[Federal Register Volume 59, Number 63 (Friday, April 1, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-7847]


[[Page Unknown]]

[Federal Register: April 1, 1994]


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SMALL BUSINESS ADMINISTRATION

 

Specialized Small Business Investment Companies

AGENCY: Small Business Administration.

ACTION: Notice.

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SUMMARY: The Small Business Administration (SBA) has completed the 3% 
Preferred Stock Repurchase Pilot Program for Small Business Investment 
Companies licensed under section 301(d) of the Small Business 
Investment Act (15 U.S.C. 681(d)) (Specialized SBICs or SSBICs), and 
now will offer each currently licensed SSBIC that was not in the Pilot 
Program the opportunity to apply for the repurchase of its 3% preferred 
stock held by SBA. This Notice sets forth the guidelines SBA is 
intending to follow in its implementation of this Repurchase Program.

DATES: This Notice is effective on April 1, 1994 Written comments on 
this Notice must be received no later than May 2, 1994.

ADDRESSES: Written comments should be sent to Robert D. Stillman, 
Associate Administrator for Investment, U.S. Small Business 
Administration, suite 6300, 409 Third Street SW., Washington, DC 20416.

FOR FURTHER INFORMATION CONTACT:George Dale, Investment Division, U.S. 
Small Business Administration, 409 Third Street SW., Washington, DC 
20416, (202) 205-7595.

SUPPLEMENTARY INFORMATION: On June 19,1992, SBA published a Notice in 
the Federal Register (the Pilot Notice) announcing the commencement of 
the 3% Preferred Stock Repurchase Pilot Program for Small Business 
Investment Companies licensed under section 301(d) of the Small 
Business Investment Act of 1958, as amended (Specialized SBICs or 
SSBICs). See 57 FR 27503.

Policy Statement

    The policy for the Repurchase Program was stated in the Pilot 
Notice, and is repeated verbatim as follows:
    ``SBA's policy is to administer the Repurchase Program in such a 
way as to maximize the capacity of SSBICs to provide financing to 
businesses owned by persons whose participation in the free enterprise 
system is hampered by social or economic disadvantage
    SBA will structure each transaction with the aim of:
    1. Encouraging and facilitating the investment of new private 
capital into SSBICs;
    2. Conserving the cash resources of each participant;
    3. Conserving the borrowing potential of each participant;
    4. Conserving the direct and guaranty budget of the Specialized 
SBIC program;
    5. Improving the financial status of the participating SSBICs;
    6. Rehabilitating (where necessary) weak SSBICs to improve their 
financial and operating effectiveness without undue risk to SBA; and
    7. Discouraging voluntary liquidations of SSBICs and the premature 
surrender of licenses.
    The methodology of computing the price at which the 3% preferred 
stock is sold back to an SSBIC will be a function of four factors 
independent of any SSBIC, and four factors that are variable with each 
SSBIC. The independent factors are:
    1. Average SBIC Treasury-based 10 year rate,
    2. Barron's Junk Bond Spread over Treasury,
    3. Preferred stock dividend rate (3%), and
    4. The adjustment to the price for non-marketability of shares.
    The four factors that are variable with each individual SSBIC are:
    1. Number of years that dividends are in arrears,
    2. Financial rating of SSBIC, as rated by SBA,
    3. Ability of SSBIC to have paid dividends, and
    4. Par value of stock to be purchased.
    The above policy will be executed in such a way as to prevent 
windfall opportunities to SSBICs, their managements, or owners; and to 
avoid transfer of cash flows from SSBICs into SBA to the detriment of 
the program's effectiveness and liquidity.''

Implementation of the Repurchase Program

    In accordance with the Pilot Notice, SBA selected nine Specialized 
SBICs which had indicated an interest in participating in the Pilot 
Program. The nine licensees represented a cross-section of the 
industry, including both financially distressed and non-distressed 
companies. SBA considered and structured each repurchase transaction in 
accordance with the policy restated above.
    Of the nine companies selected to participate in the Pilot Program, 
six have completed the repurchase of their stock. Of the remaining 
three companies, one withdrew voluntarily, one never submitted an 
application, and one was denied participation because of regulatory 
violations which would not have been cured by the repurchase.
    As stated in the Pilot Notice, the objective of the Pilot Program 
was to test SBA's Repurchase Program procedures and to suggest changes 
that might facilitate future transactions. Many of the issues raised 
during the Pilot Program concerned the following:
    1. Development of a formula for determining the repurchase price;
    2. Special considerations dependent on the financial condition of 
SSBICs;
    3. Application of the Repurchase Program to companies which are 
involved in change of ownership transactions; and
    4. Methods and conditions of financing the repurchase. Approaches 
to these issues, and their resolution for the Repurchase Program, are 
described below:

1. Repurchase Price Formula

    A repurchase price formula was developed in general accordance with 
the methodology included in the policy statement repeated above, and 
applied to the particular situation of each of the pilot participants. 
The formula for the preferred share price was a substitute for fair 
market value, since there is no market for these shares. Based on the 
recommendations of two independent expert studies, the formula for 
computing the percentage of par value to be used in the Pilot Program 
was the sum of three elements:
    (1) The percentage of par which represented the differential 
between an instrument paying 3% and the ``all-in'' cost of the June 
1991 SBIC funding rate. This differential represented a discount from 
par, since a 3% return was significantly below the market rate at June 
1991. The percentage of par value remaining after subtracting the 
discount computed to 32.05%.
    (2) An adjustment based on the financial rating of the particular 
SSBIC, plus an adjustment based on a junk bond spread over Treasures, 
plus an adjustment for lack of marketability of the 3% preferred stock. 
In practice, these adjustments added only 2% to 4% to the price for 
individual companies in the Pilot Program.
    (3) The third element represented the present value of the benefit 
to the SSBIC from deferring payment of preferred dividends which it had 
the capacity to pay.
    In view of the very small effect of the second element on overall 
valuation, the complexity of its computation, and the extent of 
financial data and analysis required for its determination, SBA has 
decided to substitute a fixed input of 3% for the Repurchase Program. 
This was the midpoint of the range of adjustments for this element in 
the Pilot Program.
    SBA also determined that the third element may be duplicative of 
the continuing obligation of a licensee to pay accrued dividends under 
certain conditions enumerated herein. Consequently, only the first two 
elements will be utilized in determining the price for the preferred 
shares being repurchased.
    For the Repurchase Program, SBA intends to fix the sum of the two 
elements at 35% of par value, using the June 1991 interest rate inputs 
in recognition of the extended delay in completing the Pilot Program. 
Thus, the price to be paid by any SSBIC repurchasing 3% preferred stock 
under this Program will be 35% of par. This compares with a range of 
repurchase prices calculated for all of the pilot participants of 
34.6554% to 36.2257% of par value.
    To avoid a windfall, and to assure the desired result of retaining 
funds in an active SSBIC program, repurchases below par during the 
Pilot Program were made on condition that if the licensee became 
inactive or was liquidated during a five year period following the 
repurchase, SBA would have a preferred liquidating interest in the 
licensee. SBA intends to continue this practice for the remainder of 
the Repurchase Program, as described below under ``Other critical terms 
of the repurchase transactions.''

2. Special Considerations Dependent Upon Financial Condition of SSBIC

    SBA's evaluation of the Pilot Program has led it to conclude that 
in order to be consistent with the stated policy objectives of the 
Program, the amount and the timing of any required payment of accrued 
dividends should be related to the financial strength of the particular 
SSBIC purchasing its preferred stock from SBA.
    For an SSBIC which has no practical prospect of making dividend 
payments, the Repurchase Program will assist in strengthening the 
licensee's financial condition and enabling it to attract new capital.
    For those SSBICs which are financially strong enough to make 
dividend payments, the program objectives are met if the deferral or 
reduction of dividend payments provides an incentive for the SSBIC to 
remain active in its investment program, and to defer distributions to 
its shareholders.
    Accordingly, the following guidelines have been developed to 
distinguish between the two categories of SSBICs and to provide for the 
treatment of accrued dividends for each category:
    (a) Companies which lack any reasonable prospect of paying accrued 
dividends are defined as those which, as of the licensee's fiscal year 
end immediately preceding the publication of this Notice, have 
undistributed realized losses and a capital impairment percentage (as 
defined in 13 CFR part 107) of at least 10%. These licensees are 
referred to as ``distressed'' for purposes of the Repurchase Program. 
For distressed licensees, the accrued dividends will be extinguished 
completely at the time of repurchase. This will remove a contingent 
liability which would otherwise impede their efforts to raise new 
capital. In the distressed licensee's repurchase agreement with SBA, 
the company will agree to remain active for a five year period and to 
be subject to the guidelines for change of ownership transactions 
discussed below.
    (b) For the remaining ``non-distressed'' SSBICs, which have a 
reasonable prospect of being able to pay accrued dividends, forgiveness 
of the dividends by SBA will be used as an inducement to defer 
distributions of cash out of the program, either to SBA or the owners. 
In these cases, forgiveness is conditioned on their agreement to remain 
active in the SSBIC program for a five year period, during which time 
the accrued dividends are reduced on a straight-line basis over a 
period of five years or the term of any debt incurred to finance the 
repurchase, whichever is longer. Distributions to owners may be made 
only after paying the remaining dividends payable to SBA. The licensee 
will agree to be subject to the guidelines for change of ownership 
transactions discussed below.

3. Change of Ownership Transactions

    For SSBICs that engage in a change of ownership either before or 
after the repurchase of their 3% preferred stock, it is necessary to 
avoid having the benefits of the repurchase result in a windfall to the 
seller or buyer, rather than increasing the funds available for 
investment by the SSBIC. To avoid having a prospective repurchase of 3% 
preferred stock affect the purchase price of the company, the following 
policy has been adopted:
    (a) Where the selling SBIC is ``distressed'', the dividends accrued 
at the time of repurchase will be forgiven. The preferred stock may be 
repurchased at the formula price, subject to the agreement of the 
purchaser to operate as an active SSBIC, and if operations are 
discontinued or the SSBIC liquidated within five years, to pay SBA the 
amount of its liquidating interest, as described under ``Other critical 
terms of the repurchase transactions'' below.
    (b) Where the selling SSBIC is not ``distressed'', the remaining 
balance of accrued dividends as of the date of the change of ownership 
must be paid before any future distributions are made by the licensee. 
In addition, the purchaser must agree to the conditions concerning 
active operation described in the preceding paragraph.

4. Financing the Repurchase

    Since the purpose of the Repurchase Program is to strengthen the 
financial condition of SSBICs, the most desirable source of financing 
for the repurchase transaction is new capital invested in the SSBIC. 
Financing with cash already in the SSBIC is inconsistent with the 
policy of avoiding the transfer of cash flows from SSBICs into the SBA. 
Experience in the Pilot Program, however, confirmed that new capital is 
not available to all participants, particularly those which are in 
financial distress. Consequently, payment of the repurchase price for 
the participating companies was structured in one of four ways: (1) All 
cash, following the raising of new capital, (2) a promissory note 
payable to SBA in exchange for the preferred stock, (3) all cash, from 
third-party unsecured financing, or (4) a combination of any of the 
above.
    Where borrowings from SBA or third parties are used to finance the 
repurchase, they are intended to provide interim financing while 
permanent equity capital is raised. SBA loans made for this purpose 
will be at an interest rate which is 2% higher than the Treasury rate 
for a comparable maturity, and any such loans must fully amortize if 
longer than five years. SBA loans will provide the Agency with a 
security interest in the licensee's assets and will contain restrictive 
covenants and conditions.
    Long-term financing by SBA in the form of guaranteed debentures or 
4% preferred stock is intended to be used to increase the capacity of 
SSBICs to invest or lend money to small businesses; consequently, it is 
inappropriate to use these as sources of financing for the preferred 
stock repurchase.
    SBA shall, in its sole discretion, determine the form of payment it 
will accept for a licensee's 3% preferred stock, including cash or an 
amortizing or non-amortizing note, or a combination thereof.
    Third party debt used for the repurchase must be unsecured since 
granting a security interest in the SSBIC's assets reduces the value of 
SBA's liquidating interest.
    For licensees financing their repurchase through SBA or a third 
party, the liquidating interest held by SBA will amortize over a period 
of five years or the term of the repurchase debt, whichever is longer.
    It is contemplated that the SSBIC will increase its private capital 
by an amount equal to the repurchase price, either from the proceeds of 
new capital invested in the SSBIC since April 1, 1993 or through the 
permanent capitalization of retained earnings available for 
distribution as permitted under program accounting rules. The amount 
that may be capitalized for this purpose is limited to profits 
generated since the licensee's fiscal year end immediately preceding 
the publication of this Notice.
    Other terms required in connection with the use of debt financing 
of the repurchase are included in ``Other critical terms of the 
repurchase transactions'' below.

Further Discussion of the Repurchase Program

    The Repurchase Program is intended to strengthen the SSBIC Program 
and enable it to provide additional financing to small businesses. It 
is not intended to transfer value from SBA to the owners of SSBICs 
without consideration. The proposed terms of the Repurchase Program 
assure these intentions are fulfilled.
    It should be noted that the 3% preferred stock to be repurchased 
under the Repurchase Program has no provision for a ``put'' by SBA or 
mandatory redemption by the SSBIC. Further, the SSBIC is not required 
to pay accrued dividends to SBA; however, distributions to other 
shareholders may not be made until any such dividends have been paid.
    The repurchase price to be paid for the preferred stock is based on 
actual market indicators, and is intended to represent a reasonable 
substitute for fair market value, since these securities are not 
publicly traded. For an SSBIC which does not intend to liquidate or 
transfer ownership in the foreseeable future, the difference between 
par value and the repurchase price is an unrealized loss already 
sustained by SBA. In this case, the sale itself does not create the 
loss.
    An SSBIC which intends to liquidate or transfer ownership would be 
required, in the absence of the Repurchase Program, to pay its accrued 
dividends and repurchase its 3% preferred at par before any liquidating 
distributions could be made to its other shareholders. Nevertheless, 
there is often insufficient value in the licensee under such 
circumstances for SBA to recover the full amount due.
    To avoid the opportunity for a windfall through repurchase at a 
price below par value and/or the forgiveness of accrued dividends, the 
Repurchase Program requires that as consideration for the repurchase, 
the SSBIC agree to remain active for a five year period. If the SSBIC 
liquidates or becomes inactive prior to the end of this period, it is 
required to pay a declining proportion of the difference between the 
par value and the repurchase price of the shares. This is consistent 
with the purpose of the Program: To encourage SSBICs to continue 
investing or lending funds to small businesses.
    Similarly, the terms of forgiveness of accrued dividends are 
designed to further the purpose of the Program without providing a 
windfall to the SSBIC, its owners or management.
    In the case of an SSBIC in financial distress, with no reasonable 
prospect of paying its accrued dividends, SBA is not surrendering value 
when it forgives such dividends. At the same time, the SSBIC program 
benefits from such forgiveness because it strengthens the financial 
condition of the SSBIC and increases the licensee's opportunities to 
secure additional financing or to be acquired by owners who would 
commit to remain active in the program.
    A non-distressed SSBIC can gain the benefit of the dividend 
forgiveness only by agreeing to remain active in the program for five 
years, and to pay the dividends on a declining scale during that period 
(or during the term of any repurchase debt, if longer) as a 
precondition to any distributions to its other shareholders. This 
should encourage these SSBICs to defer distributions, and therefore 
have greater resources available for investments or loans to small 
businesses. Should the SSBIC become inactive, SBA will have the right 
to demand payment of the accrued dividends as of the end of the fiscal 
year for which the licensee became inactive.
    In the event of a change of ownership of an SSBIC, the potential 
forgiveness of accrued dividends would be a factor in determining the 
purchase price to the new owner. To avoid the possibility that the 
benefit of such forgiveness might therefore benefit buyer or seller, 
without increasing the financial strength of the SSBIC, the terms of 
the repurchase provide that in this case the remaining balance of 
dividends accrued as of the date of the ownership change (which may 
have been reduced by the terms of the preferred repurchase, if 
completed earlier) must be paid, either at the time of sale, or later, 
but before any distributions are made by the new owner.
    It should also be noted that SSBICs with regulatory violations that 
would not be cured by repurchasing their stock at a discount will be 
ineligible to participate in the Repurchase Program.

Other Critical Terms of the Repurchase Transactions

    SBA has determined that it is necessary to include the following 
provisions in the agreements to repurchase 3% preferred stock:
    1. To evidence the agreement of the SSBIC to remain active as a 
consideration for the opportunity to repurchase, an SSBIC repurchasing 
its preferred stock at a discount will be required to grant SBA a 
preferential limited ownership interest (the ``liquidating interest'') 
in a newly created capital account. As soon as the repurchase is 
completed, this account will be credited by the SSBIC in an amount 
equal to the discount at which the stock was repurchased. The value of 
SBA's liquidating interest in the account will decline on a straight 
line basis over time (generally five years or the duration of any 
repurchase financing, whichever is longer). In the event of a change of 
ownership of the licensee, SBA's liquidating interest continues in 
effect on the same terms as would have applied had the change of 
ownership not taken place.
    The balance in the new capital account may be included in the 
licensee's private capital only for purposes of calculating the 
licensee's ``overline'' limitation and its capital impairment 
percentage.
    In order to make the SBA liquidating interest a matter of public 
record, the SSBIC will be required to evidence it by an amendment to 
its Articles of Incorporation.
    2. An SSBIC that finances its repurchase through SBA or a third 
party lender will be expected to agree that, during the term of the 
financing, or until private capital in the amount of the repurchase 
price is raised (whichever is earlier), it will not:
    a. Make any distribution in favor of any non-SBA shareholder or 
associate (as defined in 13 CFR 107.3) of the licensee, except with the 
prior approval of SBA. This is to protect the value of SBA's 
liquidating interest.
    b. Prepay the financing without SBA's approval. This is intended to 
conserve the cash resources of the SSBIC, avoid the use of its idle 
funds for the repurchase, and avoid the transfer of cash resources from 
the SSBIC to SBA.
    c. Apply for new leverage from SBA. This is meant to encourage the 
SSBIC to raise new capital for the repurchase. Refundings of existing 
leverage would not be restricted by this provision.
    d. Grant a security interest in its assets to any party other than 
SBA. This is to protect the value of SBA's liquidating interest.

Application Procedure

    After considering any comments received concerning this Notice, SBA 
will distribute a Policy and Procedure Release to all SSBICs announcing 
the commencement of the Repurchase Program and explaining the 
application procedures. All licensees with outstanding 3% preferred 
stock will then have one year to apply to repurchase their stock from 
SBA. No applications will be accepted after that date.
    SBA intends to consider applications and process repurchases in the 
order in which the applications are received, subject to any special 
needs of severely distressed licensees. SBA anticipates that all 
repurchases will be completed within three years from the effective 
date of the final rule.

    Authority: Title III of the Small Business Investment Act, 15 
U.S.C. 681 et seq.; 15 U.S.C. 687(c); 15 U.S.C. 683; 15 U.S.C. 687d; 
15 U.S.C. 687g; 15 U.S.C. 687b; 15 U.S.C. 687m, as amended by Pub. 
L. 102-366.

    Dated: March 24, 1994.
Erskine B. Bowles,
Administrator.
[FR Doc. 94-7847 Filed 3-31-94; 8:45 am]
BILLING CODE 8025-01-M