) to read as follows:

Sec. 107.1120 General eligibility requirements for Leverage.

* * * * *

(c) Meet the minimum capital requirements of Sec. 107.210, subject

to the following additional conditions:

(1) If you were licensed after September 30, 1996 under the

exception in Sec. 107.210(a)(1), you will not be eligible for Leverage

until you have Regulatory Capital of at least $5,000,000.

(2) If you were licensed on or before September 30, 1996, and have

Regulatory Capital of less than $5,000,000 (less than $10,000,000 if

you wish to issue Participating Securities):

(i) You must certify in writing that at least 50 percent of the

aggregate dollar amount of your Financings extended after September 30,

1996 will be provided to Smaller Enterprises (as defined in

Sec. 107.710(a)); and

(ii) You must demonstrate to SBA's satisfaction that the approval

of Leverage will not create or contribute to an unreasonable risk of

default or loss to the United States government, based on such

measurements of profitability and financial viability as SBA deems

appropriate.

(d) Certify in writing that you are in compliance with the

requirement to finance Smaller Enterprises in Sec. 107.710(b).

* * * * *

20. Section 107.1130 is proposed to be amended by revising the

heading and paragraphs (a) through (c), redesignating paragraph (d) as

paragraph (e), and adding a new paragraph (d) to read as follows:

Sec. 107.1130 Leverage fees and additional charges payable by

Licensee.

(a) Leverage fee. You must pay a leverage fee to SBA for each

issuance of a Debenture or Participating Security. The fee is 3 percent

of the face amount of the Leverage issued.

(b) Payment of leverage fee. (1) If you issue a Debenture or

Participating Security to repay or redeem existing Leverage, you must

pay the leverage fee before SBA will guarantee or purchase the new

Leverage security.

(2) If you issue a Debenture or Participating Security that is not

used to repay or redeem existing Leverage, SBA will deduct the leverage

fee from the proceeds remitted to you, unless you prepaid the fee under

Sec. 107.1210.

(c) Refundability. The leverage fee is not refundable under any

circumstances.

(d) Additional charge for Leverage.--(1) Debentures. You must pay

to SBA a Charge of 1 percent per annum on the outstanding amount of

your Debentures issued on or after October 1, 1996, payable under the

same terms and conditions as the interest on the Debentures. This

Charge does not apply to Debentures issued pursuant to a Leverage

commitment obtained from SBA on or before September 30, 1996.

(2) Participating Securities. You must pay to SBA a Charge of 1

percent per annum on the outstanding amount of your Participating

Securities issued on or after October 1, 1996, payable under the same

terms and conditions as the Prioritized Payments on the Participating

Securities. This Charge does not apply to Participating Securities

issued pursuant to a Leverage commitment obtained from SBA on or before

September 30, 1996.

* * * * *

21. Section 107.1160 is proposed to be amended by adding

introductory text to read as follows:

[[Page 53265]]

Sec. 107.1160 Maximum amount of Leverage for a Section 301(d)

Licensee.

This section applies to Leverage issued by a Section 301(d)

Licensee on or before September 30, 1996. Effective October 1, 1996, a

Section 301(d) Licensee may apply to issue new Leverage, or refinance

existing Leverage, only on the same terms permitted under

Sec. 107.1150.

* * * * *

22. Section 107.1200 is proposed to be amended by revising

paragraphs (c) and (d) to read as follows:

Sec. 107.1200 SBA's Leverage commitment to a Licensee--application

procedure, amount, and term.

* * * * *

(c) Limitations on the amount of a Leverage commitment. The amount

of a Leverage commitment must be a multiple of $5,000.

(d) Term of Leverage commitment. SBA's Leverage commitment will

automatically lapse on the expiration date stated in the commitment

letter issued to you by SBA.

23. Section 107.1210 is proposed to be revised to read as follows:

Sec. 107.1210 Payment of leverage fee upon receipt of commitment.

(a) Prepayment of leverage fee. As a condition of SBA's Leverage

commitment, and before you draw any Leverage, you must prepay the

leverage fee established under Sec. 107.1130(a). The fee is equal to 3

percent of the face amount of the Debentures or Participating

Securities reserved under the commitment.

(b) Automatic cancellation of commitment. Unless you pay the full

amount of the leverage fee by 5 P.M. Eastern Time on the 30th calendar

day following the issuance of SBA's Leverage commitment, the commitment

will be automatically canceled.

24. In Sec. 107.1230, paragraphs (a) and (b) are proposed to be

revised to read as follows:

Sec. 107.1230 Draw-downs by Licensee under SBA's Leverage commitment.

(a) Licensee's authorization of SBA to purchase or guarantee

securities. By submitting a request for a draw against SBA's Leverage

commitment, you authorize SBA, or any agent or trustee SBA designates,

to guarantee your Debenture or Participating Security and to sell it

with SBA's guarantee.

(b) Limitations on amount of draw. The amount of a draw must be a

multiple of $5,000. SBA, in its discretion, may determine a minimum

dollar amount for draws against SBA's Leverage commitments. Any such

minimum amounts will be published in Notices in the Federal Register

from time to time.

* * * * *

25. Section 107.1240 is proposed to be amended by revising

paragraphs (a)(1), (b), (c) and (d) to read as follows:

Sec. 107.1240 Funding of Licensee's draw request through sale to

short-term investor.

(a) Licensee's authorization of SBA to arrange sale of securities

to short-term investor. * * *

(1) The sale of your Debenture or Participating Security to a

short-term investor at a rate that may be different from the Trust

Certificate Rate which will be established at the time of the pooling

of your security;

* * * * *

(b) Sale of Debentures to a short-term investor. If SBA sells your

Debenture to a short-term investor:

(1) The sale price will be the face amount.

(2) At the next scheduled date for the sale of Debenture Trust

Certificates, whether or not the sale actually occurs, you must pay

interest to the short-term investor for the short-term period. If the

actual sale of Trust Certificates takes place after the scheduled date,

you must pay the short-term investor interest from the scheduled sale

date to the actual sale date. This additional interest is due on the

actual sale date.

(3) Failure to pay the interest constitutes noncompliance with the

terms of your Leverage (see Sec. 107.1810).

(c) Sale of Participating Securities to a short-term investor. If

SBA sells your Participating Security to a short-term investor, the

sale price will be the face amount.

(d) Licensee's right to repurchase its Debentures before pooling.

You may repurchase your Debentures from the short-term investor before

they are pooled. To do so, you must:

(1) Give SBA written notice at least 10 days before the cut-off

date for the pool in which your Debenture is to be included; and

(2) Pay the face amount of the Debenture, plus interest, to the

short-term investor.

26. Subpart I of Part 107 is proposed to be amended by removing the

undesignated center heading ``Exchange of Outstanding Debentures for

Participating or Preferred Securities--Section 301(d) Licensees'', by

redesignating Sec. 107.1350 as Sec. 107.1585, and by revising

redesignated Sec. 107.1585 to read as follows:

Sec. 107.1585 Exchange of Debentures for Participating Securities.

You may, in SBA's discretion, retire a Debenture through the

issuance of Participating Securities. To do so, you must:

(a) Obtain SBA's approval to issue Participating Securities;

(b) Pay all unpaid accrued interest on the Debenture, plus any

applicable prepayment penalties, fees, and other charges;

(c) Have outstanding Equity Capital Investments (at cost) equal to

the amount of the Debenture being refinanced; and

(d) Classify all your existing Loans and Investments as Earmarked

Assets.

27. In Sec. 107.1400, the heading and introductory text are

proposed to be revised to read as follows:

Sec. 107.1400 Dividends or partnership distributions on 4 percent

Preferred Securities.

If you issued Preferred Securities to SBA on or after November 21,

1989, you must pay SBA a dividend or partnership distribution of 4

percent per year, from the date you issued Preferred Securities to the

date you repay them, both inclusive. The dividend or partnership

distribution is:

* * * * *

28. Section 107.1420 is proposed to be revised to read as follows:

Sec. 107.1420 Articles requirements for 4 percent Preferred

Securities.

If you have outstanding 4 percent Preferred Securities, your

Articles must contain all the provisions in Secs. 107.1400 and

107.1410.

Sec. 107.1430 [Amended]

29. Section 107.1430 is proposed to be revised by removing the last

sentence.

30. In Sec. 107.1500, paragraphs (b)(1) and (b)(4), the last

sentence of paragraph (e), and paragraph (f)(2) are proposed to be

revised to read as follows:

Sec. 107.1500 General description of Participating Securities.

* * * * *

(b) Special eligibility requirements for Participating Securities.

* * *

(1) Minimum capital (see Sec. 107.210).

* * * * *

(4) Equity investing, as set forth in this paragraph (b)(4). If you

issue Participating Securities, you must invest an amount equal to the

Original Issue Price of such securities solely in Equity Capital

Investments, as defined in Sec. 107.50.

* * * * *

(e) Mandatory redemption of Participating Securities. * * * You

must pay the Redemption Price plus any unpaid Earned Prioritized

Payments and any earned Adjustments and earned Charges (see

Sec. 107.1520).

[[Page 53266]]

(f) Priority of Participating Securities in liquidation of

Licensee. * * *

(2) Any Earned Prioritized Payments and any earned Adjustments and

earned Charges (see Sec. 107.1520); and

* * * * *

31. In Sec. 107.1505, the last sentence of paragraph (a) and

paragraph (b) are proposed to be revised to read as follows:

Sec. 107.1505 Liquidity requirements for licensees issuing

Participating Securities.

(a) Definition of Liquidity Impairment. * * * You are responsible

for calculating whether you have a condition of Liquidity Impairment:

(1) As of the close of your fiscal year;

(2) At the time you apply for Leverage, unless SBA permits

otherwise; and

(3) At such time as you contemplate making any Distribution.

(b) Computation of Liquidity Ratio. Your Liquidity Ratio equals

your Total Current Funds Available (A) divided by your Total Current

Funds Required (B), as determined in the following table:

Calculation of Liquidity Ratio

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

Amount reported

Financial account on SBA Form 468 Weight Weighted amount

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

(1) Cash and invested idle funds............ ............... x 100 .................

(2) Commitments from investors.............. ............... x 1.00 .................

(3) Current maturities...................... ............... x 0.50 .................

(4) Other current assets.................... ............... x 1.00 .................

(5) Publicly Traded and Marketable ............... x 1.00 .................

Securities.

(6) Anticipated operating revenue for next ............... x 1.00 .................

12 months (\1\).

(7) Total Current Funds Available........... ............... .............................. A

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

(8) Current liabilities..................... ............... x 1.00 .................

(9) Commitments to Small Businesses......... ............... x 0.75 .................

(10) Anticipated operating expense for next (\1\) x 1.00 .................

12 months.

(11) Anticipated interest expense for next (\1\) x 1.00 .................

12 months.

(12) Contingent liabilities (guarantees).... ............... x 0.25 .................

(13) Total Current Funds Required........... ............... .............................. B

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

\1\ As determined by Licensee's management under its business plan.

* * * * *

32. In Sec. 107.1510, the introductory text, the last sentence of

paragraph (c) and paragraph (d)(1)(ii) are proposed to be revised to

read as follows:

Sec. 107.1510 How a Licensee computes Earmarked Profit (Loss).

Computing your Earmarked Profit (Loss) is the first step in

determining your obligations to pay Prioritized Payments, Adjustments

and Charges under Sec. 107.1520 and Profit Participation under

Sec. 107.1530.

* * * * *

(c) How to compute your Earmarked Asset Ratio. * * * Otherwise,

compute your Earmarked Asset Ratio using the following formula:

EAR = (EA)(LI) x 100

where:

EAR=Earmarked Asset Ratio

EA=Average Earmarked Assets (at cost) for the fiscal year or

interim period

LI=Average Loans and Investments (at cost) for the fiscal year or

interim period

(d) How to compute your Earmarked Profit (Loss) if Earmarked Asset

Ratio is 100 percent. * * *

(1) * * *

(ii) For the purpose of determining Net Income (Loss), leverage

fees paid to SBA and partnership syndication costs that you incur must

be capitalized and amortized on a straight-line basis over not less

than five years.

* * * * *

33. Section 107.1520 is proposed to be revised to read as follows:

Sec. 107.1520 How a Licensee computes and allocates Prioritized

Payments to SBA.

This section tells you how to compute Prioritized Payments,

Adjustments and Charges on Participating Securities and determine the

amounts you must pay. To distribute these amounts, see Sec. 107.1540.

(a) How to compute Prioritized Payments and Adjustments--(1)

Prioritized Payments. For a full fiscal year, the Prioritized Payment

on an outstanding Participating Security equals the Redemption Price

times the related Trust Certificate Rate. For an interim period, you

must prorate the annual Prioritized Payment. If your Participating

Security was sold to a short-term investor in accordance with

Sec. 107.1240, the Prioritized Payment for the short-term period equals

the Redemption Price times the short-term rate.

(2) Adjustments. Compute Adjustments using paragraph (f) of this

section.

(3) Charges. Compute Charges in accordance with

Sec. 107.1130(d)(2).

(b) Licensee's obligation to pay Prioritized Payments, Adjustments

and Charges. You are obligated to pay Prioritized Payments, Adjustments

and Charges only if you have profit as determined in paragraph (d) of

this section.

(1) Prioritized Payments that you must pay (or have already paid)

because you have sufficient profit are ``Earned Prioritized Payments''.

(2) Prioritized Payments that have not become payable because you

lack sufficient profit are ``Accumulated Prioritized Payments''. Treat

all Prioritized Payments as ``Accumulated'' until they become

``Earned'' under this section.

(3) Adjustments (computed under paragraph (f) of this section) and

Charges (computed under Sec. 107.1130(d)(2)) are ``earned'' according

to the same criteria applied to Prioritized Payments.

(c) How to keep track of Prioritized Payments. You must establish

three accounts to record your Accumulated and Earned Prioritized

Payments:

(1) Accumulation Account. The Accumulation Account is a memorandum

account. Its balance represents your Accumulated Prioritized Payments,

unearned Adjustments and unearned Charges.

(2) Distribution Account. The Distribution Account is a liability

account. Its balance represents your unpaid Earned Prioritized

Payments, earned Adjustments and earned Charges.

[[Page 53267]]

(3) Earned Payments Account. The Earned Payments Account is a

memorandum account. Each time you add to the Distribution Account

balance, add the same amount to the Earned Payments Account. Its

balance represents your total (paid and unpaid) Earned Prioritized

Payments, earned Adjustments and earned Charges.

(d) How to determine your profit for Prioritized Payment purposes.

As of the end of each fiscal year and any interim period for which you

want to make a Distribution:

(1) Bring the Accumulation Account up to date by adding to it all

Prioritized Payments and Charges through the end of the appropriate

fiscal period.

(2) Determine whether you have profit for the purposes of this

section by doing the following computation:

(i) Cumulative Earmarked Profit (Loss) under Sec. 107.1510(f);

minus

(ii) The Earned Payments Account balance; minus

(iii) All Distributions previously made under Secs. 107.1550,

107.1560 and 107.1570(a); minus

(iv) Any Profit Participation previously allocated to SBA under

Sec. 107.1530, but not yet distributed.

(3) The amount computed in paragraph (d)(2) of this section, if

greater than zero, is your profit. If the amount is zero or less, you

have no profit.

(4) If you have a profit, continue with paragraph (e) of this

section. Otherwise, continue with paragraph (f) of this section.

(e) Allocating Prioritized Payments to the Distribution Account.

(1) If you have a profit under paragraph (d) of this section, determine

the lesser of:

(i) Your profit; or

(ii) The balance in your Accumulation Account.

(2) Subtract the result in paragraph (e)(1) of this section from

the Accumulation Account and add it to the Distribution Account and the

Earned Payments Account.

(f) How to compute Adjustments. You must compute Adjustments as of

the end of each fiscal year if you have a balance greater than zero in

either your Accumulation Account or your Distribution Account, after

giving effect to any Distribution that will be made no later than the

second Payment Date following the fiscal year end.

(1) Determine the combined average Accumulation Account and

Distribution Account balances for the fiscal year, assuming that

Prioritized Payments accumulate on a daily basis without compounding.

(2) Multiply the average balance computed in paragraph (f)(1) of

this section by the average of the Trust Certificate Rates for all the

Participating Securities poolings during the fiscal year.

(3) Add the amounts computed in this paragraph (f) to your

Accumulation Account.

(g) Licensee's obligation to pay Prioritized Payments after

redeeming Participating Securities. This paragraph (g) applies if you

have redeemed all your Participating Securities, but you still hold

Earmarked Assets and still have a balance in your Accumulation Account.

(1) You must continue to perform all the procedures in this

Sec. 107.1520 as of the end of each fiscal quarter and prior to making

any Distribution. You must distribute any Earned Prioritized Payments,

earned Adjustments and earned Charges in accordance with Sec. 107.1540.

(2) After you dispose of all your Earmarked Assets and make any

required Distributions in accordance with Sec. 107.1540, your

obligation to pay any remaining Accumulated Prioritized Payments,

unearned Adjustments and unearned Charges will be extinguished.

34. Section 107.1530 is proposed to be amended by removing

paragraphs (e)(3) and (e)(4) and revising paragraphs (c), (e)(2) and

(h) to read as follows:

Sec. 107.1530 How a Licensee computes SBA's Profit Participation.

* * * * *

(c) How to compute the Base. As of the end of each fiscal year and

any year-to-date interim period for which you want to make a

Distribution, compute your Base using the following formula:

B = EP-PPA-UL

where:

B=Base

EP=Earmarked Profit (Loss) for the period from Sec. 107.1510

PPA=Prioritized Payments for the period from Sec. 107.1520(a)(1),

Adjustments (if applicable) from Sec. 107.1520(f), and Charges (if

applicable) from Sec. 107.1130(d)(2)

UL=``Unused Loss'' from prior periods as determined in this

paragraph (c).

(1) If the Base computed as of the end of your previous fiscal year

(your ``Previous Base'') was less than zero, your Unused Loss equals

your Previous Base.

(2) If your Previous Base was zero or greater, your Unused Loss

equals zero, with the following exception: If you made an interim

Distribution of Profit Participation during your previous fiscal year,

and your Previous Base was lower than the interim Base on which your

Distribution was computed, then your Unused Loss equals the difference

between the interim Base and the Previous Base. For example, assume you

are computing your Base as of December 31, 1997, your fiscal year end.

Your Previous Base, computed as of December 31, 1996, was $3,000,000.

During 1996, you made an interim Distribution which was computed on a

Base of $3,500,000 as of June 30, 1996. The $500,000 difference between

the 1996 interim and year-end Bases would be carried forward as Unused

Loss in the computation of your Base as of December 31, 1997.

(3) If you had no Participating Securities outstanding as of the

end of your last fiscal year, you may request SBA's approval to treat

your Undistributed Net Realized Loss, as reported on SBA Form 468 for

that year, as Unused Loss. If you did not file SBA Form 468 because you

were not yet licensed as of the end of your last fiscal year, you may

request SBA's approval to treat pre-licensing losses as Unused Loss.

* * * * *

(e) Compute the ``PLC ratio''. * * *

(2) Exception. You may reduce the ratio computed under paragraph

(e)(1) of this section if you have increased your Leverageable Capital

above its highest previous level. The increase must have taken place at

least 120 days before the date as of which your Base is computed. In

addition, the increase must have been expressly provided for in a plan

of operations submitted to and approved by SBA in writing, or must be

the result of the takedown of commitments or the conversion of non-cash

assets that were included in your Private Capital. If these conditions

are satisfied, compute your reduced PLC ratio as follows:

(i) Divide the highest dollar amount of Participating Securities

you have ever had outstanding by your increased Leverageable Capital.

(ii) If the result in paragraph (e)(2)(i) is lower than your PLC

ratio currently in effect, such result will become your new PLC ratio.

* * * * *

(h) Computing SBA's Profit Participation. If the Base from

paragraph (c) of this section is greater than zero, you must compute

SBA's Profit Participation as follows:

(1) Multiply the Base from paragraph (c) by the Profit

Participation Rate from paragraph (g).

(2) If your last Profit Participation computation was for an

interim period during the same fiscal year and used a higher Profit

Participation Rate than the

[[Page 53268]]

Rate you just used in paragraph (h)(1) of this section, you must adjust

the amount computed in paragraph (h)(1) as follows:

(i) Determine the difference between the Profit Participation Rate

you just used in paragraph (h)(1) and the Rate used in your previous

computation;

(ii) Multiply the difference by the Base from your last Profit

Participation computation; and

(iii) Add the result to the amount you computed in paragraph

(h)(1).

(3) Reduce the Profit Participation computed in paragraphs (h)(1)

and (h)(2) by any amounts of Profit Participation that you distributed

or reserved for distribution to SBA, or its designated agent or

Trustee, for any previous interim period(s) during the fiscal year. The

result is SBA's Profit Participation (unless it is less than zero, in

which case SBA's Profit Participation is zero).

* * * * *

35. Section 107.1540 is proposed to be amended by adding a sentence

at the end of the introductory text to read as follows:

Sec. 107.1540 Distributions by Licensee--Prioritized Payment and

Adjustments.

* * * You must notify SBA of any planned distribution under this

section 10 business days before the distribution date, unless SBA

permits otherwise.

* * * * *

36. Section 107.1550 is proposed to be amended by adding a sentence

at the end of the introductory text and by revising paragraphs (a)(1)

and (b) to read as follows:

Sec. 107.1550 Distributions by Licensee--permitted ``tax

Distributions'' to private investors and SBA.

* * * You must notify SBA of any planned distribution under this

section 10 business days before the distribution date, unless SBA

permits otherwise.

(a) Conditions for making a tax Distribution. * * *

(1) You have paid all your Prioritized Payments, Adjustments, and

Charges, so that the balance in both your Distribution Account and your

Accumulation Account is zero (see Sec. 107.1520).

* * * * *

(b) How to compute the Maximum Tax Liability. (1) Compute your

Maximum Tax Liability for a full fiscal year only. Use the following

formula:

M=(TOI x HRO) + (TCG x HRC)

where:

M=Maximum Tax Liability

TOI=Net ordinary income allocated to your partners or other owners

for Federal income tax purposes for the fiscal year immediately

preceding the Distribution, excluding Prioritized Payments allocated to

SBA

HRO=The highest combined marginal Federal and State income tax rate

for corporations or individuals on ordinary income, determined in

accordance with paragraphs (b)(2) through (b)(4) of this section

TCG=Net capital gains allocated to your partners or other owners

for Federal income tax purposes for the fiscal year immediately

preceding the Distribution, excluding Prioritized Payments allocated to

SBA

HRC=The highest combined marginal Federal and State income tax rate

for corporations or individuals on capital gains, determined in

accordance with paragraphs (b)(2) through (b)(4) of this section.

(2) You may compute the highest combined marginal Federal and State

income tax rate on ordinary income and capital gains using either

individual or corporate rates. However, you must apply the same type of

rate, either individual or corporate, to both ordinary income and

capital gains.

(3) In determining the combined Federal and State income tax rate,

you must assume that State income taxes are deductible from Federal

income taxes. For example, if the Federal tax rate was 35 percent and

the State tax rate was 5 percent, the combined tax rate would be [35%

x (1-.05)]+5% = 38.25%.

(4) For purposes of this paragraph (b), the ``State income tax'' is

that of the State where your principal place of business is located,

and does not include any local income taxes.

* * * * *

37. In Sec. 107.1560, in the first column of the table in paragraph

(e), the column heading is proposed to be revised to read ``If your

ratio of Leverage to Leverageable Capital as of the fiscal period end

is:'', a sentence is proposed to be added at the end of the

introductory text, and paragraphs (a)(1), (a)(4) and (b) are proposed

to be revised to read as follows:

Sec. 107.1560 Distributions by Licensee--required Distributions to

private investors and SBA.

* * * You must notify SBA of any planned distribution under this

section 10 business days before the distribution date, unless SBA

permits otherwise.

(a) Conditions for making distributions. * * *

(1) You must have paid all Prioritized Payments, Adjustments and

Charges, so that the balance in both your Distribution Account and your

Accumulation Account is zero (see Secs. 107.1520 and 107.1540).

* * * * *

(4) The amount you distribute under this section must not exceed

your remaining Retained Earnings Available for Distribution.

(b) Total amount you must distribute. Unless SBA permits otherwise,

the total amount you must distribute equals the result (if greater than

zero) of the following computation:

(1) Your Retained Earnings Available for Distribution as of the end

of your fiscal year, after giving effect to any Distribution under

Secs. 107.1540 and 107.1550; minus

(2) All previous Distributions under this Sec. 107.1560 and

Sec. 107.1570(a) that were applied as redemptions or repayments of

Leverage; plus

(3) All previous Distributions under Sec. 107.1570(b) that reduced

your Retained Earnings Available for Distribution.

* * * * *

38. Section 107.1570 is proposed to be amended by adding a sentence

at the end of the introductory text and by revising the heading and

paragraphs (b)(1)(i) and (b)(1)(ii) to read as follows:

Sec. 107.1570 Distributions by Licensee--optional Distributions to

private investors and SBA.

* * * You must notify SBA of any planned distribution under this

section 10 business days before the distribution date, unless SBA

permits otherwise.

* * * * *

(b) Other optional Distributions. * * *

(1) Conditions for making a Distribution. * * *

(i) You have distributed all Earned Prioritized Payments, earned

Adjustments, and earned Charges, so that the balance in your

Distribution Account is zero (see Sec. 107.1520).

(ii) You have distributed all Profit Participation computed under

Sec. 107.1530 which you are required to distribute under Sec. 107.1560

or permitted to distribute under Sec. 107.1570(a), as appropriate, and

you have made all required Distributions under Sec. 107.1560.

* * * * *

39. Section 107.1575 is proposed to be added to subpart I to read

as follows:

Sec. 107.1575 Distributions on other than Payment Dates.

(a) Permitted distributions on other than payment dates.

Notwithstanding any provisions to the contrary in Secs. 107.1540

through 107.1570, you may make Distributions on dates other than

Payment Dates as follows:

[[Page 53269]]

(1) Required annual Distributions under Secs. 107.1540(a)(1), and

any Distributions under Secs. 107.1550 and 107.1560, must be made no

later than the second Payment Date following the end of your fiscal

year;

(2) Required Distributions under Sec. 107.1540(b) must be made no

later than the first Payment Date following the end of the applicable

fiscal quarter;

(3) Optional Distributions under Sec. 107.1540(a)(2) and

Sec. 107.1570 may be made on any date.

(b) Conditions for making distribution. All Distributions under

this Sec. 107.1575 are subject to the following conditions:

(1) You must obtain SBA's written approval before the distribution

date;

(2) You must use the distribution date as the ending date of the

period for which you compute your Earmarked Profits, Prioritized

Payments, Adjustments, Charges, Profit Participation, Retained Earnings

Available for Distributions, liquidity ratio, Capital Impairment, and

any other applicable computations required under Secs. 107.1500 through

107.1570;

(3) If your Distribution includes an amount which SBA will apply as

a redemption of Participating Securities, the effective date of such

redemption, for all purposes including future computations of

Prioritized Payments, will be the next Payment Date following the

distribution date.

40. In Sec. 107.1580, the introductory text of paragraph (a) is

proposed to be revised to read as follows:

Sec. 107.1580 Special rules for In-Kind Distributions by Licensees.

(a) In-Kind distributions. A Distribution under Secs. 107.1540,

107.1560 or 107.1570 may consist of securities (an ``In-Kind

Distribution''). Such a Distribution must satisfy the conditions in

this paragraph (a).

* * * * *

41. Section 107.1590 is proposed to be amended by removing

paragraph (c), redesignating paragraph (d) as paragraph (c), and

revising paragraph (a)(1) to read as follows:

Sec. 107.1590 Special rules for companies licensed on or before March

31, 1993.

* * * * *

(a) Election to exclude pre-existing portfolio. * * *

(1) The proceeds of your first issuance of Participating Securities

are not used to refinance outstanding Debentures (see

Sec. 107.1585(a)). SBA will consider payment or prepayment of any

outstanding Debenture to be a refinancing unless you demonstrate to

SBA's satisfaction that you can pay the Debenture principal without

relying on the proceeds of the Participating Securities.

* * * * *

42. In Sec. 107.1600, the first sentence of paragraph (a) and

paragraph (b) are proposed to be revised to read as follows:

Sec. 107.1600 SBA authority to issue and guarantee Trust Certificates.

(a) Authorization. Sections 319 (a) and (b) of the Act authorize

SBA or its CRA to issue TCs, and SBA to guarantee the timely payment of

the principal and interest thereon. * * *

(b) Periodic exercise of authority. SBA will issue guarantees of

Debentures and Participating Securities under section 303 and of TCs

under section 319 of the Act at three month intervals, or at shorter

intervals, taking into account the amount and number of such guarantees

or TCs.

* * * * *

43. Section 107.1720 is proposed to be added to subpart I to read

as follows:

Sec. 107.1720 Characteristics of SBA's guarantee.

If SBA agrees to guarantee a Licensee's Debentures or Participating

Securities, such guarantee will be unconditional, irrespective of the

validity, regularity or enforceability of the Debentures or

Participating Securities or any other circumstances which might

constitute a legal or equitable discharge or defense of a guarantor.

Pursuant to its guarantee, SBA will make timely payments of principal

and interest on the Debentures or the Redemption Price of and

Prioritized Payments on the Participating Securities.

44. In Sec. 107.1820, paragraph (e)(9) is proposed to be revised to

read as follows:

Sec. 107.1820 Conditions affecting issuers of Preferred Securities

and/or Participating Securities.

* * * * *

(e) Restricted Operations Conditions. * * *

(9) Failure to meet investment requirements. You fail to make the

amount of Equity Capital Investments required for Participating

Securities (Sec. 107.1500(b)(4)), if applicable to you; or you fail to

maintain as of the end of each fiscal year the investment ratios or

amounts required for Leverage in excess of 300 percent of Leverageable

Capital (Sec. 107.1160 (c)) or Preferred Securities in excess of 100

percent of Leverageable Capital (Sec. 107.1160(d)), if applicable to

you. In determining whether you have met the maintenance requirements

in Sec. 107.1160(c) or (d), SBA will disregard any prepayment, sale, or

disposition of Venture Capital Financings, any increase in Leverageable

Capital, and any receipt of additional Leverage, within 120 days prior

to the end of your fiscal year.

* * * * *

45. In Sec. 107.1830, paragraph (a) is revised to read as follows:

Sec. 107.1830 Licensee's Capital Impairment--definition and general

requirements.

(a) Applicability of this section. This Sec. 107.1830 applies to

Leverage issued on or after April 25, 1994. For Leverage issued before

April 25, 1994, you must comply with paragraphs (e) and (f) of this

section and the Capital Impairment regulations in this part in effect

when you issued your Leverage. For all Leverage issued, you must also

comply with any contractual provisions to which you have agreed.

* * * * *

Dated: September 25, 1997.

Aida Alvarez,

Administrator.

[FR Doc. 97-26720 Filed 10-10-97; 8:45 am]

BILLING CODE 8025-01-P