[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]
========================================================================
Proposed Rules
Federal Register
________________________________________________________________________
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.
========================================================================
Federal Register / Vol. 64, No. 26 / Tuesday, February 9, 1999 /
Proposed Rules
[[Page 6256]]
-----------------------------------------------------------------------
SMALL BUSINESS ADMINISTRATION
13 CFR Part 107
Small Business Investment Companies
AGENCY: Small Business Administration.
ACTION: Proposed rule.
-----------------------------------------------------------------------
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