[House Report 106-1]
[From the U.S. Government Publishing Office]





106th Congress                                                   Report
  1st Session           HOUSE OF REPRESENTATIVES                  106-1

_______________________________________________________________________



 
   AMENDING SECTION 20 OF THE SMALL BUSINESS ACT AND MAKE TECHNICAL 
     CORRECTIONS IN TITLE III OF THE SMALL BUSINESS INVESTMENT ACT

                                _______
                                

January 19, 1999.--Committed to the Committee of the Whole House on the 
              State of the Union and ordered to be printed

                                _______


    Mr. Talent, from the Committee on Small Business, submitted the 
                               following

                              R E P O R T

                             together with

                            ADDITIONAL VIEWS

                         [To accompany H.R. 68]

      [Including cost estimate of the Congressional Budget Office]

    The Committee on Small Business, to whom was referred the 
bill (H.R. 68) to amend section 20 of the Small Business Act 
and make technical corrections in Title III of the Small 
Business Investment Act, having considered the same, report 
favorably thereon without amendment and recommend that the bill 
do pass.

                                Purpose

    The purpose of H.R. 68 is to make certain technical 
amendments to Title III of the Small Business Investment Act of 
1958 and amend Section 20 of the Small Business Act. Title III 
authorizes the activities of the Small Business Investment 
Company program. Small Business Investment Companies (SBICs) 
are venture capital firms licensed by the Small Business 
Administration that use SBA guarantees to leverage private 
capital for investment in small businesses.
    The technical corrections proposed by H.R. 68 will improve 
the flexibility of the SBIC program and allow improved access 
to this program by small businesses.

                          Need for Legislation

    Congress revamped the SBIC program in the 103d Congress to 
provide for a new form of leverage geared specifically towards 
equity investment in small businesses. Over the ensuing years, 
as the new program has become established, certain deficiencies 
have come to light; in addition, certain statutory provisions 
have become obsolete.
    Moreover, the nature of the SBIC industry has changed. The 
result is a participating securities industry made up primarily 
of smaller SBICs. The fact that these smaller SBICs are 
dominating the program points to shifting dynamics in the SBIC 
program. Smaller, start-up investments are more typical and, 
therefore, the demand for leverage has shifted to smaller 
individual placements.
    H.R. 68 seeks to correct these deficiencies, and remove 
provisions that may produce confusion due to changes in law and 
the character of the SBIC program. First, H.R. 68 will modify 
the SBIC program to exclude contingent obligations from the 
calculation of interest in loans made by SBICs. These 
contingent obligations include financial tools like royalties, 
warrants, conversion rights and options. Many small businesses 
use these devices to help buy down the interest rates on their 
financings. Unfortunately, current law has forced SBA and the 
SBICs to try and include these options as part of the interest 
applicable for a determination of the maximum applicable 
interest rate. These valuations have resulted in confusion and 
uncertainty for all concerned and have often resulted in the 
loss of financing opportunities for small businesses.
    Second, under H.R. 68, a provision in the Small Business 
Investment Act that reserves leverage for smaller SBICs will 
also be repealed. Changes in SBA policy regarding applications 
for leverage, statutory changes in the availability of 
commitments for SBICs, and the makeup of the industry present 
the possibility that that provision may, in fact, create 
conflicts and confusion.
    Third, H.R. 68 will increase the authorization levels for 
the participating securities segment of the SBIC program. The 
authorization levels will rise from $800 million to $1 billion 
in fiscal year 1999, and from $900 million to $1.2 billion in 
fiscal year 2000. These increases are necessary to meet the 
rising demands for this section of the SBIC program.
    Fourth, H.R. 68 modifies a test for determining the 
eligibility of small businesses for SBIC financing. Current 
statutory language does not account for small businesses 
organized in pass-through tax structures such as S 
corporations, limited liability companies, and certain 
partnerships. These organizations do not pay taxes at the 
enterprise level, but instead pass through income and the 
ensuing tax liabilities to their partners and shareholders. 
Consequently, many of these small businesses face difficulties 
when the income test is applied to them, and are often declared 
ineligible for financing they should receive.
    Finally, H.R. 68 will allow the SBA greater flexibility in 
issuing trust certificates to finance the SBIC program's 
investments in small businesses. Current law allows fundings to 
be issued every six months or more frequently. This inhibits 
the ability of the SBICs and the SBA to form pools of 
certificates that are large enough to generate serious investor 
interest. Allowing more time between fundings will permit SBA 
and the industry to form larger pools for sale in the market, 
thereby increasing investor interest and improving the interest 
rates for the small businesses financed.

                            Committee Action

    In the 105th Congress, a hearing was held on May 12, 1998, 
to discuss H.R. 3412 a bill substantially similar to H.R. 68. 
Mr. Lee Mercer, President of the National Association of Small 
Business Investment Companies, testified concerning the 
provisions of H.R. 3412. At that hearing, Chairman Talent 
questioned Mr. Mercer regarding concerns that repeal of the 
provision reserving leverage for smaller SBICs might impair 
access to leverage for those firms. Mr. Mercer responded that 
his organization, which is composed primarily of smaller SBICs, 
endorsed the provision. Further, he informed the Committee 
that, based on industry and SBA data, 80 percent of the 
participating securities licensees were smaller SBICs. He also 
stated that demands for leverage in the participating 
securities were generally for small individual placements 
rather than any single large investments that would seriously 
deplete funding. Ms. Velazquez then questioned Mr. Mercer about 
the correction of the after-tax income test, and asked if he 
could supply any specific firms who had been denied eligibility 
due to the current test. Mr. Mercer stated that he could not 
name any specific firms but that he had heard of several such 
firms.
    Ms. Velazquez, Mr. Davis and Mrs. Kelly then asked Mr. 
Mercer several questions concerning the SBIC industry's efforts 
to attract more minority and women-owned businesses for 
financing assistance. Mr. Mercer described a number of 
initiatives that his organization had started to achieve those 
ends. Ms. Velazquez also requested that Mr. Mercer and his 
organization develop and provide an outreach program for 
minority and women-owned businesses.
    On Thursday, January 7, 1999, the Committee on Small 
Business held a brief hearing to consider the provisions of 
H.R. 68. Testifying at the hearing was Mr. Lee Mercer, 
President of the National Association of Small Business 
Investment Companies. Mr. Mercer reiterated his testimony from 
the 105th Congress regarding the beneficial effects that H.R. 
68 would have on the SBIC program. He recognized the 
improvements in management that have occurred in the program 
over recent years and strongly recommended the corrections 
contained in H.R. 68. Mr. Mercer explained the five provisions 
and the effect they would have in detail. The hearing was in 
essence a reprise of the hearing held the previous year to 
discuss the provisions of H.R. 3412.
    Mr. Hinojosa asked questions concerning the establishment 
of the cost of money for the SBIC program through the secondary 
market. Mr. Mercer explained that the cost was variable and 
fluctuated in correspondence with changes in the 10-year 
Treasury rate and the varying spread requirements of 
institutional investors. Ms. Napolitano also asked Mr. Mercer 
about the various examples of the effect and impact of the SBIC 
program. There being no further questions, the hearing was 
gaveled to a close and the Committee moved on to consideration 
of H.R. 68.
    Immediately after the hearing, Chairman Talent called the 
Committee to order for the purpose of marking up and reporting 
H.R. 68. The bill was introduced, considered as read, and 
opened for amendment. No amendments were offered. Mrs. Kelly 
then moved to pass H.R. 68 and report it to the House. At 11:05 
a.m., by a unanimous voice vote, a quorum being present, the 
Committee passed the bill, H.R. 68, and ordered it reported.

                      Section-by-Section Analysis

Section 1. Short title

    Designates the bill as ``The Small Business Investment 
Company Technical Corrections Act of 1999''.

Section 2. SBIC program

    (1) Paragraph (a) of section 2 modifies section 308(i)(2) 
of the Small Business Investment Act of 1958 to exclude 
contingent obligations from the calculation used to determine 
the maximum allowable interest rate in an SBIC financing. 
Contingent obligations include financial tools such as options, 
warrants, conversion rights and royalties. Because such devices 
are contingent and speculative their correct valuation has been 
a problem for small businesses, SBICs and the SBA.
    (2) Paragraph (b) changes Section 20 of the Small Business 
Act to increase the authorization levels for participating 
securities under the SBIC program. The authorizations are 
increased from $800 million to $1 billion in fiscal year 1999, 
and from $900 million to $1.2 billion in fiscal year 2000.
    (3) The first part of paragraph (c) removes subparagraph 
(13) of Section 303(g) of the Small Business Investment Act (15 
U.S.C. 683(g)). That provision reserves 50% of participating 
securities leverage for Small Business Investment Companies 
with private capital of less than $20 million until the fourth 
fiscal quarter. While the Committee continues to be interested 
that all SBICs have access to the funding needed to complete 
their investments, we also recognize that this provision is no 
longer necessary. Only 12 of the 60 SBICs in the participating 
leverage program have more than $20 million in private capital, 
and the original concern that a few large SBICs would dominate 
the program has proved unfounded. It appears that most SBIC 
equity placements are in smaller early-stage businesses, and 
consequently most participating securities SBICs are 
established as smaller funds.
    (4) The second part of paragraph (c) establishes a test for 
small businesses formed as tax ``pass-through'' entities such 
as S corporations or limited liability companies. Such 
businesses will have their small business investment 
eligibility determined by multiplying their net income by the 
combined federal and state corporate tax rate and then 
subtracting the result from their net income. That result will 
serve as the small business' estimated ``after-tax income'' for 
the purpose of determining eligibility. This removes an 
uncertainty in the statute that means a C corporation with as 
much as $9 million in pretax income could be a small business 
but a pass-through S corporation with $6,000,001 in income was 
ineligible.
    (5) The final part of paragraph (c) changes Section 320 of 
the Small Business Investment Act to allow issuance of Small 
Business Administration-backed trust certificates not less than 
every twelve months rather than the current standard of every 
six months. SBA would retain the discretion to issue guarantees 
and trust certificates at shorter intervals if appropriate. The 
chance will give SBA increased flexibility in negotiating the 
terms and costs associated with the placement of certificates, 
either by contract or public offering. This will ultimately 
benefit the small business seeking financing since the rates 
sought by SBICs are reflected in the rates charged to small 
businesses.

               Congressional Budget Office Cost Estimate

                                     U.S. Congress,
                               Congressional Budget Office,
                                  Washington, DC, January 13, 1999.
Hon. James M. Talent,
Chairman, Committee on Small Business,
House of Representatives, Washington, DC.
    Dear Mr. Chairman: The Congressional Budget Office has 
prepared the enclosed cost estimate for H.R. 68, the Small 
Business Investment Company Technical Corrections Act of 1999.
    If you wish further details on this estimate, we will be 
pleased to provide them. The CBO staff contact is Mark Hadley.
            Sincerely,
                                              James L. Blum
                                   (For June E. O'Neill, Director).
    Enclosure.

H.R. 68--Small Business Investment Company Technical Corrections Act of 
        1999

    Summary: H.R. 68 would make a number of technical 
corrections to the Small Business Investment Act of 1958. It 
would eliminate a provision in current law that reserves funds 
for smaller Small Business Investment Companies (SBICs) until 
the last quarter of the fiscal year. The bill also would allow 
a more accurate determination of eligibility of small 
businesses for SBIC programs by requiring the Small Business 
Administration (SBA) to measure a firm's revenues assuming that 
it has paid all required income taxes. (Certain corporate 
structures, such as ``S'' corporations, pass all income through 
to the stockholders. Other firms do not pass through income, 
but instead pay taxes at the corporate level). Finally H.R. 68 
would give SBA more flexibility in issuing certificates that 
help finance SBIC activities by increasing the minimum 
placement period for public offerings from 6 months to 12 
months.
    The bill would increase the authorized level of the SBIC 
participating securities program in 1999 and 2000. CBO 
estimates that the subsidy costs of guarantees for the 
authorized levels would increase by about $10 million over the 
1999-2004 period.
    H.R. 68 would not affect direct spending or receipts; 
therefore, pay-as-you-go procedures do not apply. H.R. 68 
contains no intergovernmental or private-sector mandates as 
defined in the Unfunded Mandates Reform Act (UMRA) and would 
not affect the budgets of state, local, or tribal governments.
    Estimated cost to the Federal Government: For purposes of 
this estimate, CBO assumes that the bill will be enacted by 
March 31, 1999. CBO further assumes appropriation of authorized 
amounts, including a supplemental appropriation for increases 
of authorized amounts in fiscal year 1999. The estimated 
budgetary impact of H.R. 68 is shown in the following table. 
The costs of this legislation fall within budget function 370 
(commerce and housing credit).

                                    [By fiscal year, in millions of dollars]
----------------------------------------------------------------------------------------------------------------
                                                        1999      2000      2001      2002      2003      2004
----------------------------------------------------------------------------------------------------------------
                                        Authorizations of Appropriations

SBIC Participating Securities Loans: \1\
    Estimated authorization level...................         4         6         0         0         0         0
    Estimated outlays...............................         1         6         2     (\2\)         0         0
----------------------------------------------------------------------------------------------------------------
\1\ Implementing H.R. 68 also would increase SBA's costs for administering loans, but CBO estimates that the
  changes in administrative expenses would be less than $500,000 a year.
\2\ Less than $500,000.

    The Federal Credit Reform Act of 1990 requires 
appropriation of the subsidy costs and administrative costs for 
credit programs. The subsidy cost is the estimated long-term 
cost to the government of a direct loan or loan guarantee, 
calculated on a net present-value basis and excluding 
administrative costs.
    H.R. 68 would increase the authorized program level of the 
SBIC participating securities program from $800 million to $1 
billion in 1999 and from $900 million to $1.2 billion in 2000. 
Based on information from the SBA and on historical data for 
this program, CBO estimates that the subsidy costs of 
guarantees for the authorized levels would increase by $10 
million over the 1999-2004 period. CBO estimates that this 
provision would not significantly increase the administrative 
costs of the agency.
    Pay-as-you-go considerations: None.
    Intergovernmental and private-sector impact: H.R. 68 
contains no intergovernmental or private-sector mandates as 
defined in UMRA and would not affect the budgets of state, 
local, or tribal governments.
    Estimate prepared by: Mark Hadley.
    Estimate approved by: Paul N. Van de Water, Assistant 
Director for Budget Analysis.

                      Committee Estimate of Costs

    Pursuant to the Congressional Budget Act of 1974, the 
Committee estimates that the amendments to Small Business 
Administration authorization levels in H.R. 68 will increase 
appropriations by no more than $10 million over the next five 
fiscal years, if fully funded. Furthermore, pursuant to clause 
3(d)(2)(A) of rule XIII of the Rules of the House of 
Representatives, the Committee estimates that implementation of 
H.R. 68 will not significantly increase administrative costs. 
This concurs with the estimate of the Congressional Budget 
Office.

                           Oversight Findings

    In accordance with clause 4(c)(2) of rule X of the Rules of 
the House of Representatives, the Committee states that no 
oversight findings or recommendations have been made by the 
Committee on Government Reform with respect to the subject 
matter contained in H.R. 68.
    In accordance with clause 2(b)(1) of rule X of the Rules of 
the House of Representatives, the oversight findings and 
recommendations of the Committee on Small Business with respect 
to the subject matter contained in H.R. 68 are incorporated 
into the descriptive portions of this report.

                 Statement of Constitutional Authority

    Pursuant to clause 3(d)(1) of rule XIII of the Rules of the 
House of Representatives, the Committee finds the authority for 
this legislation in Article I, Section 8, Clause 18 of the 
Constitution of the United States.

         Changes in Existing Law Made by the Bill, as Reported

    In compliance with clause 3 of rule XIII of the Rules of 
the House of Representatives, changes in existing law made by 
the bill, as reported, are shown as follows (existing law 
proposed to be omitted is enclosed in black brackets, new 
matter is printed in italic, existing law in which no change is 
proposed is shown in roman):

SMALL BUSINESS INVESTMENT ACT OF 1958

           *       *       *       *       *       *       *


TITLE III--SMALL BUSINESS INVESTMENT COMPANIES

           *       *       *       *       *       *       *


                            Borrowing Power

    Sec. 303. (a) * * *

           *       *       *       *       *       *       *

    (g) In order to encourage small business investment 
companies to provide equity capital to small businesses, the 
Administration is authorized to guarantee the payment of the 
redemption price and prioritized payments on participating 
securities issued by such companies which are licensed pursuant 
to section 301(c) of this Act, and a trust or a pool acting on 
behalf of the Administration is authorized to purchase such 
securities. Such guarantees and purchases shall be made on such 
terms and conditions as the Administration shall establish by 
regulation. For purposes of this section, (A) the term 
``participating securities'' includes preferred stock, a 
preferred limited partnership interest or a similar instrument, 
including debentures under the terms of which interest is 
payable only to the extent of earnings and (B) the term 
``prioritized payments'' includes dividends on stock, interest 
on qualifying debentures, or priority returns on preferred 
limited partnership interests which are paid only to the extent 
of earnings. Participating securities guaranteed under this 
subsection shall be subject to the following restrictions and 
limitations, in addition to such other restrictions and 
limitations as the Administration may determine:
          (1) * * *

           *       *       *       *       *       *       *

          [(13) Participating securities for smaller small 
        business investment companies.--
                  [(A) In general.--Subject to the provisions 
                of subparagraph (B), of the amount of the 
                annual program level of participating 
                securities approved in appropriations Acts, 50 
                percent shall be reserved for funding small 
                business investment companies with private 
                capital of not more than $20,000,000.
                  [(B) Exception.--During the last quarter of 
                each fiscal year, if the Administrator 
                determines that there is a lack of qualified 
                applicants with private capital of not more 
                than $20,000,000, the Administrator may utilize 
                all or any part of the program level for 
                securities reserved under subparagraph (A) for 
                qualified applicants with private capital of 
                more than $20,000,000.]

           *       *       *       *       *       *       *


                             Miscellaneous

    Sec. 308. (a) * * *

           *       *       *       *       *       *       *

    (i)(1) The purpose of this subsection is to facilitate the 
orderly and necessary flow of long-term loans and equity funds 
from small business investment companies to small business 
concerns.
    (2) In the case of a business loan, the small business 
investment company making such loan may charge interest on such 
loan at a rate which does not exceed the maximum rate 
prescribed by regulation by the Administration for loans made 
by any licensee (determined without regard to any State rate 
incorporated by such regulation). In this paragraph, the term 
``interest'' includes only the maximum mandatory sum, expressed 
in dollars or as a percentage rate, that is payable with 
respect to the business loan amount received by the small 
business concern, and does not include the value, if any, of 
contingent obligations, including warrants, royalty, or 
conversion rights, granting the small business investment 
company an ownership interest in the equity or increased future 
revenue of the small business concern receiving the business 
loan.

           *       *       *       *       *       *       *

    (j) For the purposes of sections 304 and 305, in any case 
in which an incorporated or unincorporated business is not 
required by law to pay Federal income taxes at the enterprise 
level, but is required to pass income through to its 
shareholders or partners, an eligible small business or smaller 
enterprise may be determined by computing the after-tax income 
of such business by deducting from the net income an amount 
equal to the net income multiplied by the combined marginal 
Federal and State income tax rate for corporations.

           *       *       *       *       *       *       *


         Periodic Issuance of Guarantees and Trust Certificates

    Sec. 320. The Administration shall issue guarantees under 
section 303 and trust certificates under section 319 at 
periodic intervals of not less than every [6] 12 months and 
shall do so at such shorter intervals as it deems appropriate, 
taking into consideration the amount and number of such 
guarantees or trust certificates.

           *       *       *       *       *       *       *

                              ----------                              


                  SECTION 20 OF THE SMALL BUSINESS ACT

    Sec. 20. (a) * * *

           *       *       *       *       *       *       *

    (d) Fiscal Year 1999.--
          (1) Program levels.--The following program levels are 
        authorized for fiscal year 1999:
                  (A) * * *

           *       *       *       *       *       *       *

                  (C) For the programs authorized by title III 
                of the Small Business Investment Act of 1958, 
                the Administration is authorized to make--
                          (i) [$800,000,000] $1,000,000,000 in 
                        purchases of participating securities; 
                        and
                          (ii) $700,000,000 in guarantees of 
                        debentures.

           *       *       *       *       *       *       *

    (e) Fiscal Year 2000.--
          (1) Program levels.--The following program levels are 
        authorized for fiscal year 2000:
                  (A) * * *

           *       *       *       *       *       *       *

                  (C) For the programs authorized by title III 
                of the Small Business Investment Act of 1958, 
                the Administration is authorized to make--
                          (i) [$900,000,000] $1,200,000,000 in 
                        purchases of participating securities; 
                        and

           *       *       *       *       *       *       *


                            ADDITIONAL VIEWS

    As the Ranking Democratic Member of the Small Business 
Committee, I want to express my strong support for a piece of 
legislation that I am an original cosponsor of--H.R. 68, The 
Small Business Investment Company Technical Corrections Act of 
1999. This bill will make several key improvements to the Small 
Business Investment Company Act and create a more efficient and 
effective SBIC program.
    The five provisions contained in H.R. 68 include three 
passed by the House early last year as H.R. 3412, The Small 
Business Investment Company Act of 1998. As a proponent of the 
SBIC program, I was a cosponsor of that bill. It successfully 
passed the House of Representatives by a unanimous vote last 
summer. I was also pleased to work in conjunction with Chairman 
Talent to ensure that the SBIC program was fully funded in the 
Fiscal Year 1999 Commerce, Justice, State Appropriations. These 
efforts were undertaken to make the program more efficient and 
responsive to the needs of investors and small entrepreneurs.
    There is no question that the value of Small Business 
Investment Companies has been felt across the country. SBICs 
have invested nearly $15 billion in long-term debt and equity 
capital to over 90,000 small businesses. Millions of jobs have 
been created and billions of dollars have been added to our 
economy. For this reason, I believe that starting the 106th 
Congressional Session with an SBIC-focused bill is important.
    Building on the success of last year's legislation, there 
are five technical improvements included in H.R. 68, The Small 
Business Investment Company Technical Corrections Act of 1999. 
The first change provides greater flexibility for funding 
leverage, permitting the Small Business Administration (SBA) to 
explore the broadest range of funding mechanisms that might 
reduce the cost of leverage.
    The next improvement establishes an assumed tax rate for 
small businesses formed as pass-through entities for use in 
determining eligibility for SBIC funding. This will increase 
the number of small businesses that are eligible for SBIC 
funding.
    The third change ends the requirement that the SBA reserve 
50% of participating security leverage for the first three 
fiscal quarters of each year for SBICs with less than $20 
million in private capital. This removes an administrative 
burden rendered unnecessary by the commitment process. 
Additionally, H.R. 68 increases the authorization level for 
participating securities from $800 million to $1 billion for 
current fiscal year 1999 and $900 million to at least $1.2 
billion for fiscal year 2000.
    In particular, I would like to clarify the first provision 
which excludes royalty agreements from the cost of money 
calculations. The manner in which the change is drafted is 
meant to give SBA the greatest flexibility possible when they 
promulgate regulations. Currently, SBICs may charge one maximum 
permissible rate of interest for straight loans--those with no 
contingent rights in the small business--or a lower maximum 
permissible rate for hybrid loans--those with contingent rights 
or other equity features. SBA has long struggled with how to 
treat the value, if any, of the contingent equity features that 
an SBIC receives in these hybrid loan transactions.
    This proposal aims to be a powerful new tool for 
underserved areas in their campaign to increase access to 
investment capital. However, excluding royalties is not only 
important for underserved areas, it is key for any small 
businesses trying to attract SBIC financing.
    During the past few years, the SBIC program has expanded 
into new areas. In 1997 alone, we saw several ground breaking 
efforts with the creation of two women owned SBICs, and the 
establishment of the first Hispanic owned SBIC. The corrections 
envisioned by H.R. 68 are part of an ongoing process that will 
enable us to provide more ground breaking efforts to serve 
small entrepreneurs.

                                                Nydia M. Velazquez.

                                
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