[Federal Register Volume 65, Number 157 (Monday, August 14, 2000)]
[Proposed Rules]
[Pages 49511-49513]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-20477]


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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. 65, No. 157 / Monday, August 14, 2000 / 
Proposed Rules  

[[Page 49511]]



SMALL BUSINESS ADMINISTRATION

13 CFR Part 107


Small Business Investment Companies

AGENCY: Small Business Administration.

ACTION: Proposed rule.

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SUMMARY: This proposed rule would modify the management-ownership 
diversity requirement in SBA's Small Business Investment Company 
(``SBIC'') Program to prohibit the ownership of more than 70% of a 
leveraged SBIC by any single investor or group of affiliated investors. 
This action will help to ensure that each new leveraged SBIC has 
managers that exercise independence in managing the operations of the 
SBIC.

DATES: Submit comments on or before September 13, 2000.

ADDRESSES: Address comments to Leonard Fagan, Investment Division, U.S. 
Small Business Administration, 409 3rd Street, SW., Suite 6300, 
Washington, DC 20416.

FOR FURTHER INFORMATION CONTACT: Leonard W. Fagan, at (202) 205-7583.

SUPPLEMENTARY INFORMATION: In 1994, SBA adopted a regulation requiring 
that all small business investment companies (``SBICs'') intending to 
issue participating securities have independence, or ``diversity'', 
between the management and the ownership of the company. 59 FR 16918 
(April 8, 1994). This requirement of independence was designed to 
prevent the types of abuses that SBA had observed in SBICs owned and 
operated by a single individual or group of individuals. The abuses, 
which included conflict of interest transactions, misapplication of 
funds, and other types of self-dealing activities, had resulted in 
significant losses to SBA.
    To satisfy the 1994 management-ownership diversity regulation, at 
least 30% of the capital of the SBIC had to be owned by investors who 
were neither Associates nor Affiliates of any Associates of the SBIC 
(as such terms were defined in 13 CFR parts 107 and 121). In other 
words, at least 30% of the capital of the SBIC had to be owned by 
investors who were not part of the SBIC's management team and did not 
control the SBIC's management team. In general, three such ``diversity 
investors'' were required, but a single diversity investor would 
suffice if the investor was an entity that met certain net worth and 
regulatory oversight requirements.
    The 1994 regulation permitted an SBIC with a parent company (i.e., 
an investor owning greater than 50% of the SBIC) to treat the parent 
company's investors as if they were direct investors in the SBIC for 
purposes of demonstrating diversity. SBA would, in effect, ``look-
through'' to the investors in the parent company for the desired 
independence from, and oversight of, the management of the SBIC.
    In 1996, SBA extended the management-ownership diversity 
requirement to all new SBICs intending to use SBA financial assistance, 
or ``leverage'', whether the leverage was in the form of participating 
securities or debentures. 61 FR 3177 (January 31, 1996). SBA also 
replaced the automatic look-through provision described above with a 
discretionary look-through: SBA, in the exercise of its discretion, 
could look through to the parent's investors, but such treatment was no 
longer automatic. This change was in response to the increasing 
complexity SBA was encountering in ``drop-down'' SBICs (SBIC 
subsidiaries of larger companies), where the combination of multi-
tiered organizational structures and other factors had led SBA to 
conclude that the necessary oversight by independent owners might not 
be present. SBA could still look through to the parent company's 
investors to find diversity, but would do so only if SBA believed that 
the result was consistent with the intent of the diversity regulation.
    Later in 1996, Congress expressed its support for management-
ownership diversity by enacting a statutory provision requiring SBA to 
ensure that the management of all new SBICs ``is sufficiently 
diversified from and unaffiliated with the ownership of the licensee in 
a manner that ensures independence and objectivity in the financial 
management and oversight of the investments and operations of the 
licensee.'' 15 U.S.C. 682(c); Pub. L. 104-208, Sec. 208(c)(3) 
(September 30, 1996). SBA subsequently made minor changes to strengthen 
the management-ownership diversity regulation. These changes included 
requiring (1) that the diversity investors be unrelated to each other, 
(2) that each diversity investor have a significant ownership interest 
in dollar and percentage terms, and (3) that an SBIC's diversity be 
evidenced in its paid-in capital, not just its unfunded commitments. 63 
FR 5859 (February 5, 1998).
    SBA believes that, overall, the management-ownership diversity 
regulation has been successful in encouraging the presence of investors 
who are truly independent of management. However, SBA has had concerns 
with whether independence is assured when a single investor, unrelated 
to the management team, owns substantially all of an SBIC.
    Under the current regulation, to provide diversity the non-
management interest is required to be at least 30% of the SBIC, but 
could be as much as 100% and could be owned by a single entity. This 
single super-majority investor can provide the required diversity from 
management as long as the investor does not control, is not controlled 
by, and is not under common control with, the managers of the SBIC. 
Thus, for diversity to be provided by a single super-majority investor 
who is otherwise unrelated to the SBIC's management team, SBA must 
conclude that the investor does not control the SBIC's managers by 
virtue of the size of the investor's ownership interest in the SBIC.
    In that regard, SBA believes that the degree of influence that can 
be exerted by a super-majority investor may significantly reduce the 
management team's ability to act independently and objectively. The 
larger the size of an investor's ownership interest, the greater the 
investor's potential influence over the activities of the SBIC. This is 
true even if the investor is a passive limited partner.
    At some ownership level, an investor's power to influence 
effectively becomes the power to control the managers of the SBIC, and 
the management team can no longer be said to have the ability to act 
independently. SBA's experience in administering the existing 
management-ownership diversity regulation has persuaded it

[[Page 49512]]

that it is difficult to objectively establish when that ownership level 
is reached. However, if the super-majority investor is limited to 
owning not more than 70%, and there is a 30% diversity investor that is 
independent of both the management and the super-majority investor, the 
super-majority investor's degree of potential influence on management 
becomes acceptable.
    Accordingly, SBA proposes to amend the management-ownership 
diversity regulation, section 107.150, to prohibit ownership of more 
than 70% of a leveraged SBIC by a single investor or group of 
affiliated investors.
    SBA recognizes that there may be categories of investors who can be 
permitted to own in excess of 70% of an SBIC without destroying the 
SBIC's management-ownership diversity. SBA believes that one such 
category is the traditional investment company--a professionally 
managed firm organized exclusively to pool capital from more than one 
source for the purpose of investing in businesses that are expected to 
generate substantial returns to the firm's investors.
    A subsidiary SBIC of such a traditional investment company can 
offer meaningful management-ownership diversity even if the investment 
company owns substantially all of the SBIC. This is true for a number 
of reasons. First, a traditional investment company has managers who 
are largely unrelated to and unaffiliated with the investors in the 
firm. These independent managers typically also serve as the managers 
of the subsidiary SBIC. Second, the managers of a traditional 
investment company and its subsidiary SBIC are properly authorized and 
motivated to make investments that, in their independent judgment, are 
likely to produce significant returns to all investors in the 
investment company and in the SBIC. Although the managers act 
independently of the investors in the firm, they are directly 
accountable to them. Most importantly, a traditional investment company 
benefits from the use of a subsidiary SBIC only if the SBIC makes 
profitable investments.
    SBICs with other types of super-majority investors do not 
necessarily present the same degree of management independence and 
objectivity, plus investor oversight. The objectives of other super-
majority investors may include something other than profit maximization 
at the SBIC level. Large operating companies, for example, may profit 
from the use of a subsidiary SBIC other than through the financial 
performance of the SBIC. The SBIC might make strategic investments to 
support or otherwise benefit the non-investing activities of the 
operating company, rather than investments intended solely to 
contribute to the profitability of the SBIC. This would defeat one of 
the underlying purposes of management-ownership diversity--the 
protection of SBA's financial interest in the SBIC.
    The proposed rule would permit a traditional investment company to 
own and control more than 70% of an SBIC. SBA welcomes comments and 
suggestions as to whether a similar exception should be provided for 
other types of investors in an SBIC.
    The 30% test in the current diversity regulation would continue to 
be required under the proposed regulation, but with slight 
modifications. First, current paragraph (a)(2), which treats publicly-
traded licensees as automatically satisfying the 30% test, would be 
eliminated. SBA expects that the small number of license applicants 
intending to be public companies should easily be able to demonstrate 
their compliance with the 30% test.
    Second, the proposed rule would add two new categories to the list 
of entities currently permitted to serve as the sole (30%) diversity 
investor in an SBIC, and would clarify one of the existing categories. 
The current list includes, in paragraph (a)(1)(i), entities that are 
subject to some satisfactory form of government oversight or 
regulation. The proposed rule clarifies that this category is intended 
to capture only those entities whose overall activities are both 
regulated and periodically examined by a satisfactory governmental 
authority. U.S. federal and state bank regulators or insurance 
commissions are examples of satisfactory governmental authorities for 
this purpose. Regulation of an entity's health and safety activities by 
the Office of Safety and Health Administration (OSHA), on the other 
hand, would not be acceptable for this purpose.
    The two new categories of entities to be added to paragraph (a)(1) 
by the proposed rule would cover any Institutional Investor that (1) is 
listed on the New York Stock Exchange or (2) is publicly-traded and 
meets the minimum numerical and corporate governance listing standards 
of that Exchange. Companies satisfying either of these listing 
standards have sufficient size and public oversight and visibility to 
justify treating them the same as regulated companies for purposes of 
the diversity regulation. SBA expects this proposed change to resolve 
any uncertainty as to the requirements for a publicly-traded company to 
be considered acceptable to SBA as a single diversity investor under 
the regulation.
    The proposed management-ownership diversity regulation would apply 
to an existing SBIC only if SBA requires management-ownership diversity 
as a condition of SBA's approval of the licensee's change of control or 
if a non-leveraged SBIC wants to be approved as eligible to issue 
leverage. SBA is proposing to amend section 107.440(c) to clarify that 
SBA's approval of a change of control of an SBIC may be conditioned 
upon the licensee's compliance with the diversity regulation, as well 
as minimum capital requirements, then in effect. This has been SBA's 
practice since the diversity regulation was first adopted.

Compliance With Executive Orders 12866, 12988, and 13132, the 
Regulatory Flexibility Act (5 U.S.C. 601-612), and the Paperwork 
Reduction Act (44 U.S.C. Ch. 35).

    This proposed rule is a significant regulatory action for purposes 
of Executive Order 12866 and was reviewed by the Office of Management 
and Budget.
    SBA has determined that this proposed rule would 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. 601-612. 
The purpose of the proposed rule is to redefine and clarify the concept 
of management-ownership diversity in an SBIC. The proposed rule would 
not apply to the approximately 365 companies currently licensed as 
SBICs, except in the insignificant number of cases where a transfer of 
control of the licensee occurs or where an SBIC that was not licensed 
with the expectation that it would issue leverage applies for such 
approval.
    For purposes of Executive Order 12988, SBA has determined that this 
proposed rule is drafted, to the extent practicable, in accordance with 
the standards set forth in Section 3 of that Order.
    For purposes of Executive Order 13132, SBA has determined that this 
proposed would have no federalism implications.
    For purposes of the Paperwork Reduction Act, 44 U.S.C. Ch. 35, SBA 
has determined that this proposed rule, if adopted in final form, would 
contain no new reporting or recordkeeping requirements.

List of Subjects in 13 CFR Part 107

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

[[Page 49513]]

    For the reasons stated above, the 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), 6887b, 687d, 687g 
and 687m.

    2. Revise Sec. 107.150 to read as follows:


Sec. 107.150  Management and ownership diversity requirement.

    You must have diversity between your management and your ownership
    (1) In order to obtain an SBIC license (unless you do not plan to 
obtain Leverage),
    (2) If at the time you were licensed you did not plan to obtain 
Leverage, but you now wish to be eligible for Leverage, or
    (3) If SBA requires it as a condition of approval of your transfer 
of Control under Sec. 107.440. To establish diversity you must meet the 
requirements in paragraphs (a) and (b) of this section, and you must 
maintain voting rights and diversity in accordance with paragraphs (c) 
and (d) of this section.
    (a) Percentage ownership requirement. (1) Except as provided in 
paragraph (a)(2) of this section, no Person or group of Persons who are 
Affiliates of one another may own or control, directly or indirectly, 
more than 70 percent of your Regulatory Capital or your Leverageable 
Capital.
    (2) Exception. An investor that is a traditional investment 
company, as determined by SBA, may own and control more than 70 percent 
of your Regulatory Capital and your Leverageable Capital. For purposes 
of this section, a traditional investment company must be a 
professionally managed firm organized exclusively to pool capital from 
more than one source for the purpose of investing in businesses that 
are expected to generate substantial returns to the firm's investors. 
In determining whether a firm is a traditional investment company for 
purposes of this section, SBA will also consider:
    (i) Whether the managers of the firm are unrelated to and 
unaffiliated with the investors in the firm;
    (ii) Whether the managers of the firm are authorized and motivated 
to make investments that, in their independent judgment, are likely to 
produce significant returns to all investors in the firm;
    (iii) Whether the firm benefits from the use of the SBIC only 
through the financial performance of the SBIC; and
    (iv) Other related factors.
    (b) Non-affiliation requirement.--(1) General rule. At least 30 
percent of your Regulatory Capital and Leverageable Capital must be 
owned and controlled by three Persons unaffiliated with your management 
and unaffiliated with each other, and whose investments are significant 
in dollar and percentage terms as determined by SBA. Such Persons must 
not be your Associates (except for their status as your shareholders, 
limited partners, or members) and must not Control, be Controlled by, 
or be under Common Control with any of your Associates. A single 
``acceptable'' Institutional Investor may be substituted for two or 
three of the three Persons who are otherwise required under this 
paragraph. The following Institutional Investors are ``acceptable'' for 
this purpose:
    (i) Entities whose overall activities are regulated and 
periodically examined by state, Federal, or other governmental 
authorities satisfactory to SBA;
    (ii) Entities listed on the New York Stock Exchange;
    (iii) Entities that are publicly-traded and that meet both the 
minimum numerical listing standards and the corporate governance 
listing standards of the New York Stock Exchange;
    (iv) Public or private employee pension funds;
    (v) Trusts, foundations, or endowments, but only if exempt from 
Federal income taxation; and
    (vi) Other Institutional Investors satisfactory to SBA.
    (2) Look-through for traditional investment company investors. SBA, 
in its sole discretion, may consider the requirement in paragraph 
(b)(1) of this section to be satisfied if at least 30 percent of your 
Regulatory Capital and Leverageable Capital is owned and controlled 
indirectly, through a traditional investment company, by Persons 
unaffiliated with your management.
    (c) Voting requirement. (1) Except as provided in paragraph (c)(2) 
of this section, the investors required for you to satisfy diversity 
may not delegate their voting rights to any Person who is your 
Associate, or who Controls, is Controlled by, or is under Common 
Control with any of your Associates, without prior SBA approval.
    (2) Exception. Paragraph (c)(1) of this section does not apply to 
investors in publicly-traded Licensees, to proxies given to vote in 
accordance with specific instructions for single specified meetings, or 
to any delegation of voting rights to a Person who is neither a 
diversity investor in the Licensee nor affiliated with management of 
the Licensee.
    (d) Requirement to maintain diversity. If you were required to have 
management-ownership diversity at any time, you must maintain such 
diversity while you have outstanding Leverage or Earmarked Assets. To 
maintain management-ownership diversity, you may continue to satisfy 
the diversity requirement as in effect at the time it was first 
applicable to you or you may satisfy the management-ownership diversity 
requirement as currently in effect. If, at any time, you no longer have 
the required management-ownership diversity, you must:
    (1) Notify SBA within 10 days; and
    (2) Re-establish diversity within six months. For the consequences 
of failure to re-establish diversity, see Secs. 107.1810(g) and 
107.1820(f).
    3. In Sec. 107.440, revise paragraph (c) to read as follows:


Sec. 107.440  Standards governing prior SBA approval for a proposed 
transfer of Control.

* * * * *
    (c) Require compliance with any other conditions set by SBA, 
including compliance with the requirements for minimum capital and 
management-ownership diversity as in effect at such time for new 
license applicants.

    Dated: August 7, 2000.
Fred P. Hochberg,
Acting Administrator.
[FR Doc. 00-20477 Filed 8-11-00; 8:45 am]
BILLING CODE 8025-01-U