[Federal Register Volume 64, Number 26 (Tuesday, February 9, 1999)]
[Proposed Rules]
[Pages 6256-6259]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 99-2915]


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 Proposed Rules
                                                 Federal Register
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 This section of the FEDERAL REGISTER contains notices to the public of 
 the proposed issuance of rules and regulations. The purpose of these 
 notices is to give interested persons an opportunity to participate in 
 the rule making prior to the adoption of the final rules.
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  Federal Register / Vol. 64, No. 26 / Tuesday, February 9, 1999 / 
Proposed Rules  

[[Page 6256]]


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SMALL BUSINESS ADMINISTRATION

13 CFR Part 107


Small Business Investment Companies

AGENCY: Small Business Administration.

ACTION: Proposed rule.

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SUMMARY: In order to encourage small business investment companies 
(SBICs) to invest in inner cities and rural areas and in businesses 
that serve such areas, the Small Business Administration (SBA) is 
proposing to introduce a new SBIC investment category called low and 
moderate income investments (LMI Investments). For each SBIC financing 
that qualifies as an LMI Investment, SBA proposes to modify its 
regulations on control of the small business, ``cost of money'' of the 
financing, and term of the financing. SBA is also proposing to make 
available a patient form of debenture leverage that could be issued 
only by SBICs that make LMI Investments. These incentives would apply 
only to LMI Investments made after the effective date of a final rule.

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

ADDRESSES: Written comments should be addressed to Don A. Christensen, 
Associate Administrator for Investment, U.S. Small Business 
Administration, 409 3rd Street, S.W., Suite 6300, Washington, D.C. 
20416.

FOR FURTHER INFORMATION CONTACT: Saunders Miller, Investment Division, 
at (202) 205-3646.

SUPPLEMENTARY INFORMATION: Since its creation in 1958, the SBIC Program 
has proven to be an extremely effective mechanism for serving the 
capital needs of tens of thousands of small businesses. However, there 
are many eligible small businesses that have not yet been reached by 
either the SBIC Program or the private marketplace. Many of these 
businesses are located in inner cities and rural areas around the 
country. SBA has made a commitment to increase access to its programs, 
including the SBIC Program, by these businesses.
    Small businesses located in inner cities and rural areas appear to 
have greater difficulty raising capital than small businesses located 
elsewhere. Explanations for this may vary, but surely include the 
perceived risks associated with investing in any previously untapped 
market. Especially when the untapped market is in an area of above-
average unemployment and poverty, the perceived risks may overshadow 
the real opportunities.
    SBA is proposing a program of narrowly-tailored regulatory and 
financial incentives to overcome those perceptions and to encourage 
SBICs to expand their investment activity into inner cities and rural 
areas. The incentives would be available to any SBIC making qualified 
investments (LMI Investments) in qualified small businesses (LMI 
Enterprises) that are located in or that provide employment for inner 
cities and rural areas (LMI Zones). The proposed incentives fall into 
two categories. First, SBA would allow SBICs greater regulatory 
flexibility when structuring and making LMI Investments. Second, SBA 
would make available a deferred-interest debenture exclusively for the 
financing of LMI Investments.

Defining Low and Moderate Income Zones (LMI Zones)

    The Federal Government has already identified five different and, 
in some cases, overlapping geographic areas in need of special 
attention: (1) Historically underutilized business zones or HUBZones) 
(as defined in 13 CFR Sec. 126.103), (2) Urban Empowerment Zones (as 
designated by the Secretary of the Department of Housing and Urban 
Development (Sec'y-HUD)) and Rural Empowerment Zones (as designated by 
the Secretary of the Department of Agriculture (Sec'y-AG)), (3) Urban 
Enterprise Communities (as designated by the Sec'y-HUD) and Rural 
Enterprise Communities (as designated by the Sec'y-AG), (4) Low and 
Moderate Income areas (as recognized by the Federal Financial 
Institutions Examination Council), and (5) Persistent Poverty counties 
(as classified by the Economic Research Service of the Department of 
Agriculture). These areas share a shortage of investment capital and a 
critical need for job creation. These areas also conform generally to 
what would be considered inner cities and rural areas. For the purposes 
of the SBIC Program, SBA is proposing to consolidate all of these areas 
into a single category to be named Low and Moderate Income Zones, or 
LMI Zones. A new defined term, LMI Zone, would be added.
    Each of the five areas that would comprise LMI Zones has an 
electronic address-database associated with it. These databases are 
Government-operated and are accessible to the general public via the 
Internet. An SBIC can determine whether an address is located in an LMI 
Zone by going to one of the Government websites listed below and 
inputting the address. If the address is not in that database's defined 
area, the SBIC can go to the next Government website on the list. If 
the address is located in a HUBZone, an Empowerment Zone, an Enterprise 
Community, a Low or Moderate Income area, or a Persistent Poverty 
county, it will be considered to be located in an LMI Zone.
    The Government databases for the five areas are:
    1. HUBZones: www.sba.gov/hubzone/hubqual.html
    2. Empowerment Zones: www.hud.gov/ezec/locator/
 3. Enterprise Communities: same as for Empowerment Zones
    4. Low and Moderate Income areas: www.ffiec.gov/geocode
    5. Persistent Poverty counties: www.econ.ag.gov/epubs/other/typolog
    SBA is exploring the possibility of consolidating these databases 
into a single electronic database at SBA. The final rule will contain 
further information on this subject.

Defining LMI Enterprise

    SBA is proposing to add a new defined term, LMI Enterprise. The 
definition would include any eligible small business with a principal 
place of business in an LMI Zone at the time the business applies for 
SBIC financing. In addition, SBA recognizes that businesses located 
outside of LMI Zones can be an important source of employment for 
persons residing within LMI Zones. To reach these important sources of 
employment, the proposed definition of LMI Enterprise would also 
include any eligible small business, regardless of its location, that 
has at least 35 percent of its full time employees residing in LMI 
Zones at the

[[Page 6257]]

time the business applies for SBIC financing. The percentage 
requirement is based on SBA's HUBZone Program (15 U.S.C. 632(p)).
    Under proposed Section 107.610(e), each LMI Enterprise would be 
required to certify to the investing SBIC as to the location of either 
its principal place of business or the primary residences of all of its 
full-time employees. The certification would be dated no earlier than 
the date the small business applies for the SBIC financing. The SBIC 
would keep the certification in its files, along with the SBIC's own 
certification that the small business qualifies as an LMI Enterprise 
and the basis for such qualification. To make this certification, the 
SBIC would have to access the electronic databases to verify that the 
addresses of the small business or 35 percent of its full-time 
employees are within an LMI Zone.

Defining LMI Investment

    SBA wants to ensure that the SBIC Program is used to promote true 
venture capital financing in LMI Zones, not just high-interest lending. 
SBA is also concerned that the assets of LMI Enterprises not be placed 
unduly at risk as a result of receiving financing from SBICs. SBA is 
therefore proposing that LMI Investments be defined to include only 
those SBIC financings that are in the form of equity securities (as 
defined in Sec. 107.800) or debt securities (as defined in 
Sec. 107.815) which are subordinated to all borrowings of the business 
from financial institutions. As a further requirement, LMI Investments 
in the form of debt securities would be required to be unsecured, 
although the SBIC would be permitted to accept a guarantee of the debt 
security if the guarantee were itself unsecured. The SBIC would be an 
unsecured creditor of the LMI Enterprise, with all the legal remedies 
available to unsecured creditors.

Regulatory and Financial Incentives

    From SBA's discussions with community development venture capital 
managers, including managers of Specialized SBICs, and from SBA's 
observations of SBIC and private venture activity, it appears that SBA 
regulations may not encourage and may actually deter investment in LMI 
Zones. SBA regulations do not permit some of the financing structures 
and protections favored by the groups currently investing in inner 
cities and rural areas. Furthermore, the type of SBA financial 
assistance available to most SBICs--the SBA guaranteed debenture--does 
not match well with the type of venture capital financing that SBA 
wants to encourage in LMI Zones.
    After careful consideration, SBA has concluded that certain of its 
regulations need to be modified and a more patient form of debenture 
needs to be created if SBICs are to be expected to actively pursue 
investments in LMI Zones.

1. Temporary Control of the LMI Enterprise

    Many businesses located in or serving LMI Zones are at an earlier 
stage in their development than the businesses customarily financed by 
SBICs. These businesses may be perceived as having a higher degree of 
risk. Venture capital managers investing in inner cities and rural 
areas typically insist on a high degree of influence over the small 
business' operations. Often this takes the form of a controlling equity 
position in the company.
    In the SBIC Program, SBICs are not permitted to assume control over 
a small business. Over the years, though, SBA has identified four 
circumstances under which temporary control over a small business may 
be warranted. These are set forth in current Section 107.865(d). SBA is 
today proposing to add a fifth circumstance to the list--the making of 
an LMI Investment. Under the proposal, an SBIC would be permitted to 
take temporary control of each business in which it makes an LMI 
Investment.
    SBA makes this proposal with some hesitation. SBA's statutory 
mission is to protect small businesses. This mission must not be 
compromised. However, when SBA policies adopted to protect small 
businesses have the unintended effect of foreclosing opportunities for 
those businesses to grow and to modernize, SBA must reconsider its 
policies. If, as SBA has concluded, the regulations deter SBICs from 
making many LMI Investments because of the prohibition against taking 
control, then owners of LMI Enterprises are being denied the 
opportunity to choose to give up (or share) control of the business 
temporarily in exchange for SBIC financing. Under SBA's proposal, 
owners of LMI Enterprises would be given the opportunity to make that 
choice. It would be the small business owner, not SBA, who would decide 
whether the risk of losing temporary control over the business was 
worth the benefits of the financing. SBA recognizes the importance of 
this issue and encourages readers to submit comments.
    Under SBA's proposal, control over the LMI Enterprise would be 
permitted only for the term of the financing. As discussed below, the 
term of an LMI Investment may be less than the 5 years typically 
required for SBIC investments.
    If an SBIC assumes control over an LMI Enterprise that participates 
in SBA's 8(a) Program or SBA's Small Disadvantaged Business Program, 
the LMI Enterprise will lose its eligibility for those Programs.

2. Royalties and Cost of Money

    SBA is proposing to exclude royalty payments on LMI Investments 
from the calculation of ``Cost of Money'' under Section 107.855. Cost 
of Money is the term for the sum of the interest rate and other charges 
that an SBIC imposes on a small business. The Cost of Money to the 
small business must not exceed the SBIC's Cost of Money ceiling, as 
computed under Section 107.855(c).
    The computation of Cost of Money already excludes certain fees, 
charges, and other payments made by the small business, as set forth in 
Section 107.855(g)(1)-(11). This proposed rule would add royalty 
payments under an LMI Investment as one more exclusion from Cost of 
Money.
    To qualify for the exclusion, the royalty would have to be based on 
improvement in the performance of the LMI Enterprise after the date of 
the financing. The royalty could be expressed, for example, as a 
percentage of any increase in an underlying unit of measurement (e.g., 
revenues or sales) after the date of the financing.
    If the SBIC accepts a royalty payment from an LMI Enterprise that 
is expressed as a percentage of the business' overall revenues, the 
royalty payment will be included in the Cost of Money calculation. If, 
on the other hand, the royalty is expressed as a percentage of any 
increase in the business' revenues after the date of the financing, the 
royalty payment will be excluded from the Cost of Money calculation. If 
an exact measurement of revenues or sales is not possible on (or even 
``as of'') the date of the financing, the parties may use an estimate 
instead.
    SBA believes that this proposed change is necessary to encourage 
SBICs to actively pursue investments in inner cities and rural areas. 
If adopted, this change would allow greater flexibility in structuring 
LMI Investments since LMI Enterprises would have the opportunity to 
offer royalty payments to an SBIC rather than bring the SBIC in as a 
new shareholder. This would result in more financing choices for the 
small business.

3. Minimum Term of LMI Investment

    SBA is proposing a one-year minimum term for LMI Investments. As a 
general rule, SBIC financings must be for a minimum period of 5 years. 
Four

[[Page 6258]]

exceptions to the rule currently exist and are found in Section 
107.835. SBA proposes to add LMI Investments as a fifth exception. SBA 
believes that this proposed change, in combination with the proposed 
changes discussed above, would provide the necessary encouragement for 
SBICs to aggressively seek out LMI Enterprises to finance.
    A conforming change is being proposed to Section 107.850(a). 
Currently, this section prohibits the mandatory redemption of equity 
securities by a small business within 5 years from the date of the 
first closing of the financing. Under the proposed change, an SBIC 
could not require an LMI Enterprise to redeem an equity security LMI 
Investment within 1 year from the date of the first closing of the 
financing.

4. Deferred Interest Debenture

    SBA recognizes that some uncertainty naturally accompanies an 
investor's first efforts in any previously untapped market. SBA does 
not want SBICs to be deterred from making those efforts in LMI Zones 
solely because the SBIC managers are concerned about being able to make 
current interest payments on SBA guaranteed debentures. SBA is prepared 
to allow SBICs to finance LMI Investments with a more patient-type of 
debenture (called an LMI Debenture in this proposed rule).
    The LMI Debenture currently under consideration would be a ten-
year, non-amortizing debenture issued at a discount so as to be, in 
effect, ``zero coupon'' for the first 5 years. The LMI Debenture would 
require semi-annual interest payments on the face amount for the last 5 
years. For example, an SBIC issuing a $100,000 debenture at a 6 percent 
interest rate would receive approximately $75,000 upon issuance, and 
would make no interest payments for the first 5 years. Starting with 
the sixth year, the SBIC would make semi-annual interest payments based 
on an annual rate of 6 percent on the debenture's face amount of 
$100,000. At maturity (or sooner in the event of prepayment), the SBIC 
would pay the $100,000 face amount of the debenture. SBA leverage fees 
would not be deferred; they would be paid as required under current 
Section 107.1130.
    Each SBIC that is licensed and eligible to issue debentures under 
current regulations would be eligible to issue LMI Debentures to the 
extent it makes LMI Investments. To ensure that LMI Debenture funds are 
used to support LMI Investments only, an SBIC's eligibility for these 
debentures would be limited by the amount of its outstanding LMI 
Investments (made after the effective date of the final rule).
    More specifically, an SBIC's eligibility for an LMI Debenture would 
be determined in two ways. First, the SBIC would have to be eligible to 
issue leverage in an amount equal to the face amount of the LMI 
Debenture. Eligibility for this purpose is determined under Sections 
107.1120-1160. Second, the SBIC would have to have LMI Investments in 
an amount approximating the net proceeds of the LMI Debenture. Since 
the actual amount of the net proceeds of an LMI Debenture will depend 
on interest rates in effect at the time of its issuance and cannot be 
known at the time of the SBIC's leverage application, SBA is 
considering using a fixed multiple of 1.5 to make this second 
eligibility determination. An SBIC would be eligible for an LMI 
Debenture with a face amount equal to 1.5 times the amount of the 
SBIC's LMI Investments at the time of application. In the above 
example, the SBIC would be required to have $66,666 of LMI Investments 
in its portfolio at the time the SBIC applied to issue the $100,000 LMI 
Debenture.
    No regulatory changes are necessary to implement this new type of 
debenture.

Compliance With Executive Orders 12612, 12778 and 12866, the 
Regulatory Flexibility Act (5 U.S.C. 601, et seq.), and the 
Paperwork Reduction Act (44 U.S.C. Ch. 35).

    SBA certifies that this proposed rule may constitute a significant 
regulatory action within the meaning of Executive Order 12866, since it 
raises a new policy issue reflecting the President's priorities.
    SBA certifies that this proposed rule does not have a significant 
economic impact on a substantial number of small entities within the 
meaning of the Regulatory Flexibility Act, 5 U.S.C. 601, et seq. This 
proposed rule would change some requirements to encourage SBICs to make 
additional qualified investments in low and moderate income zones. In 
FY 1998, SBICs invested in 2700 small businesses. While the proposed 
rule may increase the number of small businesses receiving SBIC 
investments because SBICs may make investments in smaller increments, 
the number of small businesses eligible for SBIC investments would not 
change.
    For purposes of the Paperwork Reduction Act, 44 U.S.C. CH. 35, SBA 
is requesting a modification of SBA Forms 468 and 1031 that will permit 
participating SBICs to report the information they are required to 
maintain by the proposed rule. The proposed rule will require SBICs 
that make LMI Investments to keep track of their LMI Investments and 
periodically report them SBA. To determine whether an SBIC is making an 
LMI Investment, the SBIC will have to verify the location of the LMI 
Enterprise or its employees using the databases discussed in this 
proposed rule. SBA estimates that the time necessary to verify the 
location of an LMI enterprise or its employees will average less than 
one hour per LMI Investment. The reporting requirements are de minimis 
since current forms will only be changed to reflect LMI investments. 
SBA further estimates that SBICs may make approximately 500 LMI 
Investments per year. SBA is seeking comment on whether this 
information is necessary for the proper performance of the function of 
the agency, accuracy of burden estimate, in addition to ways to 
minimize this estimate, and ways to enhance the quality. Please send 
comments to Saunders Miller, SBA, Investment Division, 409 3rd Street, 
SW., Washington, DC 20416 and to David Rostker, Office of Management 
and Budget, Office of Information and Regulatory Affairs, 725 17th 
Street, NW., Washington, DC 20503.
    For purposes of Executive Order 12612, SBA certifies that this rule 
would not have any federalism implications warranting the preparation 
of a Federalism Assessment.
    For purposes of Executive Order 12778, SBA certifies that this rule 
is drafted, to the extent practicable, in accordance with the standards 
set forth in Section 2 of that Order.

List of Subjects in 13 CFR Part 107

    Investment companies, Loan programs-business, Reporting and 
recordkeeping requirements, Small businesses.

    For the reasons set forth above, SBA proposes to amend 13 CFR part 
107 as follows:

PART 107--SMALL BUSINESS INVESTMENT COMPANIES

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

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

    2. Amend Sec. 107.50 to add definitions of LMI Enterprise, LMI 
Investment, and LMI Zone, to read as follows:


Sec. 107.50  Definitions of terms.

* * * * *
    LMI Enterprise means, at the time of application for SBIC 
financing, a Small Business:

[[Page 6259]]

    (1) That has its principal place of business in an LMI Zone, or
    (2) In which at least 35 percent of the full-time employees have 
primary residences in LMI Zone(s).
    LMI Investment means a financing of an LMI Enterprise, made after 
March 15, 1999, in the form of equity securities or debt securities 
that are subordinated to all other borrowings of the business from 
financial institutions. The debt securities may be guaranteed, but 
neither the debt securities nor the guarantee may be collateralized or 
otherwise secured.
    LMI Zone means any area located within a HUBZone (as defined in 
Sec. 126.103 of this chapter), an Urban Empowerment Zone or Urban 
Enterprise Community (as designated by the Secretary of the Department 
of Housing and Urban Development), a Rural Empowerment Zone or Rural 
Enterprise Community (as designated by the Secretary of the Department 
of Agriculture), an area of Low Income or Moderate Income (as 
recognized by the Federal Financial Institutions Examination Council), 
or a county with Persistent Poverty (as classified by the Economic 
Research Service of the Department of Agriculture).
* * * * *
    3. Amend Sec. 107.610 to add paragraph (e) to read as follows:


Sec. 107.610  Required certifications for Loans and Investments.

* * * * *
    (e) For each LMI Investment:
    (1) A certification by the concern as to its principal place of 
business or the principal residences of its full-time employees, as 
applicable, dated no earlier than the date of application for SBIC 
financing, and
    (2) A certification by the SBIC that the concern qualifies as an 
LMI Enterprise as of the date of the concern's certification and the 
basis for such qualification.
    4.-5. Amend Sec. 107.835 to redesignate paragraph (d) as paragraph 
(e) and add paragraph (d) to read as follows:


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

* * * * *
    (d) An LMI Investment with a term of at least one year; or
* * * * *
    6. Amend Sec. 107.850 to revise the introductory text of paragraph 
(a) to read as follows:


Sec. 107.850  Restrictions on redemption of Equity Securities.

    (a) A Portfolio Concern cannot be required to redeem Equity 
Securities earlier than 5 years (or 1 year in the case of an LMI 
Investment) from the date of the first closing unless:
* * * * *
    7. Amend Sec. 107.855 to add paragraph (g)(12) to read as follows:


Sec. 107.855  Interest rate ceiling and limitations on fees charged to 
Small Businesses (``Cost of Money'').

* * * * *
    (g) * * *
    (12) Royalty payments received under any LMI Investment if the 
royalty is based on improvement in the performance of the Small 
Business after the date of the financing.
* * * * *
    8. Amend Sec. 107.865 to remove the ``or'' at the end of paragraph 
(d)(3), replace the period at the end of paragraph (d)(4) with ``; 
or'', add paragraph (d)(5) and revise paragraph (e)(3) to read as 
follows:


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

* * * * *
    (d) * * *
    (5) If your financing of the Small Business is an LMI Investment.
    (e) * * *
    (3) Your agreement to relinquish Control within 5 years (although 
you may, under extraordinary circumstances, request SBA's approval of 
an extension beyond 5 years). In the case of an LMI Investment with a 
term of less than 5 years, you must agree to relinquish Control within 
the term of the financing.
* * * * *
    Dated: January 13, 1999.
Aida Alvarez,
Administrator.
[FR Doc. 99-2915 Filed 2-8-99; 8:45 am]
BILLING CODE 8025-01-P