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: In order to encourage small business investment companies

(SBICs) to invest in inner cities and rural areas and in businesses

that serve such areas, the Small Business Administration (SBA) is

proposing to introduce a new SBIC investment category called low and

moderate income investments (LMI Investments). For each SBIC financing

that qualifies as an LMI Investment, SBA proposes to modify its

regulations on control of the small business, ``cost of money'' of the

financing, and term of the financing. SBA is also proposing to make

available a patient form of debenture leverage that could be issued

only by SBICs that make LMI Investments. These incentives would apply

only to LMI Investments made after the effective date of a final rule.

DATES: Comments must be submitted on or before March 11, 1999.

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: Saunders Miller, Investment Division,

at (202) 205-3646.

SUPPLEMENTARY INFORMATION: Since its creation in 1958, the SBIC Program

has proven to be an extremely effective mechanism for serving the

capital needs of tens of thousands of small businesses. However, there

are many eligible small businesses that have not yet been reached by

either the SBIC Program or the private marketplace. Many of these

businesses are located in inner cities and rural areas around the

country. SBA has made a commitment to increase access to its programs,

including the SBIC Program, by these businesses.

Small businesses located in inner cities and rural areas appear to

have greater difficulty raising capital than small businesses located

elsewhere. Explanations for this may vary, but surely include the

perceived risks associated with investing in any previously untapped

market. Especially when the untapped market is in an area of above-

average unemployment and poverty, the perceived risks may overshadow

the real opportunities.

SBA is proposing a program of narrowly-tailored regulatory and

financial incentives to overcome those perceptions and to encourage

SBICs to expand their investment activity into inner cities and rural

areas. The incentives would be available to any SBIC making qualified

investments (LMI Investments) in qualified small businesses (LMI

Enterprises) that are located in or that provide employment for inner

cities and rural areas (LMI Zones). The proposed incentives fall into

two categories. First, SBA would allow SBICs greater regulatory

flexibility when structuring and making LMI Investments. Second, SBA

would make available a deferred-interest debenture exclusively for the

financing of LMI Investments.

Defining Low and Moderate Income Zones (LMI Zones)

The Federal Government has already identified five different and,

in some cases, overlapping geographic areas in need of special

attention: (1) Historically underutilized business zones or HUBZones)

(as defined in 13 CFR Sec. 126.103), (2) Urban Empowerment Zones (as

designated by the Secretary of the Department of Housing and Urban

Development (Sec'y-HUD)) and Rural Empowerment Zones (as designated by

the Secretary of the Department of Agriculture (Sec'y-AG)), (3) Urban

Enterprise Communities (as designated by the Sec'y-HUD) and Rural

Enterprise Communities (as designated by the Sec'y-AG), (4) Low and

Moderate Income areas (as recognized by the Federal Financial

Institutions Examination Council), and (5) Persistent Poverty counties

(as classified by the Economic Research Service of the Department of

Agriculture). These areas share a shortage of investment capital and a

critical need for job creation. These areas also conform generally to

what would be considered inner cities and rural areas. For the purposes

of the SBIC Program, SBA is proposing to consolidate all of these areas

into a single category to be named Low and Moderate Income Zones, or

LMI Zones. A new defined term, LMI Zone, would be added.

Each of the five areas that would comprise LMI Zones has an

electronic address-database associated with it. These databases are

Government-operated and are accessible to the general public via the

Internet. An SBIC can determine whether an address is located in an LMI

Zone by going to one of the Government websites listed below and

inputting the address. If the address is not in that database's defined

area, the SBIC can go to the next Government website on the list. If

the address is located in a HUBZone, an Empowerment Zone, an Enterprise

Community, a Low or Moderate Income area, or a Persistent Poverty

county, it will be considered to be located in an LMI Zone.

The Government databases for the five areas are:

1. HUBZones: www.sba.gov/hubzone/hubqual.html

2. Empowerment Zones: www.hud.gov/ezec/locator/

3. Enterprise Communities: same as for Empowerment Zones

4. Low and Moderate Income areas: www.ffiec.gov/geocode

5. Persistent Poverty counties: www.econ.ag.gov/epubs/other/typolog

SBA is exploring the possibility of consolidating these databases

into a single electronic database at SBA. The final rule will contain

further information on this subject.

Defining LMI Enterprise

SBA is proposing to add a new defined term, LMI Enterprise. The

definition would include any eligible small business with a principal

place of business in an LMI Zone at the time the business applies for

SBIC financing. In addition, SBA recognizes that businesses located

outside of LMI Zones can be an important source of employment for

persons residing within LMI Zones. To reach these important sources of

employment, the proposed definition of LMI Enterprise would also

include any eligible small business, regardless of its location, that

has at least 35 percent of its full time employees residing in LMI

Zones at the

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time the business applies for SBIC financing. The percentage

requirement is based on SBA's HUBZone Program (15 U.S.C. 632(p)).

Under proposed Section 107.610(e), each LMI Enterprise would be

required to certify to the investing SBIC as to the location of either

its principal place of business or the primary residences of all of its

full-time employees. The certification would be dated no earlier than

the date the small business applies for the SBIC financing. The SBIC

would keep the certification in its files, along with the SBIC's own

certification that the small business qualifies as an LMI Enterprise

and the basis for such qualification. To make this certification, the

SBIC would have to access the electronic databases to verify that the

addresses of the small business or 35 percent of its full-time

employees are within an LMI Zone.

Defining LMI Investment

SBA wants to ensure that the SBIC Program is used to promote true

venture capital financing in LMI Zones, not just high-interest lending.

SBA is also concerned that the assets of LMI Enterprises not be placed

unduly at risk as a result of receiving financing from SBICs. SBA is

therefore proposing that LMI Investments be defined to include only

those SBIC financings that are in the form of equity securities (as

defined in Sec. 107.800) or debt securities (as defined in

Sec. 107.815) which are subordinated to all borrowings of the business

from financial institutions. As a further requirement, LMI Investments

in the form of debt securities would be required to be unsecured,

although the SBIC would be permitted to accept a guarantee of the debt

security if the guarantee were itself unsecured. The SBIC would be an

unsecured creditor of the LMI Enterprise, with all the legal remedies

available to unsecured creditors.

Regulatory and Financial Incentives

From SBA's discussions with community development venture capital

managers, including managers of Specialized SBICs, and from SBA's

observations of SBIC and private venture activity, it appears that SBA

regulations may not encourage and may actually deter investment in LMI

Zones. SBA regulations do not permit some of the financing structures

and protections favored by the groups currently investing in inner

cities and rural areas. Furthermore, the type of SBA financial

assistance available to most SBICs--the SBA guaranteed debenture--does

not match well with the type of venture capital financing that SBA

wants to encourage in LMI Zones.

After careful consideration, SBA has concluded that certain of its

regulations need to be modified and a more patient form of debenture

needs to be created if SBICs are to be expected to actively pursue

investments in LMI Zones.

1. Temporary Control of the LMI Enterprise

Many businesses located in or serving LMI Zones are at an earlier

stage in their development than the businesses customarily financed by

SBICs. These businesses may be perceived as having a higher degree of

risk. Venture capital managers investing in inner cities and rural

areas typically insist on a high degree of influence over the small

business' operations. Often this takes the form of a controlling equity

position in the company.

In the SBIC Program, SBICs are not permitted to assume control over

a small business. Over the years, though, SBA has identified four

circumstances under which temporary control over a small business may

be warranted. These are set forth in current Section 107.865(d). SBA is

today proposing to add a fifth circumstance to the list--the making of

an LMI Investment. Under the proposal, an SBIC would be permitted to

take temporary control of each business in which it makes an LMI

Investment.

SBA makes this proposal with some hesitation. SBA's statutory

mission is to protect small businesses. This mission must not be

compromised. However, when SBA policies adopted to protect small

businesses have the unintended effect of foreclosing opportunities for

those businesses to grow and to modernize, SBA must reconsider its

policies. If, as SBA has concluded, the regulations deter SBICs from

making many LMI Investments because of the prohibition against taking

control, then owners of LMI Enterprises are being denied the

opportunity to choose to give up (or share) control of the business

temporarily in exchange for SBIC financing. Under SBA's proposal,

owners of LMI Enterprises would be given the opportunity to make that

choice. It would be the small business owner, not SBA, who would decide

whether the risk of losing temporary control over the business was

worth the benefits of the financing. SBA recognizes the importance of

this issue and encourages readers to submit comments.

Under SBA's proposal, control over the LMI Enterprise would be

permitted only for the term of the financing. As discussed below, the

term of an LMI Investment may be less than the 5 years typically

required for SBIC investments.

If an SBIC assumes control over an LMI Enterprise that participates

in SBA's 8(a) Program or SBA's Small Disadvantaged Business Program,

the LMI Enterprise will lose its eligibility for those Programs.

2. Royalties and Cost of Money

SBA is proposing to exclude royalty payments on LMI Investments

from the calculation of ``Cost of Money'' under Section 107.855. Cost

of Money is the term for the sum of the interest rate and other charges

that an SBIC imposes on a small business. The Cost of Money to the

small business must not exceed the SBIC's Cost of Money ceiling, as

computed under Section 107.855(c).

The computation of Cost of Money already excludes certain fees,

charges, and other payments made by the small business, as set forth in

Section 107.855(g)(1)-(11). This proposed rule would add royalty

payments under an LMI Investment as one more exclusion from Cost of

Money.

To qualify for the exclusion, the royalty would have to be based on

improvement in the performance of the LMI Enterprise after the date of

the financing. The royalty could be expressed, for example, as a

percentage of any increase in an underlying unit of measurement (e.g.,

revenues or sales) after the date of the financing.

If the SBIC accepts a royalty payment from an LMI Enterprise that

is expressed as a percentage of the business' overall revenues, the

royalty payment will be included in the Cost of Money calculation. If,

on the other hand, the royalty is expressed as a percentage of any

increase in the business' revenues after the date of the financing, the

royalty payment will be excluded from the Cost of Money calculation. If

an exact measurement of revenues or sales is not possible on (or even

``as of'') the date of the financing, the parties may use an estimate

instead.

SBA believes that this proposed change is necessary to encourage

SBICs to actively pursue investments in inner cities and rural areas.

If adopted, this change would allow greater flexibility in structuring

LMI Investments since LMI Enterprises would have the opportunity to

offer royalty payments to an SBIC rather than bring the SBIC in as a

new shareholder. This would result in more financing choices for the

small business.

3. Minimum Term of LMI Investment

SBA is proposing a one-year minimum term for LMI Investments. As a

general rule, SBIC financings must be for a minimum period of 5 years.

Four

[[Page 6258]]

exceptions to the rule currently exist and are found in Section

107.835. SBA proposes to add LMI Investments as a fifth exception. SBA

believes that this proposed change, in combination with the proposed

changes discussed above, would provide the necessary encouragement for

SBICs to aggressively seek out LMI Enterprises to finance.

A conforming change is being proposed to Section 107.850(a).

Currently, this section prohibits the mandatory redemption of equity

securities by a small business within 5 years from the date of the

first closing of the financing. Under the proposed change, an SBIC

could not require an LMI Enterprise to redeem an equity security LMI

Investment within 1 year from the date of the first closing of the

financing.

4. Deferred Interest Debenture

SBA recognizes that some uncertainty naturally accompanies an

investor's first efforts in any previously untapped market. SBA does

not want SBICs to be deterred from making those efforts in LMI Zones

solely because the SBIC managers are concerned about being able to make

current interest payments on SBA guaranteed debentures. SBA is prepared

to allow SBICs to finance LMI Investments with a more patient-type of

debenture (called an LMI Debenture in this proposed rule).

The LMI Debenture currently under consideration would be a ten-

year, non-amortizing debenture issued at a discount so as to be, in

effect, ``zero coupon'' for the first 5 years. The LMI Debenture would

require semi-annual interest payments on the face amount for the last 5

years. For example, an SBIC issuing a $100,000 debenture at a 6 percent

interest rate would receive approximately $75,000 upon issuance, and

would make no interest payments for the first 5 years. Starting with

the sixth year, the SBIC would make semi-annual interest payments based

on an annual rate of 6 percent on the debenture's face amount of

$100,000. At maturity (or sooner in the event of prepayment), the SBIC

would pay the $100,000 face amount of the debenture. SBA leverage fees

would not be deferred; they would be paid as required under current

Section 107.1130.

Each SBIC that is licensed and eligible to issue debentures under

current regulations would be eligible to issue LMI Debentures to the

extent it makes LMI Investments. To ensure that LMI Debenture funds are

used to support LMI Investments only, an SBIC's eligibility for these

debentures would be limited by the amount of its outstanding LMI

Investments (made after the effective date of the final rule).

More specifically, an SBIC's eligibility for an LMI Debenture would

be determined in two ways. First, the SBIC would have to be eligible to

issue leverage in an amount equal to the face amount of the LMI

Debenture. Eligibility for this purpose is determined under Sections

107.1120-1160. Second, the SBIC would have to have LMI Investments in

an amount approximating the net proceeds of the LMI Debenture. Since

the actual amount of the net proceeds of an LMI Debenture will depend

on interest rates in effect at the time of its issuance and cannot be

known at the time of the SBIC's leverage application, SBA is

considering using a fixed multiple of 1.5 to make this second

eligibility determination. An SBIC would be eligible for an LMI

Debenture with a face amount equal to 1.5 times the amount of the

SBIC's LMI Investments at the time of application. In the above

example, the SBIC would be required to have $66,666 of LMI Investments

in its portfolio at the time the SBIC applied to issue the $100,000 LMI

Debenture.

No regulatory changes are necessary to implement this new type of

debenture.

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 may constitute a significant

regulatory action within the meaning of Executive Order 12866, since it

raises a new policy issue reflecting the President's priorities.

SBA certifies that this proposed rule does 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. This

proposed rule would change some requirements to encourage SBICs to make

additional qualified investments in low and moderate income zones. In

FY 1998, SBICs invested in 2700 small businesses. While the proposed

rule may increase the number of small businesses receiving SBIC

investments because SBICs may make investments in smaller increments,

the number of small businesses eligible for SBIC investments would not

change.

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

is requesting a modification of SBA Forms 468 and 1031 that will permit

participating SBICs to report the information they are required to

maintain by the proposed rule. The proposed rule will require SBICs

that make LMI Investments to keep track of their LMI Investments and

periodically report them SBA. To determine whether an SBIC is making an

LMI Investment, the SBIC will have to verify the location of the LMI

Enterprise or its employees using the databases discussed in this

proposed rule. SBA estimates that the time necessary to verify the

location of an LMI enterprise or its employees will average less than

one hour per LMI Investment. The reporting requirements are de minimis

since current forms will only be changed to reflect LMI investments.

SBA further estimates that SBICs may make approximately 500 LMI

Investments per year. SBA is seeking comment on whether this

information is necessary for the proper performance of the function of

the agency, accuracy of burden estimate, in addition to ways to

minimize this estimate, and ways to enhance the quality. Please send

comments to Saunders Miller, SBA, Investment Division, 409 3rd Street,

SW., Washington, DC 20416 and to David Rostker, Office of Management

and Budget, Office of Information and Regulatory Affairs, 725 17th

Street, NW., Washington, DC 20503.

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 proposes to amend 13 CFR part

107 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.

2. Amend Sec. 107.50 to add definitions of LMI Enterprise, LMI

Investment, and LMI Zone, to read as follows:

Sec. 107.50 Definitions of terms.

* * * * *

LMI Enterprise means, at the time of application for SBIC

financing, a Small Business:

[[Page 6259]]

(1) That has its principal place of business in an LMI Zone, or

(2) In which at least 35 percent of the full-time employees have

primary residences in LMI Zone(s).

LMI Investment means a financing of an LMI Enterprise, made after

March 15, 1999, in the form of equity securities or debt securities

that are subordinated to all other borrowings of the business from

financial institutions. The debt securities may be guaranteed, but

neither the debt securities nor the guarantee may be collateralized or

otherwise secured.

LMI Zone means any area located within a HUBZone (as defined in

Sec. 126.103 of this chapter), an Urban Empowerment Zone or Urban

Enterprise Community (as designated by the Secretary of the Department

of Housing and Urban Development), a Rural Empowerment Zone or Rural

Enterprise Community (as designated by the Secretary of the Department

of Agriculture), an area of Low Income or Moderate Income (as

recognized by the Federal Financial Institutions Examination Council),

or a county with Persistent Poverty (as classified by the Economic

Research Service of the Department of Agriculture).

* * * * *

3. Amend Sec. 107.610 to add paragraph (e) to read as follows:

Sec. 107.610 Required certifications for Loans and Investments.

* * * * *

(e) For each LMI Investment:

(1) A certification by the concern as to its principal place of

business or the principal residences of its full-time employees, as

applicable, dated no earlier than the date of application for SBIC

financing, and

(2) A certification by the SBIC that the concern qualifies as an

LMI Enterprise as of the date of the concern's certification and the

basis for such qualification.

4.-5. Amend Sec. 107.835 to redesignate paragraph (d) as paragraph

(e) and add paragraph (d) to read as follows:

Sec. 107.835 Exceptions to minimum duration/term of Financing.

* * * * *

(d) An LMI Investment with a term of at least one year; or

* * * * *

6. Amend Sec. 107.850 to revise the introductory text of paragraph

(a) to read as follows:

Sec. 107.850 Restrictions on redemption of Equity Securities.

(a) A Portfolio Concern cannot be required to redeem Equity

Securities earlier than 5 years (or 1 year in the case of an LMI

Investment) from the date of the first closing unless:

* * * * *

7. Amend Sec. 107.855 to add paragraph (g)(12) to read as follows:

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

Small Businesses (``Cost of Money'').

* * * * *

(g) * * *

(12) Royalty payments received under any LMI Investment if the

royalty is based on improvement in the performance of the Small

Business after the date of the financing.

* * * * *

8. Amend Sec. 107.865 to remove the ``or'' at the end of paragraph

(d)(3), replace the period at the end of paragraph (d)(4) with ``;

or'', add paragraph (d)(5) and revise paragraph (e)(3) to read as

follows:

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

Licensee.

* * * * *

(d) * * *

(5) If your financing of the Small Business is an LMI Investment.

(e) * * *

(3) Your agreement to relinquish Control within 5 years (although

you may, under extraordinary circumstances, request SBA's approval of

an extension beyond 5 years). In the case of an LMI Investment with a

term of less than 5 years, you must agree to relinquish Control within

the term of the financing.

* * * * *

Dated: January 13, 1999.

Aida Alvarez,

Administrator.

[FR Doc. 99-2915 Filed 2-8-99; 8:45 am]

BILLING CODE 8025-01-P