Small Business Investment Companies

SMALL BUSINESS ADMINISTRATION

13 CFR Part 107

Small Business Investment Companies

AGENCY: Small Business Administration.

ACTION: Final rule.

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SUMMARY: This final rule revises the regulations found at 13 CFR Part

107, governing the Small Business Investment Company (SBIC) Program. It

eliminates inconsistencies, clarifies procedures, accommodates program

experience and industry changes, and provides for more efficient

program operation. It also clarifies and shortens regulations where

appropriate, eliminates redundant provisions, consolidates and

reorganizes sections and clarifies ambiguous language.

EFFECTIVE DATE: This final rule is effective January 31, 1996.

FOR FURTHER INFORMATION CONTACT:

Leonard Fagan, Office of Investment; telephone no. (202) 205-6510.

SUPPLEMENTARY INFORMATION: In response to a Memorandum from President

Clinton for all federal agencies to simplify their regulations, SBA

published a proposed rule on November 28, 1995, to revise the

regulations governing the SBIC program. See 60 FR 58530 (November 28,

1995). The public was afforded a thirty-day period in which to submit

comments on the proposed rule to SBA. During that period, SBA received

over 30 letters containing over 200 comments. After giving careful

consideration to the comments and concerns raised in those letters, SBA

is today finalizing the proposed rule with certain modifications

discussed below. Only those sections which have changed, which were

commented on or which

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need some clarification will be discussed.

In accordance with 5 U.S.C. 553(d)(3), SBA has determined that good

cause exists to make this rule effective upon publication. Ample notice

of material changes has been given the interested public through

proposed rules published in the Federal Register inviting public

comment and through distribution of draft rules before publication of

the proposed rules. All comments received from the interested public

have been carefully considered. Representatives of the entities

affected by this rule concur with an immediate effective date. Almost

all regulatory changes will relieve restrictions or merely reorganize

and simplify text. To the extent there are substantive changes

contained in these rules, SBA believes no prejudice will occur to

affected entities by making the rules immediately effective. The

affected entities will have had an adequate opportunity to take any

necessary steps to be in compliance with the rules by the effective

date, but to the extent that may not be the case, any instance of non-

compliance with a changed regulatory provision during the first 30 days

after publication will be treated with such liberality as may be needed

to avoid prejudice. New fees imposed through these rules will not be

enforced until at least 30 days after publication.

General Comments

Those comment letters which addressed the proposed renumbering,

reorganization and rewrite of Part 107 were overwhelmingly

complimentary. Some felt the proposed regulations were a vast

improvement over the old, while others commended SBA on its efforts to

simplify and streamline the regulations. Most agreed that the

reorganization and stylistic revisions will make Part 107 easier to

follow and understand. As one commenter stated, ``Practicality and

common sense really pervade these new proposals.''

Part I

1. Subpart A--Introduction to Part 107

SBA agrees with the comment received on proposed Sec. 107.20,

suggesting that it is unnecessary to specifically mention Section

301(d) Licensees when discussing the fact that all Licensees must

comply with all applicable regulations. The section has been revised

and finalized accordingly.

2. Subpart B--Definition of Terms Used in Part 107

a. ``Associate''

(1) Several commenters suggested that the proposed language

defining ``any person regularly serving a Licensee in the capacity of

attorney at law'' as an Associate was ambiguous and could be construed

too broadly. SBA agrees and will return to the language in the current

definition which states that an Associate includes ``any Person

regularly serving a Licensee on retainer in the capacity of attorney at

law''. The definition is finalized accordingly.

b. ``Control''

The proposed definition of ``Control'' has been adopted with a

change suggested by one commenter. In the proposed rule, Control could

be achieved through possession of the ``power to veto'' the direction

of the management and policies of a concern; in the final rule, the

reference to veto power is deleted. The commenter's concern was that

this phrase could be interpreted so broadly as to prohibit normal

covenants necessary to protect a Licensee's investments. This was not

SBA's intention; furthermore the Agency believes that its concerns

about negative Control of Small Businesses are sufficiently addressed

by the reference in the definition to ``indirect'' Control, as well as

by the ``presumption of Control'' provisions under Sec. 107.865(b).

c. ``Control Person''

Under the existing regulations, a Person with at least a 40 percent

limited partnership interest in a Licensee's general partner is a

Control Person. Paragraph (4) of the proposed definition would apply

the same criterion to a limited partner in the Licensee itself. One

commenter objected to the entire concept of classifying a limited

partner as a Control Person, suggesting that the provision contradicts

established partnership principles and could threaten a limited

partner's limited liability status. SBA does not believe that a

regulatory definition would have this effect; furthermore, the Agency

has stated previously that the definition of Control Person is intended

to cover persons in a position to exercise influence, but not

necessarily control, over a Licensee. Nevertheless, in response to the

concern expressed, SBA has increased the ownership percentage required

to classify a limited partner (of either a Licensee or its general

partner) as a Control Person from 40 percent to 50 percent.

d. ``Disadvantaged Businesses''

SBA received one comment objecting to the proposed language

requiring that a Disadvantaged Business be managed ``on a day to day

basis'' by persons who meet the criteria for social or economic

disadvantage. The commenter considered this phrase an unwarranted

expansion of the definition. SBA disagrees; the requirement that

disadvantaged owners be actively involved in the management of their

companies reflects long-standing SBA policy and is consistent with the

Agency's statutory mandate for all of its programs for Disadvantaged

Businesses. Accordingly, the definition is finalized as proposed.

e. ``Equity Capital Investment''

SBA received one comment suggesting that ``a preferred stock

investment with the liquidating dividend payable to the extent of

available assets'' should be considered an Equity Capital Investment.

SBA's interpretation of the Small Business Investment Act of 1958, as

amended (``Act'') is that dividends may be payable only to the extent

of retained earnings; this treatment is consistent with the statutory

language concerning subordinated debt instruments, which can qualify as

Equity Capital Investments if, among other things, they ``provide for

interest payments contingent upon and limited to the extent of

earnings.'' Accordingly, the definition is finalized without change.

f. ``Institutional Investor''

In the proposed rule, SBA added language to the definition of

``Institutional Investor'' to clarify that an entity cannot satisfy the

net worth test on the basis of unfunded commitments from its investors.

One commenter suggested that this language be dropped and that such

commitments be recognized. SBA disagrees with this suggestion because

it increases the government's financial risk. SBA has protections in

place which allow it to require Institutional Investors to fund their

commitments to a Licensee under certain circumstances; however, it is

unlikely that such requirements could be extended to investors who are

one or more levels removed from the Licensee. Therefore, the proposed

definition is adopted as final.

g. ``Start-Up Financing''

The proposed rule did not make any changes in this definition, but

used it in a new context--it was proposed that Licensees be permitted

to take temporary Control of Start-Up Financing under Sec. 107.865(d).

In this context,

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several commenters felt that the definition was too narrow in terms of

the types of businesses covered, the length of time the business had

been in existence, and the exclusion of businesses formed to acquire

existing businesses. SBA agrees that a broader definition is

appropriate for purposes of Sec. 107.865 and is not objectionable for

purposes of determining Capital Impairment, the other context in which

it appears. Accordingly, the final rule largely eliminates these

restrictions. A business formed as an acquisition company can qualify

as long as the acquired company meets the criteria for a Start-Up

Financing.

The limitations on sales revenue and cash flow have also been

modified: Under paragraph (3) of the proposed definition, companies

could not have ``sales exceeding $5,000,000 or positive cash flow in

any fiscal year.'' The final rule prohibits ``sales exceeding

$3,000,000 or positive cash flow from operations in any of the past

three fiscal years.'' SBA believes the lower sales ceiling is more

appropriate to a true start-up company; the other changes respond to

comments received.

h. ``Unrealized Appreciation''

The proposed definition is adopted with one minor editorial change.

i. ``Unrealized Depreciation''

The proposed definition is adopted with one minor editorial change.

j. ``Qualified Non-Private Funds''

The proposed definition, which appears in Sec. 107.230(d), is

adopted without change. SBA received one comment objecting to the

language that permits government grants to nonprofit entities to be

Qualified Non-Private Funds ``if SBA determines that such funds have

taken on a private character and the nonprofit corporation or

institution is not a mere conduit.'' SBA believes the language is an

appropriate interpretation of the Act; in particular, the ``private

character'' standard is specifically cited in the legislative history.

3. Subpart C--Qualifying for an SBIC License

a. Organizing a Licensee

Comments received on proposed Sec. 107.100 and Sec. 107.110

questioned why Section 301(c) and Section 301(d) Licensees could not be

formed as limited liability companies. Limited liability companies are

not a permitted form of organization recognized by the Act. Therefore,

the rule is adopted as proposed.

b. 1940 Act and 1980 Act Companies

SBA received several comments on proposed Sec. 107.115, all of

which objected to the restriction against licensing 1940 Act or 1980

Act companies that elect to be taxed as regulated investment companies

under section 851 of the Internal Revenue Code. SBA is persuaded that

Licensees would not be denied the ability to access capital by using

these structures. Therefore, the final rule allows Licensees to

organize as or convert to 1940 Act or 1980 Act Companies, and to elect

to be taxed as regulated investment companies. The regulation also

clarifies that when the tax code conflicts with SBA regulations or

guidelines governing distributions, the SBA requirements will apply

unless the Licensee requests and receives a waiver in accordance with

the regulations.

c. SBA Approval of Initial Management Expenses

Proposed Sec. 107.140, which requires all new SBIC license

applicants (not just applicants planning to issue Participating

Securities) to obtain SBA approval of their initial Management

Expenses, is adopted with one change: This section will not apply to

non-leveraged Licensees, which present no financial risk to the Agency.

d. Management and Ownership Diversity

Proposed Sec. 107.150, which requires all license applicants

planning to obtain Leverage to have diversity between management and

ownership, is adopted without change. SBA received one comment that

applicants should be permitted in all cases to satisfy the diversity

requirement on a ``look through basis'' (that is, at the parent level).

This option is available to Licensees if SBA approves; however, as

stated in the preamble to the proposed rule, the Agency believes it

must have discretion in this area in order to assure that a Licensee

has genuine diversity, as opposed to an ownership structure that

provides ``technical'' diversity but does not satisfy the intent of the

regulation.

e. Special Rules for Partnership Licensees

Proposed Sec. 107.160(b), allowing an Entity General Partner to be

organized for the sole purpose of serving as the general partner of one

or more licensees, is adopted without change. SBA considered the

comment suggesting that an Entity General Partner not be precluded from

other activities, but rejected the suggestion due to the complexity of

examining a general partner involved in both SBA and non-SBA related

activities. The Agency believes that this would result in an undue

burden both on its examiners and on the Entity General Partner.

f. Minimum Capital Requirements for Licensees

SBA received one comment on proposed Sec. 107.210(b) (which did not

contain any substantive changes) suggesting that the Regulatory Capital

requirement for Section 301(d) Licensees be inclusive, not exclusive

of, unfunded commitments. This comment is inconsistent with SBA's

interpretation of the minimum capital requirements of the Act;

therefore, the proposed rule has been adopted as final without change.

g. Special Minimum Capital Requirements for Licensees Issuing Leverage

A comment received on proposed Sec. 107.220(b) argued in favor of

omitting the ``special'' minimum capital requirements which require any

company licensed after the regulation is finalized to have Regulatory

Capital of at least $5,000,000 in order to apply for Debentures, unless

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

over the long term with a lower amount. The same commenter also

suggested revising the ``grandfather'' provisions in Sec. 107220(c)(1),

which allow certain existing Licensees that do not meet the current

minimum capital requirements to receive additional Leverage if they are

profitable. The commenter wrote that other criteria besides

profitability should be considered.

SBA is finalizing both provisions as proposed. The Agency considers

these standards to be vital to the continuing success of the SBIC

program. As stated in the preamble to the proposed rule, a review of

the financial performance of Licensees supports the conclusion that

higher levels of Regulatory Capital significantly reduces the

likelihood of unprofitable operations over the long term. As to

Sec. 107.220(c), the profitability criterion has been used since 1990,

and SBA continues to believe that profitability is the best and most

objective indicator of future successful operations.

SBA has made two editorial changes to proposed Sec. 107.220(c)(2).

Proposed paragraph (c)(2)(i), which deals with Debentures maturing

before December 31, 1995, has been deleted because it is not longer

applicable. Proposed paragraph (c)(2)(ii) has been incorporated into

paragraph (c)(2) and revised by replacing ``a term of three years''

with ``a term to be determined by

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SBA.'' This change has been made because three-year Leverage is not

routinely available at this time.

h. Limitations on Accepting Non-Cash Capital Contributions

The heading of proposed Sec. 107.240 has been revised to read

``Limitations on including non-cash capital contributions in Private

Capital'', which is more consistent with the substance of the section.

One commenter suggested that the section be revised to state that

Licensees may still accept non-cash assets that cannot be included in

Private Capital. SBA did not adopt this suggestion, primarily because

of its concerns about liabilities that may be associated with

unapproved non-cash assets. Therefore, except for the change in the

section heading, proposed Sec. 107.240 is finalized without change.

i. Issuance of Stock Options by Licensees

SBA agrees with the comment that proposed Sec. 107.250(a), which

states that a Licensee may issue stock options, is unnecessary and has

deleted it in the final rule. The deletion does not affect a Licensee's

ability to issue stock options.

j. License Application Form & Fee

A comment received on proposed Sec. 107.300 objected to the

increase in the license fee for partnerships that plan to issue

participating securities, particularly those using the standard

partnership agreement annex already approved by SBA. SBA proposed the

fee increase in order to reflect the Agency's costs of processing

applications. Pursuant to applicable statutory provisions, the

Administration has taken into consideration direct and indirect costs

to SBA of necessary services performed, value to the recipients, the

public policy interest served and other pertinent factors involved.

After due consideration, SBA believes the increase in fees to be

justified and is finalizing Sec. 107.300 as proposed.

4. Subpart D--Changes in Ownership, Control, or Structure of Licensee;

Transfer of License

a. Changes in Control/SBA Prior Approval

Section 107.410 requires SBA's prior approval for a change of

Control while Sec. 107.440 sets out the standards governing SBA's

approval. One commenter suggested that a grandfather clause be adopted

for these sections. The effect of such a clause would be to allow an

existing Licensee to undergo a change of Control without having to meet

the increased minimum capital requirements currently in effect. SBA

believes that a grandfather clause is not necessary because the Agency

will apply the capital adequacy and financial viability standards of

Secs. 107.200 and 107.220 in evaluating an application for a change of

Control. Therefore, both sections are finalized without change.

b. Restrictions on Common Control or Ownership of Two (or More)

Licensees

SBA agrees with the comment that Sec. 107.460, which requires SBA

approval of common Control or ownership of two or more Licensees,

should not be applicable to unleveraged Licensees, so long as none of

the Licensees involved has any Leverage. This change has been

incorporated in the final rule.

5. Subpart E--Managing the Operations of a Licensee

a. Identification as a Licensee

SBA received one comment which argued the difficulty of identifying

an SBIC as a Federal Licensee on each Financing document. SBA agrees,

and has decided to revise proposed Sec. 107.501 to state that before

extending Financing or collecting an application fee from a Small

Business, a Licensee must obtain a written statement from the concern

acknowledging its awareness that it is dealing with a Federally

licensed SBIC.

b. Licensee's Adoption of an Approved Valuation Policy

Many comments on proposed Sec. 107.503(c) objected to the language

which sated that ``SBA reserves the right to review or independently

establish valuations of your Loans and Investments''. All the

commenters agreed that SBA should only become involved in a specific

valuation if that valuation is in violation of the agreed upon

valuation policy. The proposed language was intended to address SBA's

continuing concerns regarding certain instances of egregious non-

compliance with agreed-upon valuation policies, and the difficulties it

has encountered in its attempts to take action regarding such non-

compliance. However, in recognition of the legitimate concerns of

Licensees, SBA is revising Sec. 107.503. In the final rule, the

language cited at the beginning of this paragraph has been replaced by

the following: ``If SBA reasonably believes that your valuations,

individually or in the aggregate, are materially misstated, it reserves

the right to require you to engage, at your expense, an independent

third party, acceptable to SBA, to substantiate the valuations.''

In addition, purposed Sec. 107.503(d)(4) has been revised by adding

the word ``adverse'' before the word ``change'', so that only material

adverse changes in valuations must be reported quarterly to SBA.

c. SBA Approval of Licensee's Investment Adviser/Manager

SBA agrees with the comment on proposed Sec. 107.510 that annual

approval of the management contract by the Licensee's board of

directors is unnecessary. The proposed rule has been revised and is

finalized accordingly.

d. Restrictions on Investments of Idle Funds by Leveraged Licensees

With one change, proposed Sec. 107.530 regarding idle funds is

adopted as proposed. The section has been amended to permit Licensees

to maintain a reasonable petty cash fund.

e. Limitations on Secured Third-Party Debt

As discussed in the preamble to the proposed rule, proposed

Sec. 107.550(a) was intended primarily as a restatement of the existing

regulation requiring leveraged Licensees to obtain SBA approval before

incurring secured third-party debt. The only change was the requirement

that Licensees also obtain SBA approval before expanding the scope of a

security interest or lien associated with existing debt. Based on some

of the comments received, SBA realized that paragraph (a) was being

misinterpreted. In particular, it was not SBA's intention to require

approval each time a Licensee wants to draw down an approved line of

credit. Nor did SBA intend to require Licensees to obtain approval to

substitute one asset or group of assets for another as the subject of a

security interest, as long as the values are comparable. In the final

rule, proposed Sec. 107.550(a) has been split into two paragraphs and

revised to clarify the intent.

Two comments were received on proposed Sec. 107.550(c), suggesting

that the limitation of the security interest to 125 percent of a

proposed borrowing against a Licensee's investor commitments is

impractical. SBA recognizes that some Licensees may not be able to

borrow under this provision. However, it is only with reluctance that

the Agency has permitted any third-party borrowing against investor

commitments, since these are the same commitments that SBA may look to

at some point to protect its own financial interests. Therefore, SBA is

finalizing this provision (renumbered as Sec. 107.550(d)) without

change.

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Proposed Sec. 107.550(d) stated the conditions under which SBA will

provide a 30-day turnaround on applications for approval of secured

third-party debt. One of these conditions was that the security

interest be limited to the assets acquired with the borrowed funds, or

an asset coverage ratio of no more than 1.25:1. SBA agrees with the

commenters who suggested that the coverage ratio is unrealistically

low, and is revising the ratio to 2:1 in the final rule (with this

paragraph renumbered as Sec. 107.550(e)).

f. Subordination of SBA's Creditor Position

Proposed Sec. 107.560 is adopted without change. One commenter

argued that without a specific definition of subordination, expressed

in a formal subordination agreement, Licensees would find it impossible

to obtain third-party debt. SBA's experience with the subordination

regulation, which was first adopted in 1991, is that lenders have been

willing to work out the details of subordination agreements with SBA on

an individual basis. Nevertheless, SBA is sympathetic to Licensees'

desire to understand the Agency's specific concerns in this area, and

will attempt to develop guidelines for a subordination agreement that

would be generally acceptable to SBA.

g. Activity Requirement

SBA received several comments on proposed Sec. 107.590 suggesting

that the activity test is unnecessary, or should be revised, or should

not apply to non-leveraged Licensees.

SBA strongly believes that some form of activity test is necessary

for both leveraged and non-leveraged Licensees. Companies are licensed

with the understanding that they will help to fulfill the public

purpose of the program, which is to further the growth and development

of small businesses. Clearly, an inactive Licensee is not contributing

to this goal. Furthermore, an inactive Licensee, even if it is non-

leveraged, imposes some degree of administrative burden on SBA.

In response to the comments concerning the specific structure of

the activity requirements, SBA has made a number of changes intended to

make the test more practical and to modify provisions that were subject

to interpretation. In the proposed rule, the basic activity test (in

Sec. 107.590(a)) required a Licensee to satisfy two criteria dealing

with investment activity and percentage of assets maintained as idle

funds. In the final rule, a Licensee must satisfy only one of the

criteria to be considered active.

In paragraph (b)(1), the proposed rule stated that certain

``recent'' cash inflows would be disregarded in determining whether a

Licensee is active. In the final rule, ``recent'' has been replaced by

a specific time period (within nine months of the Licensee's fiscal

year end).

In paragraph (b)(3), under the proposed rule, one of the criteria

for an exception to the activity requirements was that a Licensee have

``no remaining unfunded commitments from investors''. SBA agrees with

the commenter who suggested that this standard was too narrow, and has

revised the provision to include Licensees with unfunded commitments

equal to no more than 20 percent of their Regulatory Capital.

Finally, in Sec. 107.590(d), SBA has added a phase-in period for

new Licensees, recognizing that the activity test is not relevant to

those companies that have been in operation for less than 18 months.

6. Subpart F--Recordkeeping, Reporting, and Examination Requirements

for Licensees

a. Information Required From Portfolio Concerns

With some minor changes, Sec. 107.620 is adopted as proposed. SBA

is not adopting the suggestion of one commenter that paragraphs (a) and

(b), which require Licensees to obtain certain information from Small

Businesses before extending Financing and on a periodic basis

thereafter, should not apply to non-leveraged Licensees. Although one

of the aims of these paragraphs is to mitigate SBA's financial risk,

they are also intended to insure that Licensees are operating in a

manner consistent with the goals of the Act. SBA agrees with the

comment that paragraph (b)(2), which requires that the information

submitted to the Licensee be certified by the chief financial officer,

general partner, or proprietor of the Portfolio Concern, should be

expanded to permit certification by the chief executive officer,

President, or Treasurer. The section is finalized accordingly.

b. Requirements for Licensees To File Annual Financial Statements

Except as hereafter noted, SBA adopts as final proposed

Sec. 107.630, which deals with the requirements for filing annual

financial statements with SBA. Based on comments received, SBA has

added language to Sec. 107.630(a) clarifying that the portion of SBA

Form 468 containing economic information on the Licensee's portfolio

companies may be filed up to two months later than the remainder of the

form; this reflects SBA's current policy. In Sec. 107.630(b), a cross

reference to Sec. 107.1220 has been added to clarify the reporting

requirements for Licensees with outstanding Leverage commitments.

One commenter suggested that the ``economic impact'' information

required by proposed Sec. 107.630(e) places an unfair burden on the

Licensee. SBA is finalizing this paragraph as proposed; the information

requirement is not new, having been in effect since April 25, 1994, and

Sec. 107.630(e) is actually worded more narrowly than the current

regulation that it replaces. While SBA considers the economic impact

information to be vitally important to the mission and future of the

SBIC program, the Agency recognizes that this information is not always

easy to obtain. SBA has generally accepted Licensees' good faith

efforts to provide the required data and will continue to do so to the

extent possible.

Proposed Sec. 107.630(a)(2) would have required a Licensee's

independent public accountant to carry errors and omissions insurance

in an amount acceptable to SBA, or be self-insured and have net worth

acceptable to SBA. This proposal elicited comment from representatives

of the accounting profession who objected to SBA's attempt to create a

``deep pocket'' for recovery of damages, as well as concern from a few

other commenters that the amount of insurance required be more clearly

defined. SBA is sensitive to concerns that this requirement may prevent

many smaller, but highly competent, practitioners from performing SBIC

audits; however, the Agency also must consider its need to control

financial risk. Furthermore, SBA feels that the ability of a firm to

obtain some amount of insurance can be, in itself, a useful indicator

of professional standing. After careful consideration of the issue, SBA

is finalizing Sec. 107.630(a)(2) to require the independent public

accountant to have errors and omissions insurance of at least

$1,000,000, or to be self-insured and have a net worth of at least

$1,000,000, unless SBA approves otherwise. This wording will give SBA

the flexibility to make exceptions for firms that do not meet the

insurance requirement but have strong track records as auditors of

SBICs or similar entities.

c. Changes Not Subject to SBA Prior Approval

Proposed Sec. 107.680 has been finalized with one change. A

commenter suggested that this section, which

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requires SBA's post approval of certain changes in the Licensee's

operations, capitalization, and management, should not apply to non-

leveraged Licensees. SBA does not entirely agree, particularly with

regard to changes that cause Licensee to operate in a different way

than was contemplated at the time it was licensed. However, for

Licensees that have no outstanding Leverage or Earmarked Assets, SBA

believes safety and soundness considerations do not require post

approval of directors and officers (other than the Licensee's chief

operating officer), and that it is sufficient for such Licensees to

notify SBA of any changes.

d. Responsibilities of Licensee During Examination

Proposed Sec. 107.691 included a provision requiring a Licensee and

its independent public accountant to agree that the accountant's

working papers would be made available to SBA upon request for

examination purposes. One commenter stated that this requirement would

not be objectionable if SBA provided assurance that any workpapers

requested would be treated as confidential under the Freedom of

Information Act (FOIA) or similar laws. An accountant's working papers

relating to an individual Licensee are indeed protected from disclosure

under the exemptions available under FOIA. Since these exemptions are

statutory, SBA believes it is unnecessary to restate them in the

regulations, and Sec. 107.691 is finalized as proposed.

e. Examination Fees

SBA received more than ten comments on proposed Sec. 107.692. All

of the comments objected to the increase in the examination fees to be

charged to SBICs. Many stated that the cost of an SBA examination would

far exceed the cost of their annual audit, even though the procedures

involved are more limited. Further, some felt that unleveraged

licensees would bear an unfair portion of the overall fees due to the

fact that the fees are to be assessed on total assets of the Licensee.

Unleveraged (usually bank owned) SBICs tend to have the largest amount

of total assets yet have no federal funds at risk. Therefore, it was

argued that the cost of enforcement should weigh more heavily against

leveraged Licensees.

As stated in the preamble to the proposed rule, the proposed fee

schedule was designed to produce total revenue sufficient to cover the

current direct costs to SBA of conducting examinations. SBA considers

examinations to be a key element in maintaining the integrity of the

SBIC program. However, based on the comments, SBA is persuaded that the

proposed fees were too high in general, and that the increases were

particularly excessive for the largest Licensees. In the final rule,

the examination fees have been lowered significantly, although they

still represent an increase over the current levels.

7. Subpart G--Financing of Small Business by Licensees

a. Ineligible Small Businesses

Under proposed Sec. 107.720 (a) through (i), SBA lists those Small

Businesses which are ineligible for SBIC Financing and certain

exceptions to those restrictions. Except for the revisions discussed

below, this section is finalized as proposed.

SBA received seventeen comments on this proposal. One comment

questioned whether Sec. 107.720 as a whole should be applicable to non-

leveraged Licensees. Another suggested deletion of the prohibition in

Sec. 107.720(a) against financing relenders or reinvestors as this type

of financing could result in jobs and the payment of taxes. Neither of

these comments were adopted because the provisions in question are

mandated by the Act.

b. Passive Businesses

One of the criteria defining a passive business in proposed

Sec. 107.720(b) is that the business ``is not engaged in a regular and

continuous business operation''. The proposed rule goes on to state

that the ``mere receipt of payments * * * such as * * * lease

payments'' would not be considered a regular and continuous business

operation. One commenter asked how this definition would apply with

respect to taxi medallion financing, an industry in which several SBICs

already have millions of dollars invested. It is common practice in

this industry for medallion owners to lease their medallions rather

than employ taxi drivers directly.

SBA's previously-stated position regarding taxi medallion lending

is that Licensees may finance medallion owners who lease the medallions

to others, but only if such owners are actively engaged in day to day

management activities. These include supervision of lessees and

responsibility for vehicle maintenance, insurance, and compliance with

local laws and regulations. Owners who lease their medallions and

receive payments without such active involvement will continue to be

considered passive businesses under the final rule.

Two comments objected to proposed Sec. 107.720(b)(1)(ii), which

would define as passive any companies whose employees are not carrying

on the majority of the day to day operations. The commenters argued

that many businesses use third parties, including independent

contractors and ``leased'' employees, to carry on day to day

operations. SBA recognizes that such arrangements are now common and

are not necessarily an indicator of a passive business. The final rule

has been revised to define a business as passive if ``its employees are

not carrying on the majority of day to day operation, and the company

does not provide effective control and supervision, on a day to day

basis, over persons employed under contract''.

Proposed Sec. 107.720(b)(2) was a restatement of the existing

``holding company'' exception to the passive business rule, under which

Licensees could finance a passive business if it passed through all the

proceeds to a wholly-owned active business. A number of comments

suggested that the provision could allow something less than 100

percent of the proceeds to be passed through without compromising the

intent of the regulations. SBA agrees and has changed the final rule to

require pass-through of ``substantially all'' the proceeds. The

commenters also suggested deletion of the requirement that the active

business be wholly-owned. SBA agrees that this restriction is not

necessary. Instead, the final rule allows the financing of a passive

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

the proceeds through the same eligible Small Business that is not

passive'' (italic are added). This revision clarifies that a holding

company must pass the Financing proceeds to only one Small Business,

not to multiple businesses or to a series of different businesses if

Financing is extended on more than one occasion.

c. Real Estate Businesses

SBA agrees with a comment which suggested that proposed

Sec. 107.720(c)(2) is too restrictive, in that it prohibits financing

the acquisition of unimproved realty if the business does not intend to

build on the property, even if the business intends to use it for

another legitimate business purpose such as a parking lot for customers

and employees, SBA did not intend to prohibit financing for this

purpose and the final rule has been revised accordingly.

[[Page 3183]]

d. Project Financing

One comment objected to the prohibition against project financing

in proposed Sec. 107.720(d). As stated in the preamble to the proposed

rule, though this prohibition does not appear in the current

regulations, it has been in effect as a matter of policy for more than

ten years. SBA views project financing as essentially short term and

therefore, inconsistent with the Act. SBA considers this prohibition

important and is therefore finalizing the rule without change.

e. Foreign Investments

With one change, proposed Sec. 107.720(g) is adopted as final. The

proposed rule generally would have prohibited financing a Small

Business if more that 40 percent of its employees or tangible assets

were located outside the United States. In response to comments

suggesting that this percentage was too low, SBA has increased the

allowable percentage to 49 percent in the final rule.

f. Conflicts of Interest

SBA received seven comments on proposed Sec. 107.730. The proposed

rule is adopted with changes to meet some of the concerns in the

comment letters. One comment suggesting that the conflict of interest

prohibitions not be applicable to unleveraged Licensees was rejected by

SBA. Such an exception would be inconsistent with the purpose of the

Act.

Two commenters were concerned that proposed Sec. 107.730(a)(2),

which deals with providing Financing to an Associate of another

Licensee, would unduly restrict co-investing. In particular, the

concern was whether the regulation could be construed to mean that if a

Licensee brought an investor group involving another Licensee and its

Associates into one of its investments, it would be prohibited from any

future participation in investments initiated by that investor group.

This interpretation is contrary to SBA's intent, which was to prohibit

quid pro quo financing arrangements that would allow Licensees to

accomplish indirectly what they are not permitted to do directly--

provide Financing to an Associate. SBA does not consider it necessary

to revise paragraph (a)(2) to clarify the intent, since the language is

essentially unchanged from the previous regulations.

Proposed Sec. 107.730(d) set forth provisions governing investments

in the same Small Business by a Licensee and its Associates, either

simultaneously or at different times. In general, Licensees were

required to demonstrate that the terms and conditions of such

investments were fair and equitable to the Licensee. The proposed rule

identified certain categories of Financing with Associates requiring

SBA approval, and others that would be exempt from this requirement.

Two comments suggested that the exemption in paragraph (d)(3)(iv)

should be expended to include all situations where the Licensee is

nonleveraged, regardless of the status of the Associate. SBA believes

the exceptions provided are adequate and is not adopting this

suggestion.

Proposed Sec. 107.730(e)(1) would require a Licensee to obtain

SBA's written approval for an Associate to participate in the

management of a Portfolio Concern if the Associate has an actual or

potential equity interest in the Portfolio Concern that exceeds 3

percent. Comments received suggested that 5 percent is a more generally

accepted standard used by other federal regulatory agencies in similar

circumstances. SBA agrees and is revising the final rule accordingly.

One comment was received urging the elimination of the publication

requirement of proposed Sec. 107.730(g), which requires SBA to publish

notice of exemptions requested under Sec. 107.730. The concern was that

this requirement could slow down Financings, work a hardship on the

Small Business or potentially disclose confidential information to

competitors. Although SBA is sympathetic to these concerns, the

publication requirement is mandated by the Act and cannot be deleted.

g. Overline Limitation

Three comments were received on proposed Sec. 107.740. One

commenter suggested that the ``overline'' limits not be imposed on non-

leveraged Licensees. This exemption has been effective since April 1994

and was included in the proposed rule. The other comments dealt with

paragraph (c), which allows Licenses to compute an ``increased limit''

if they have unrealized gains on Publicly Traded and Marketable

securities. Both commenters advocated a more liberal cure period if a

Licensee has overline violations resulting from a drop in the value of

its securities. Because of the inherent volatility of publicly traded

securities, SBA does not consider it prudent to encourage the use of

the increased limit and is finalizing the proposed rule without change.

h. Change of Ownership

The comments received on proposed Sec. 107.750 addressed the

definitions of ``debt'' (paragraph (c)(2)) and ``equity'' (paragraph

(c)(3)) used in determining whether the Small Business has an

acceptable debt to equity ratio. It was suggested that the definition

of ``debt'' (which, in this section, generally means long-term debt)

specifically exclude any liabilities under a non-compete covenant with

the seller. SBA chose not to add this automatic exclusion because such

covenants are unique to the circumstances of each transaction. It was

also suggested that the definition of ``equity'' should include

subordinated notes payable to the seller. Such notes are specifically

excluded from the definition of debt; to also include them in equity

would further reduce the debt to equity ratio. SBA believes this result

is inconsistent with the intent of the regulation and is finalizing the

section as proposed.

i. Change in Size or Activity of a Portfolio Concern--Affect on

Licensee

SBA did not propose any change in the provisions governing

additional investment in a Portfolio Concern that no longer meets the

size standard. However, one commenter suggested that proposed

Sec. 107.760(a) should be revised to allow a Licensee to make

additional investments in such a concern either to honor a Commitment

it has made or to protect its investment. The proposed rule already

allows a Licensee to make follow-on investments without restriction in

any Portfolio Concern up to the time it makes a public offering, so the

commenter's suggestion would be relevant only after that time. SBA has

added language to the final rule permitting a Licensee to honor a

Commitment made before a public offering, since it would be legally

bound to do so in any case. However, the Agency believes the

``protection of investment'' standard is so broad as to be inconsistent

with the goals of the program and has not adopted this change.

In response to a comment, proposed Sec. 107.760(b) is being adopted

as final with one non-substantive change. Paragraphs (b)(2) and (b)(3),

which state that violations under paragraph (b) constitute default by

the Small Business and allow the Licensee to pursue certain remedies,

have been deleted. SBA agrees that these provisions cover matters that

should be left to the Licensee and that it is unnecessary to include

them in the regulations.

j. Definition of ``Equity Securities''

SBA received two comments on the definition of Equity Securities in

proposed Sec. 107.800. One suggested that the definition should include

warrants

[[Page 3184]]

and options. SBA agrees and has revised the section accordingly. The

other commenter sought clarification of the statement that the presence

of certain default or redemption provisions would cause a security,

even if it has the legal form of equity, to be considered a Debt

Security ``for all regulatory purposes''. SBA's intent was that such a

security would be treated as a Debt Security only for purposes of

Sec. 107.855, the Cost of Money regulations. The final rule is revised

accordingly.

k. Options Received From Small Businesses

Except for the following changes and revisions, proposed

Sec. 107.815(b) is adopted as final. This section restricts the ability

of a Licensee's employees, officers, directors, or general partners to

receive options in a Small Business Financed by the Licensee. Under the

proposed rule, such persons could receive options only if they

participated in the Financing on the same terms and conditions as the

Licensee (paragraph (b) (1)) or if approved by SBA (paragraph (b) (2)).

Three comments were received on this section. Two suggested that

paragraph (b) not be applicable to non-leverage SBICs and SBA agrees.

The provision is revised accordingly.

Two commenters suggested that the regulations should permit the

receipt of stock options as compensation of service as a board member,

as this is a common practice in the industry and is beneficial to the

Small Business. SBA agrees and has added Sec. 107.815(b)(3) to the

final rule to permit this practice, with the condition that the

compensation paid must not exceed that paid to other outside board

members. In the absence of such board members, fees must be reasonable

when compared with amounts paid to outside directors of similar

companies.

l. Guarantees of the Obligations of Small Businesses

SBA received one comment seeking to clarify that if a Licensee

invests in a Small Business and also guarantees its debt obligation,

the guaranty should count against the overline limitation only to the

extent of the Licensee's risk over and above its original investment.

The situation described by the commenter is covered by

Sec. 107.820(a)(2), which states that a guaranty consisting only of ``a

pledge of the Equity Securities of the issuer'' does not count towards

the overline limitation.

m. Commitments to Small Businesses

SBA received one comment suggesting that proposed Sec. 107.825 be

deleted, a second suggesting that it be moved back to the definitions

section, and a third seeking clarification as to whether ``reasonable

conditions precedent'' to a Licensee's obligation to fund its

commitment can include ``completion of due diligence which confirms the

accuracy of the initial business plan''.

SBA is not deleting the defined term ``Commitment'' from the

regulations because it is used in several important contexts (see, for

example, the new provision in Sec. 107.860(g) that allows a Licensee to

charge a ``breakup fee'' if a Small Business accepts its Commitment and

then fails to close because it has accepted funds from another source).

SBA agrees that proposed Sec. 107.825 properly belongs in the

definitions section and has revised the final rule accordingly.

SBA has addressed the meaning of ``reasonable conditions

precedent'' in an earlier preamble and will repeat that discussion

here: Although SBA is reluctant to provide a list of reasonable

conditions precedent in the regulation for fear that such list might be

regarded as an exclusive one, it is willing to describe ``reasonable

conditions precedent'' in general terms. A ``reasonable condition

precedent'' is one that does not lie within the Licensee's ability to

cause or prevent. ``Completion of due diligence with results

satisfactory to the Licensee'' is an example of a condition precedent

that lies within the Licensee's control. On the other hand,

requirements that a disinterested person verify the value of the Small

Businesses' assets or its net worth, or that there be no adverse change

in the Small Businesses' financial condition between the date of the

commitment and the scheduled disbursement date, or that the Small

Business do or achieve something that lies reasonably within its

capacity would all be considered a ``reasonable condition precedent.''

n. Purchasing Securites From an Underwriter

Comments received on proposed Sec. 107.828 requested relief for

non-leveraged Licensees, reduction or elimination of recordkeeping

requirements and reconsideration of fee limitations for Associate

underwriters. SBA believes certain constraints on purchasing securities

from underwriters are warranted in keeping with the purpose of the Act,

but has made some revisions in response to the comments. Non-leveraged

Licensees have been exempted from the recordkeeping requirements in

paragraph (b) and the fee restrictions in paragraph (c). For leveraged

Licensees, paragraph (c) has been revised to permit a Licensee to pay

``reasonable and customary'' commissions and expenses to an Associate

underwriter, provided the Licensee is purchasing no more than 25

percent of the total offering.

In the final rule, this section is renumbered as Sec. 107.825.

o. Minimum Term of Financing

The comments received on proposed Sec. 107.830 strongly supported

the changes made with regard to the minimum term of Financings for

Section 301(d) Licensees. One commenter suggested allowing Section

301(c) Licensees to have up to 25 percent of their investments with

less than a five year term as long the weighted average duration of the

portfolio is at least five years. SBA believes such a provision is not

in keeping with the intent of the Act and would impose a burdensome

recordkeeping requirement. Accordingly, SBA is finalizing the proposed

rule without change.

p. Exceptions to Minimum Term of Financing

One commenter requested a clarification of proposed Sec. 107.835,

which allows a Licensee to make Short-term Financings (with terms less

than five years) under certain circumstances. The commenter asked

whether the provision in paragraph (c), which limits the dollar amount

of Short-Term Financings to 20 percent of total Loans and Investment

applies only to that paragraph or to all of Sec. 107.835, as has been

the case in the past. It was SBA's intent to apply the 20 percent limit

only to paragraph (c), which deals with Short-Term Financing for the

purpose of financing a change in ownership under proposed Sec. 107.750.

Therefore, the section is finalized as proposed. However, as stated in

the preamble to the proposed rule, Licensees should bear in mind that

the purpose of the SBIC program, as stated in the Act, is to provide

equity capital and long-term loan funds to Small Businesses. Thus,

Licensees should not plan to have the bulk of their portfolios in

short-term investments; to do so would constitute engaging in

activities not contemplated by the Act.

q. Maximum Term of Financing

All of the comments received on proposed Sec. 107.840 suggested

that the general rule which requires a maximum term of not longer than

20 years for any

[[Page 3185]]

Financing should apply only to Loans and Debt Securities. SBA agrees

and has revised the final rule accordingly.

r. Redemption of Equity Securities

Two comments were received on proposed Sec. 107.850. One commenter

suggested that book value should be a permitted basis for determining

the redemption price of an Equity Security under

Sec. 107.850(b)(2)(ii). SBA agrees and has revised the final rule

accordingly.

The other commenter stated that Sec. 107.850(b)(1) should be

broadened to allow accumulated dividends to be included in the

redemption price of an Equity Security. SBA is not adopting this

change. A Licensee is already permitted to structure its investments in

this manner; the only consequence is that such investments are subject

to the Cost of Money rules. Furthermore, as long as the dividends are

payable only from earnings, such investments are not precluded from

qualifying as Equity Capital Investments.

s. Cost of Money

Under proposed Sec. 107.855, SBA sought to substantively revise

some of the Cost of Money rules and to clarify others. SBA received six

comments on this section, two of which advocated deleting the entire

section and letting the market control. While the proposed rule gave

Licensees considerable more flexibility than in the past, the Agency

believes that some Cost of Money rules are necessary to provide a

measure of protection for Small Businesses. The commenters generally

applauded the increase in the minimum ``Cost of Money ceiling'' for

Loans in Sec. 107.855(c); however, some argued that the ceiling for

Debt Securities should also be raised. SBA believes that the proposed

five percentage point difference between Loans and Debt Securities is

justified because Loans do not allow for the Licensee to obtain any

equity interest in the Small Business, and is finalizing this provision

without change.

One comment stated that it was very important for Licensees to be

able to establish the Cost of Money ceiling for a Financing as of the

date a Commitment is issued, not as of the date of the first closing as

proposed in Sec. 107.855(b). The commenter explained that if rates went

up between a Commitment date and a closing date, they would be able to

increase the rate quoted in the Commitment. However, if rates went

down, they would be forced by regulations to close at the lower rate.

SBA is persuaded that Licensees should have flexibility in this area

and has revised this paragraph to allow the ceiling to be set either at

the time the Commitment is issued or as of the date of the first

closing of the Financing.

A Licensee is permitted to compute its Cost of Money ceiling based

on either the current Debenture rate on its own ``Cost of Capital'' as

determined under proposed Sec. 107.855(d). SBA received one comment

suggesting that non-leveraged Licensees should be permitted to compute

a Cost of Capital based on their non-SBA borrowings. The proposed rule

would permit this practice and is therefore finalized without change.

Proposed Sec. 107.855(g)(10) would allow a Licensee to charge a

higher interest rate when a Small Business is in default. For this

purpose, ``default'' is defined to include failure to provide

information required under SBA regulations. One commenter pointed out

that this appears to require Small Businesses to have knowledge of SBA

regulations, and that it is the responsibility of Licensees to put all

necessary default provisions in the Financing documents. SBA agrees and

has deleted the reference to SBA regulations from the final rule.

Proposed Sec. 107.855(i)(3) would allow Licensees to charge a one-

time ``bonus'' at the end of a loan instead of taking equity in the

Small Business. One commenter suggested that the bonus not be limited

to one time only, and that the bonus be computable on the earlier of

five years or when the debt was originally due.

SBA proposed the bonus to allow Licensees to obtain an adequate

return on Financings of companies that do not want to give up equity.

The Agency believes the proposed rule provides Licensees with

sufficient flexibility and is not adopting the suggested changes.

However, SBA is clarifying Sec. 107.855(i)(1) in the final rule to

state that the bonus is computable ``on or after the date that the

Financing is repaid in full or was originally scheduled to be repaid in

full, whichever is earlier''.

SBA has also made an editorial change in Sec. 107.855(i)(3), which

states that a bonus must be contingent upon factors that reflect the

performance of the Small Business. As an example, the proposed rule

stated that net income and operating cash flow were generally

acceptable factors, while gross revenue and gross profit were generally

unacceptable. One commenter interpreted ``gross profit'' as pretax

profit and suggested that this should be acceptable. SBA's

interpretation of ``gross profit'' was the difference between sales and

cost of goods sold, also known as ``gross margin''; to avoid confusion,

the latter term is used in the final rule.

s. Financing Fees Charged to Small Businesses

Two comments received on proposed Sec. 107.860 dealt with problems

faced by Licensees in their dealings with Small Businesses that apply

for Financing. According to the comments received, it is not unusual

for a Small Business to use a Licensee's Commitment to solicit

competing offers. Also, there are a number of frivolous ``shoppers''

who will use a Licensee's time and resources with no genuine intent of

closing a transaction. One such commenter suggested that Licensees be

permitted to address these problems by charging a ``break-up'' fee if a

Small Business fails to close a Financing because it has accepted funds

from another source. SBA is persuaded that the break-up fee represents

a reasonable protection for Licensees and has finalized Sec. 107.860

with a new paragraph (g) containing this provision. The permitted fee

is the same as the closing fee the Licensee would have been permitted

to charge under Sec. 107.860 (c) or (d).

Another comment questioned whether the ``application fee'' and the

``closing fee'' had to be two distinct fees separately identified, or

whether they could both be collected together at closing. To clarify

SBA's intent, language has been added to paragraph (a) of the final

rule stating that the application fee may be collected at closing or at

any time before closing.

t. Control of a Small Business

Twelve comments were received on proposed Sec. 107.865. One comment

objected to paragraph (b) which establishes a ``presumption of

Control'' based on a Licensee's percentage of ownership, stating that

this paragraph represented a ``poor and onerous change'', and further

noting that investor groups typically own 75 percent of a business by

the second or third round of Financing. In response, SBA, wishes to

point out that the proposed provisions concerning the presumption of

Control are exactly the same as those in the previous regulations.

However, proposed paragraph (c) was added to identify specific

conditions that would permit the presumption of Control to be rebutted.

By defining such conditions, the provision was actually intended to

make it easier for a Licensee to co-invest.

With respect to proposed Sec. 107.865(c), two commenters argued

that the ``presumption of Control'' should be

[[Page 3186]]

rebutted if management can elect 25 percent of the board seats. SBA

believes 40 percent is an appropriate standard for an automatic

rebuttal; Licensee can still seek to rebut the presumption based on

other evidence if this test is not met. Accordingly, proposed

paragraphs (b) and (c) are finalized without change.

u. Temporary Control

Proposed Sec. 107.865(d) set out those circumstances under which a

Licensee may take temporary Control of a Small Business, and includes

the provision: ``(1) Where reasonably necessary for the protection of

your investment under circumstances where a Small Business is

threatened with insolvency or closure.'' Several commenters suggested

that by the time insolvency or closure occurs, it is often too late to

``protect their investment''. SBA agrees and has revised the final rule

to delete all of the language after the word ``investment'' in

Sec. 107.865(d)(1). However, SBA advises Licensees that mere

disagreement with the management of a Small Business does not provide

grounds for taking temporary Control under this provision; rather, the

Licensee must be facing a clearly identifiable risk of financial loss.

In response to another comment, proposed Sec. 107.865(d)(3) has

been revised by deleting the world ``original'', which SBA agrees is

unnecessary. Another comment requested that temporary Control be

permitted if a Licensee satisfies either of the criteria in paragraph

(d)(3) instead of both. SBA considers the language in the proposed rule

to be appropriate and has not adopted the comment.

Proposed paragraph (d)(4) would allow a Licensee to take temporary

Control if the Financing is a Start-up Financing and the Licensee (or

investor group including the Licensee) is the concern's major source of

capital. It was suggested by one commenter that this paragraph should

also allow temporary Control if the Financing is a ``change of Control

of a Small Business pursuant to proposed Sec. 107.750.'' SBA believes

that the proposed temporary Control provisions give Licensees

sufficient protection and flexibility, and is finalizing

Sec. 107.865(d) without change.

SBA received three comments on proposed Sec. 197.865(e)(3)

questioning the reduction from seven years to five years of the time

limit for maintaining temporary Control (subject to an extension

granted by SBA in extraordinary circumstances). One comment suggested

going back to seven years, one questioned the necessity of any time

limit (due to the fact that it is inherent in the venture business to

want to exit investments as soon as possible), and one suggested

language stating that SBA would grant an extension if a Licensee can

establish ``that the relinquishment of Control will materially impair

the value'' of its investment.'' SBA rejects all three of these

suggestions and is finalizing Sec. 107.865(e)(3) as proposed. Control

is prohibited under the Act and SBA believes that exceptions to this

prohibition must be narrowly tailored. The Agency considers the five

year period sufficient in most cases and can grant exceptions if

circumstances warrant.

v. Management Fees for Services Provided to Small Businesses

Three comment letters were received regarding proposed

Sec. 107.900. While one commenter approved the liberalization of the

rules governing management services provided to Small Businesses, it

was suggested that greater liberalization is still needed. The other

two commenters argued in favor of expanding the criteria under which a

Licensee could provide management services to a Financed Small Business

without SBA approval. Specifically, they focused on the requirement

that the Services be provided only on an hourly fee basis. They

explained that the current trend is moving away from hourly billing

toward ``project fees'' and that hourly billing has been perceived as

being both inefficient and unfair. They further noted that while this

issue can be resolved by acquiring SBA's prior written approval

pursuant to proposed Sec. 107.900(c), this process is both time

consuming and burdensome. SBA has reexamined this issue in light of the

comments received and recognizes the reasonableness of this suggestion.

Therefore, proposed Sec. 107.900 is revised to allow a Licensee to

charge on a project fee or other reasonable basis. However, the burden

of proof will be on the licensee to demonstrate, upon request, that

fees charged to not exceed prevailing rates charged for comparable

services by other organizations in the geographic area of this Small

Business.

Paragraph (b), concerning fees for service as a board member, is

revised in the final rule in accordance with comments received, to

allow for fees to be paid in the form of cash, warrants or other

consideration. In addition, the following language is added at the end

of the last sentence of paragraph (b): ``* * * or, in the absence of

outside board members, amounts reasonable when compared to similar

companies with outside board members.''

Proposed Sec. 107.900(e)(2) discusses transaction fees which may be

charged a Small Business by a Licensee's Associate for services

performed in connection with a public or private offering made by the

Small Business or the sale of all or part of the business. The comment

received on this paragraph suggested that the 95 percent unrelated

revenue test was too restrictive and would force Small Businesses to

hire outside investment bankers who would be unfamiliar with the

company, which could result in higher fees. SBA is persuaded by this

argument and has deleted this provision from paragraph (e)(2).

Except for the revisions discussed above, Sec. 107.900 has been

finalized as proposed.

8. Subpart H--Non-Leveraged Licensees--Exceptions to Regulations

Two comments were received on proposed Sec. 107.1000. One

specifically praised the flexibility embodied in the proposal, which

provides a consolidated listing of those regulatory provisions from

which a non-leveraged Licensee would be exempt. The other comment

listed a number of sections from which non-leveraged Licensees should

be exempt, but these largely involved statutory requirements. As

discussed throughout this preamble, some additional provisions have

been added to this section. In addition to the exemptions in the

proposed rule, the final rule exempts non-leveraged Licensees from:

(1) The recordkeeping requirements and fee limitations in

Sec. 107.825(b) and (c) for securities purchased through or from an

underwriter;

(2) The requirement to obtain SBA's prior approval of initial

Management expenses under Sec. 107.140 and increases in Management

Expenses under Sec. 107.520;

(3) The prior approval requirement in Sec. 107.815(b) for options

obtained from a Small Business by the Licensee's management or

employees; and

(4) The requirement to obtain post approval for new directors and

new officers, other than the Licensee's chief operating officer. A

notification requirement has been substituted.

9. Subpart I--SBA Financial Assistance for Licensees (Leverage)

a. Types of Leverage Available

Only one comment was received on proposed Sec. 107.1100 which

strongly supported the language clarifying that a Section 301(d)

Licensee may apply for both Debenture and Participating Security

Leverage. The section is therefore finalized without change.

[[Page 3187]]

b. General Eligibility Requirements for Leverage

One comment was received on proposed Sec. 107.1120, objecting to

the presumption that only Licensees with $5 million or more of

Regulatory Capital are financially viable. The commenter stated that

this represents a 300 percent increase for Section 301(d) Licensees, is

not warranted and threatens the financial viability of Section 301(d)

Licensees. As stated previously in this preamble, SBA considers the

minimum capital requirements to be vital to the sound operation of the

SBIC program.

c. Requirement To File Quarterly Financial Statements

Proposed Sec. 107.1220 requires that Licensees file quarterly,

unaudited financial statements on SBA Form 468 (short form) within 30

days of the end of the quarter, so long as any part of SBA's Leverage

commitment is outstanding to the Licensee. A commenter suggested, and

SBA agrees, that this section should be revised to clarify that the

quarterly filing requirement does not apply at the Licensee's fiscal

year end, which is covered by the annual filing of Form 468 under

Sec. 107.630. The section is revised and finalized accordingly.

d. Draw-downs by Licensee Under SBA's Leverage Commitment

All three of the comment letters received on proposed Sec. 107.1230

objected to one of the requirements listed under the ``procedures for

funding draws'' in paragraph (d). As proposed, paragraph (d)(3) would

require a Licensee, when requesting a ``draw'' pursuant to SBA's

Leverage commitment, to furnish a statement to SBA ``that the proceeds

are needed to fund one or more particular Small Business, including the

name and address of each Small Business, and the amount and anticipated

closing date of each proposed financing.'' One commenter labeled this

paragraph an ``unnecessary burden requiring an act of prophecy.'' All

agreed that as investors, they are not motivated to draw capital and

not invest it, but that they may be looking at many investments at the

time of the request, expecting to make one or more investments based

upon proposals outstanding or being negotiated, and not all close. It

was further pointed out that some negotiations may delay closing or

alter amounts actually invested.

SBA considered this issue at length. As participants in the SBIC

program are aware, there is insufficient Leverage currently available

to meet demand, and no change is expected in the near future. This

places SBA in the position of having to allocate the limited Leverage

available among all the eligible applicants. Under these conditions,

SBA finds it useful to be able to review each Licensee's track record

in closing its anticipated investments as part of its evaluation of the

Licensee's need for Leverage in comparison with others. Thus, SBA is

not willing to delete the requirement for information on specific

planned Financings at this time.

Nevertheless, SBA is sympathetic to the commenters' concerns and is

open to future changes in this area, particularly if Leverage ceases to

be in short supply. In the final rule, the information requirements in

paragraph (d)(3) are preceded by the phrase ``if required by SBA''.

This language gives the Agency the flexibility to drop these

requirements in the future if conditions warrant, without having to

revise the regulations.

e. Participating Securities--Requirement To Make Equity Capital

Investments

Under proposed Sec. 107.1500(b)(4), which was unchanged from the

existing regulations, Licensees issuing Participating Securities would

have been required to make Equity Capital Investments equal to the

total amount of Participating Securities issued, and also to maintain

Equity Capital Investments in an amount equal to their outstanding

Participating Securities. SBA received a comment arguing strongly that

the requirement to maintain a certain level of Equity Capital

Investments should be deleted. The commenter's concern was that it is

impossible to predict when investments will be liquidated and that a

Licensee might fall into violation due to circumstances largely beyond

its control.

SBA appreciates the commenter's concern. However, section 303(g)(4)

of the Act specifically requires Licensees to ``maintain an amount

equal to the outstanding face value'' of Participating Securities in

Equity Capital Investments. Therefore, this requirement cannot be

abandoned, and the section is finalized as proposed. However, in

considering waiver requests, the Agency will give weight to

circumstances which suggest that noncompliance is the result of factors

not readily controllable by the Licensee.

f. Participating Securities--Liquidity Requirement

Proposed Sec. 107.1505(a) contained language giving SBA the right

to make the final determination of a Licensee's liquidity impairment.

SBA received a comment suggesting that this language be deleted. SBA is

persuaded that Licensees are unlikely to be motivated to manipulate the

liquidity computation in order to make distributions that would leave

them without sufficient liquidity to continue their operations;

therefore, this language has been deleted from the final rule.

g. Participating Securities--Computation of Earmarked Profit (Loss)

In proposed Sec. 107.1510(d), SBA attempted to provide a simplified

formula for the computation of Earmarked Profit (Loss) without changing

the substance of the calculation. One comment pointed out that the

revised language, which referred to ``Net Income (Loss) as reported on

SBA Form 468'', created ambiguity with respect to the treatment of user

fees paid to SBA and partnership syndication costs incurred by

Licensees. Licensees have presented these items on Form 468 using a

variety of accounting treatments, and in some cases have not made them

a component of Net Income (Loss).

SBA believes that Licensees should be permitted to treat both user

fees and syndication costs as expenses for the purpose of determining

Earmarked Profit (Loss). Accordingly, the final rule states that for

the purpose of determining Net Income (Loss) in the Earmarked Profit

formula, user fees and commitment fees paid to SBA, as well as

partnership syndication costs, must be capitalized and amortized on a

straight-line basis over five year. In all other respects, Net Income

(Loss) must be as reported on SBA Form 468.

h. Participating Securities--Base for Profit Participation

Proposed Sec. 107.1530(c) presented the formula for the Base on

which a Licensee computes SBA Profit Participation. There was no change

proposed in the formula; however, SBA received one comment pointing out

a situation in which the formula produces an unintended result. If a

Licensee were to compute and distribute Profit Participation for an

interim period, and then experience losses during the remainder of its

fiscal year which partially offset the interim profit, the later losses

could not be included in Unused Losses for the purpose of determining

the Base going forward. SBA agrees with the need for a technical

correction of the Unused Loss definition, and is finalizing

Sec. 107.1530(c) with the necessary revision.

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i. Participating Securities--``PLC Ratio'' Used in Profit Participation

Rate Formula

Proposed Sec. 107.1530(e)(2) set forth the conditions under which a

Licensee can reduce its PLC Ratio by increasing its Leverageable

Capital. A reduction of the PLC Ratio has the effect of reducing the

Licensee's Profit Participation Rate. One commenter suggested that a

Licensee should be permitted to include a Leverageable Capital increase

in the ratio without express SBA approval, provided the increase was

the result of the takedown of commitments or the conversion to cash of

non-cash assets included in Private Capital. Language to this effect

was previously included in the regulations and was inadvertently

dropped from the proposed rule. It has been restored in the final

version of Sec. 107.1530(e)(2).

j. Participating Securities--Adjustment of Interim Profit Participation

Calculations for Changes in the Year-End Profit Participation Rate

SBA received a comment suggesting that proposed Sec. 107.1530(h)(3)

be deleted. This provision, which was unchanged from the existing

regulations, stated that if a Licensee computing Profit Participation

had previously made an interim computation during the same fiscal year,

it would be required to adjust the interim amount to account for any

subsequent increases in the Profit Participation Rate. The commenter

pointed out that the provision was inconsistent with the mechanics of

Sec. 107.1530(h) (1) and (2), which resulted in automatic adjustment of

interim computations for subsequent increases or decreases in the

Licensee's Profit Participation Rate.

SBA agrees that the provisions are inconsistent; however, the

preamble to the April 8, 1994 final rule concerning the Participating

Securities program (59 FR 16898) makes the following statement: ``Any

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

fiscal quarter is subject to adjustment whenever any subsequent interim

distributions are contemplated, and at the end of the fiscal year, in

order to account for any increase in the Profit Participation Rate. If

the Profit Participation Rate decreases as a result of an approved

increase in Leverageable Capital, Profit Participations already

computed for any interim periods shall not be adjusted.''

Thus, with respect to the original intent of the regulations, the

error in the proposed rule is found not in paragraph (h)(3), but in

paragraphs (h)(1) and (h)(2), which incorrectly adjust interim Profit

Participation computations for decreases in the Rate as well as

increases. Accordingly, in the final rule, SBA has revised paragraph

(h) so that an adjustment takes place only when the Profit

Participation Rate increases.

k. Participating Securities--Basis for Distribution of Prioritized

Payments and Adjustments

Proposed Sec. 107.1540(a), which is essentially the same as the

existing regulation, would require a Licensee to distribute the balance

in its Distribution Account (consisting of Earned Prioritized Payments

and earned Adjustments) annually, based on its profits as determined

under Sec. 107.1520. One commenter pointed out that ``no distinction is

made in Sec. 107.1520 between cash and non-cash earnings. Consequently,

this provision effectively requires that a Licensee make an annual

distribution of cumulative profits to pay Prioritized Payments even if

the Licensee did not receive cash for all or a portion of these

profits.'' The commenter suggested that distributions should be

required only for profits earned by the Licensee in cash.

SBA appreciates the concern expressed, but has decided to finalize

this section as proposed. The Agency believes that Licensees are

sufficiently protected by the provision in Sec. 107.1540(a) that makes

all distributions under Sec. 107.1540 conditional upon the satisfaction

of the liquidity requirement in Sec. 107.1505. Thus, a Licensee that

had received only non-cash income likely would be precluded from making

a distribution.

l. Payment of Prioritized Payments on Participating Securities in Order

of Issue Date

Under proposed Sec. 107.1540(c), Licensees would be required to pay

Prioritized Payments on their Participating Securities in order of the

securities' issue dates. One commenter pointed out that this would

impose a substantial burden by requiring Licensees to maintain detailed

sub-accounts to track the Accumulated Prioritized Payments associated

with each individual Participating Security, and would not provide any

benefit to the Agency. SBA agrees that this provision is unnecessary

and has deleted it in the final rule.

m. Participating Securities--Computation of ``Maximum Tax Liability''

Proposed Sec. 107.1550(b) set forth the formula used to compute a

Licensee's Maximum Tax Liability, from which the Licensee calculates

its permitted tax distribution. One element in the formula is ``total

ordinary income'' allocated to Licensee's investors for Federal income

tax purposes. One commenter sought clarification as to whether this

phrase was intended to represent ordinary income less ordinary

deductions. That is the interpretation intended by SBA, and the

paragraph has been revised in the final rule to clarify the meaning.

With respect to the same paragraph, the commenter also suggested

that ``total ordinary income'' be defined to exclude expenses that

partners may not be able to deduct fully under the tax law. SBA

believes this suggestion is inconsistent with the Act, which refers to

``income allocated to each partner or shareholder * * * for Federal

income tax purposes'' and does not provide for any adjustment for

nondeductible expenses. Furthermore, the Agency finds no compelling

reason to provide all investors with an additional benefit based on the

possibility that some may face limitations on their deductions.

n. Participating Securities--Payment Dates

SBA received several comments concerning the Participating Security

distribution regulations (Secs. 107.1540 through 107.1570) which would

require Licensees to make distributions only on quarterly Payment

Dates. All the commenters objected to the inflexibility of these

provisions. As stated in the preamble to the proposed rule, the Payment

Dates represent the dates on which Trust Certificate holders receive

interest payments and any returns of principal to which they are

entitled. Because Participating Securities can be redeemed only on

Payment Dates, the proposed rule limited Licensees' distributions to

these dates to avoid certain problems, such as the question of who is

responsible for Prioritized Payments on a Participating Security during

the interval between the making of a distribution and the actual

redemption of the Participating Security with the proceeds of the

distribution.

However, SBA recognizes that the loss of flexibility under the

Payment Date structure can have a significant negative impact on both

the Licensee and the Agency, particularly in the case of distributions

to be made in the form of securities. In this instance, the

restrictions may force the Licensee to hold securities for a

substantial period of time, during which the Licensee and its investors

(including SBA) would be subject to a high degree of market risk.

Because of time constraints, SBA is unable to modify the Payment

Date restrictions in this final rule. However,

[[Page 3189]]

the Agency intends to seek a solution that will provide Licensees with

greater flexibility in making distributions of securities, and to

publish a proposed rule dealing with this problem as soon as possible.

One change concerning the timing of distributions is being

incorporated in the final rule. In the preamble to the proposed rule,

SBA indicated that it was willing to consider allowing tax

distributions under Sec. 107.1550 to be made during some window period

between the February 1 and May 1 Payment Dates, in order to allow

investors to receive cash before their Federal tax filing deadlines.

Based on the comments received, SBA is finalizing Sec. 107.1550(d) with

revised language permitting a tax Distribution to be made between March

1 and April 15 by a Licensee with a December 31 year end. Licensees

still must pay all Prioritized Payments before being eligible to make a

tax distribution.

o. Trust Certificates

During the comment period, SBA reviewed proposed Secs. 107.1600

through 107.1680 pertaining to Trust Certificates guaranteed by SBA to

fund Leverage. Section 321 of the Act and the documentation of the

Trust Certificates are very specific with respect to the terms and

conditions. SBA has chosen to shorten these sections by eliminating

language contained in the statute or detailed in the Trust

Certificates. None of the changes made to the proposed Secs. 107.1600

through 107.1680 are substantive. In the final rule, Trust Certificates

are covered in renumbered Secs. 107.1600 through 107.1640.

p. Miscellaneous Leverage Provisions

In the final rule, SBA has eliminated proposed Sec. 107.1700(a) and

(c) as redundant and unnecessary language. Section 321(a) of the Act is

specific with respect to SBA's unconditional guarantee and the

requirement for a bond. SBA will continue to provide for an

unconditional guarantee. The bonding requirement has been eliminated in

this section as well as in the Trust Certificate sections because the

bond is required by statute.

10. Subpart J--Licensee's Noncompliance With Terms of Leverage

a. Capital Impairment

SBA received one comment on proposed Sec. 107.1840(d)(6), which

would have required a Licensee, in computing its Capital Impairment

Percentage, to reduce its ``Adjusted Unrealized Gain'' by the amount of

any borrowing or other obligation associated with portfolio securities

that were the source of the Unrealized Appreciation used as the basis

for determining the Adjusted Unrealized Gain. The commenter correctly

pointed out that the reduction should be limited to the extent of the

Unrealized Appreciation. SBA agrees and has finalized the provision

accordingly.

11. Appendices to Part 107

The existing regulations include two appendices: Appendix I,

Accounting Standards and Financial Reporting Requirements for Small

Business Investment Companies, and appendix II, Valuation Guidelines

for SBICs. SBA has decided to delete the appendices from Part 107, and

will publish them in a different format at a later date. Although they

are no longer part of the regulations themselves, both the accounting

standards and the valuation guidelines remain applicable to all

Licensees.

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 final rule will not be a significant

regulatory action for purposes of Executive Order 12866 because it will

not have an annual effect on the economy of more than $100 million, and

that it will 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 primary purpose of the rule is to streamline the regulations

governing the SBIC program by eliminating obsolete regulations and

reorganizing the remainder in a more logical and readable format.

Two areas of the regulations will have some economic effect,

including possible effects on small entities. First, license

application fees and examination fees will be raised. An SBIC license

applicant will pay a fee of $10,000 to $20,000, compared with the

current $5,000. This increase is not significant relative to the

private capital of an average Licensee, which exceeds $10 million. Exam

fees will continue to be based on the total assets of a Licensee, but

at higher rates. The largest Licensees, generally those with several

hundred million dollars of assets, could experience fee increases of

$20,000 or more; however, the number of such Licensees is currently

very small.

Second, the changes in the regulations governing ``Cost of Money''

(the maximum amount a Licensee can charge on loans and debt securities)

will potentially affect the borrowing costs of small entities. Although

the interest rate on loans is determined primarily by market forces,

the final rule will raise the interest rate ceiling on loans extended

by Licensees from 15 percent to 19 percent. The total amount of loans

provided to small businesses by Licensees is approximately $240 million

per year. Even if the additional four percentage points were charged on

the entire balance of such loans, the annual economic impact would be

less than $10 million.

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

certifies that this final rule contains no new reporting or record

keeping requirements that have not already been approved by the Office

of Management and Budget. The ``Financing Eligibility Statement'' (SBA

Form 1941) which is required under Sec. 107.610 has already been

approved by OMB under Control Number 3245-0301.

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

does 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 revises Part 107 of

Title 13 of the Code of Federal Regulations to read as follows:

BILLING CODE 8025-01-M