[Federal Register Volume 65, Number 230 (Wednesday, November 29, 2000)]
[Rules and Regulations]
[Pages 71053-71056]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-30415]



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 Rules and Regulations
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  Federal Register / Vol. 65, No. 230 / Wednesday, November 29, 2000 / 
Rules and Regulations  

[[Page 71053]]



SMALL BUSINESS ADMINISTRATION

13 CFR Part 107


Small Business Investment Companies

AGENCY: Small Business Administration.

ACTION: Final rule.

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SUMMARY: This final rule modifies 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. An exception 
to the prohibition permits an investor that qualifies as a 
``traditional investment company'', as determined by SBA, to own in 
excess of 70% of an SBIC. This final rule will help to ensure that each 
new leveraged SBIC has managers that exercise independence in managing 
the operations of the SBIC.

DATES: This rule is effective on December 29, 2000.

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

SUPPLEMENTARY INFORMATION: On August 14, 2000, SBA published a proposed 
rule (65 FR 49511) to revise the management-ownership diversity 
regulation in SBA's Small Business Investment Company (``SBIC'') 
Program. Under the proposal, no single investor or group of affiliated 
investors would be permitted to own or control more than 70% of a 
leveraged SBIC. SBA also proposed an exception to allow an entity 
qualifying as a ``traditional investment company'' to own and control 
more than 70% of an SBIC. SBA solicited comments on the proposed rule 
and specifically sought comment as to whether the proposed exception 
should be expanded to cover other categories of investors.
    SBA received no comments on the proposed rule and, accordingly, is 
finalizing it without substantive change. SBA has made certain minor 
non-substantive edits to the proposed version of section 107.150 
(``Management-ownership diversity requirement''), including relettering 
of the paragraphs, in order to conform to drafting requirements of the 
Federal Register.
    The proposed rule summarized the changes in the management-
ownership diversity regulation since its adoption in 1994. That summary 
and SBA's explanation of the proposed changes to the regulation, all of 
which have been implemented in this final rule, are repeated here as a 
convenience to the reader.
    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 Fed. Reg. 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); Public Law 104-208, section 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).
    As SBA stated in the proposed rule published on August 14, 2000, 
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

[[Page 71054]]

concerns as to whether independence was assured when a single investor, 
unrelated to the management team, owned substantially all of an SBIC.
    To provide diversity under the regulation as in effect since 1994, 
the non-management interest was required to be at least 30% of the 
SBIC, but could have been as much as 100% and could have been owned by 
a single entity. This single super-majority investor could provide the 
required diversity from management as long as the investor did not 
control, was not controlled by, and was not under common control with, 
the managers of the SBIC. Thus, for diversity to be provided by a 
single super-majority investor who was otherwise unrelated to the 
SBIC's management team, SBA had to conclude that the investor did not 
control the SBIC's managers by virtue of the size of the investor's 
ownership interest in the SBIC.
    As SBA explained in the proposed rule, 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 management-
ownership diversity regulation persuaded it 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 proposed 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 recognized that there might be categories of investors who 
could be permitted to own in excess of 70% of an SBIC without 
destroying the SBIC's management-ownership diversity. SBA proposed an 
exception for one such category--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.
    As SBA discussed in the proposed rule, 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.
    Under the final rule, a traditional investment company is permitted 
to own and control more than 70% of an SBIC.
    In addition, the final rule adopts without change the proposed 
revisions to the 30% test (new paragraph (c) of section 107.150) in the 
management-ownership diversity regulation. Under those revisions, (1) 
publicly-traded licensees can no longer automatically satisfy the 30% 
test, (2) two new categories are added to the list of entities 
permitted to serve as the sole (30%) diversity investor in an SBIC, and 
(3) the scope of one of the other categories of entities on that list 
is clarified.
    The first of those revisions is accomplished by deleting paragraph 
(a)(2) of the old diversity regulation. The second revision, the 
addition of two new categories of entities permitted to serve as the 
sole diversity investor, appears in new paragraphs (c)(1)(ii) and (iii) 
of section 107.150. The new categories are Institutional Investors that 
(1) are listed on the New York Stock Exchange or (2) are publicly-
traded and meet 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 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 third revision referred to above appears in new paragraph 
(c)(1)(i) of section 107.150. It makes clear that an entity seeking to 
qualify as the sole diversity investor because it is subject to 
government oversight or regulation must have its overall activities 
both regulated and periodically examined by a governmental authority 
satisfactory to SBA. 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.
    An existing SBIC that is not currently required to have diversity 
will become subject to the new management-ownership diversity 
regulation only if (1) the SBIC applies for approval of a change of 
control and SBA requires diversity as a condition of its approval, or 
(2) the SBIC was not licensed with the expectation that it would issue 
leverage but it now seeks approval to do so.
    As was proposed, SBA also is amending 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.

[[Page 71055]]

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 final rule is not a significant regulatory action for purposes 
of Executive Order 12866 and therefore was not reviewed by the Office 
of Management and Budget.
    SBA has determined that this final rule will 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 final rule is to redefine and clarify the concept of 
management-ownership diversity in an SBIC. The final rule will 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 
final 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 
final rule will have no federalism implications.
    For purposes of the Paperwork Reduction Act, 44 U.S.C. Ch. 35, SBA 
has determined that this final rule contains 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.

    For the reasons stated above, the SBA amends 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-ownership diversity requirement.

    (a) Diversity requirement. You must satisfy the requirements in 
paragraphs (b), (c) and (d) of this section:
    (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 so requires as a condition of approval of your transfer 
of Control under Sec. 107.440.
    (b) Percentage ownership requirement. (1) Except as provided in 
paragraph (b)(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.
    (c) 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 
(c)(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.
    (d) Voting requirement. (1) Except as provided in paragraph (d)(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 (d)(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.
    (e) 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:

[[Page 71056]]

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: November 16, 2000.
Aida Alvarez,
Administrator.
[FR Doc. 00-30415 Filed 11-28-00; 8:45 am]
BILLING CODE 8025-01-P