Small Business Administration: Inadequate Documentation of Eligibility of
Businesses Receiving SSBIC Financing (Letter Report, 04/26/94,
GAO/RCED-94-182).

Specialized small business investment companies (SSBIC) often do not
comply with the Small Business Administration's (SBA) guidance for
documenting the eligibility of the small businesses they finance.  GAO
estimates that for more than a third of the small businesses financed,
SSBICs did not prepare eligibility profiles documenting that the
businesses were owned by socially or economically disadvantaged persons.
Even when SSBICs did prepare eligibility profiles, they often cited a
single factor as the basis for eligibility--typically minority
ownership--although SBA has told SSBICs to base eligibility on a
composite of factors, such as owners' minority status, limited
education, and low income.  One possible reason for the lack of
compliance with SBA guidance is that SSBICs do not believe documentation
is always needed, particularly when the small business is minority
owned.  SBA's requirement that examiners accept eligibility
determinations on the basis of minority status alone continues to be
inconsistent with the agency's instructions to SSBICs to use a composite
of factors as a basis for determining eligibility.  Consequently,
examiners would not be expected to spot cases in which SSBICs are
financing businesses owned by ineligible persons.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  RCED-94-182
     TITLE:  Small Business Administration: Inadequate Documentation of 
             Eligibility of Businesses Receiving SSBIC Financing
      DATE:  04/26/94
   SUBJECT:  Small business assistance
             Small business investment companies
             Disadvantaged persons
             Small business loans
             Compliance
             Eligibility determinations
             Minorities
             Economic development
             Financial records
             Documentation
IDENTIFIER:  SBA Minority Small Business and Capital Ownership 
             Development Program
             SBA 8(a) Program
             
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Cover
================================================================ COVER


Report to the Chairman,
Committee on Small Business,
House of Representatives

April 1994

SMALL BUSINESS ADMINISTRATION -
INADEQUATE DOCUMENTATION OF
ELIGIBILITY OF BUSINESSES
RECEIVING SSBIC FINANCING

GAO/RCED-94-182

Eligibility of Businesses Receiving SSBIC Financing


Abbreviations
=============================================================== ABBREV

  SBA - Small Business Administration
  SBIC - Small Business Investment Company
  SSBIC - Specialized Small Business Investment Company

Letter
=============================================================== LETTER


B-256971

April 26, 1994

The Honorable John J.  LaFalce
Chairman, Committee on Small Business
House of Representatives

Dear Mr.  Chairman: 

The Small Business Investment Act of 1958 created a program to help
small businesses obtain financing for starting, maintaining, and
expanding operations.  Under the program, small business investment
companies (SBIC) provide financing to small businesses through equity
investments (purchasing their stock) and debt (issuing them loans). 
In 1972, the Congress amended the act to establish a new class of
SBICs, sometimes called specialized SBICs, or SSBICs.  Using their
own funds as well as government funds provided through the Small
Business Administration (SBA), SSBICs provide financing to small
businesses that are owned by persons who are socially or economically
disadvantaged.\1 As of February 1994, there were 99 active SSBICs,
with investments in over 3,000 small businesses.  As of October 1,
1993, SSBICs had over $300 million in funding from SBA. 

SBA's Investment Division administers the SSBIC program, licenses the
investment companies, and maintains regulatory oversight of them. 
This oversight includes ensuring that SSBICs finance only eligible
businesses.  You requested that we review (1) the operations of
Capital Management Services, Inc.--an SSBIC--and (2) SSBICs'
compliance with SBA's guidance laying out eligibility criteria for
firms seeking financing from SSBICs.  Separately, we reported in
March 1994 on the operations of Capital Management Services, Inc.\2
This report discusses the extent to which SSBICs comply with SBA's
guidance for documenting that the small businesses receiving
financing are owned by persons who are socially or economically
disadvantaged.  In order to provide national estimates, we randomly
selected 30 SSBICs and spoke with the owners/managers for each of
them.  Additionally, for all but one of these SSBICs, we randomly
selected up to 20 small businesses receiving financing, for a total
of 381 small businesses.  For each of these small businesses, we
reviewed the eligibility documentation maintained by the SSBIC.\3 As
agreed with your office, we did not verify that these small
businesses did, in fact, meet SBA's criteria for social or economic
disadvantage. 


--------------------
\1 Government funding of SSBICs may take the form of SBA-guaranteed
debentures or SBA-purchased preferred stock and reduced interest rate
debentures. 

\2 Small Business Administration:  Inadequate Oversight of Capital
Management Services, Inc.--an SSBIC (GAO/OSI-94-23, Mar.  21, 1994). 

\3 For one SSBIC, we could not obtain access to its files:  It was
closing its operations, and its records were not available for
review. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

SSBICs often do not comply with SBA's guidance for documenting the
eligibility of the small businesses they finance.\4 On the basis of
our random sample, we estimate that for more than a third of all of
the small businesses financed, SSBICs did not prepare eligibility
profiles to document that the businesses were owned by persons who
were socially or economically disadvantaged, as required by SBA.\5
Even when SSBICs do prepare eligibility profiles, they often cite a
single factor as the basis for eligibility--typically that the owners
are minorities--though SBA has instructed SSBICs to base eligibility
on a composite of factors such as owners' minority status, limited
education, and low income.  Specifically, we estimate that SSBICs
based eligibility on one factor alone for 62 percent of all of the
small businesses they financed, and for 72 percent of these small
businesses, SSBICs based eligibility upon minority status alone. 

One possible reason why SSBICs do not comply with SBA's guidance is
that they believe such documentation is not needed in all
cases--particularly when the small business is owned by a minority. 
In fact, even within SBA, guidance concerning the bases used for
determining eligibility is inconsistent.  That is, while SBA requires
that SSBICs not rely on a single factor when determining the
eligibility of the small businesses they finance, SBA also instructs
its examiners to accept SSBICs' documentation of eligibility if
membership in a designated minority group, a single factor, is cited. 
We cannot say whether relying on a single factor as the basis of
eligibility has resulted in SSBICs' financing businesses owned by
persons who are not socially or economically disadvantaged.  However,
the requirement placed on SSBICs to not rely on a single factor in
determining the eligibility of businesses they finance is not
enforced given the current instructions provided to examiners. 


--------------------
\4 Neither the law nor SBA's regulations define social or economic
disadvantage.  Rather, criteria for establishing social or economic
disadvantage are contained in SBA's guidance to SSBICs.  See app.  I. 

\5 App.  III includes the sampling errors and confidence intervals
for the statistical estimates included in this report. 


   BACKGROUND
------------------------------------------------------------ Letter :2

SSBICs were created by the 1972 amendments to the Small Business
Investment Act of 1958.  This new class of investment companies was
an outgrowth of a similar program created by SBA in 1969, which
targeted assistance to minority-owned businesses.  The 1972
amendments require that SSBICs invest only in small businesses owned
by persons whose participation in the free enterprise system is
hampered because of social or economic disadvantage.\6

But neither the legislation nor SBA's regulations define social or
economic disadvantage--though SBA has established criteria for
determining whether a small business is socially or economically
disadvantaged.  However, at the time of the amendments, the House
Committee on Banking and Currency reported that in order to bring
benefits to as many worthy individuals as possible, the phrase
"minority enterprise SBIC" should be eliminated from the name of the
program, since the phrase implies that only members of minority
groups are eligible for this type of assistance.\7

SBA, in its 1980 Policy Release 2017, specified procedures for
determining whether a business is owned by a person who is
disadvantaged and is therefore eligible for financing from an
SSBIC.\8 These procedures state that reliance should not be placed
upon a single factor, but on a composite of factors that have
prevented owners of small businesses from obtaining financial or
other assistance available to the average entrepreneur in the
economic mainstream.  SBA's policy release cites several factors that
may be considered in determining whether the owner of the small
business is disadvantaged, including minority status, limited
education, low income, a physical or other special handicap, the fact
that the owner is a Vietnam era veteran, an inability to compete in
the marketplace, and an unfavorable location of the business. 
Finally, SBA requires that SSBICs complete a separate profile of this
information for each small business they finance and that this
eligibility profile be maintained by the SSBIC. 

In exchange for financing only businesses owned by socially or
economically disadvantaged persons, SSBICs may receive more liberal
funding from SBA than do other investment companies.  That is, SSBICs
may receive a 5-year, 3-percent interest rate subsidy for debentures
sold to SBA.  In addition, SSBICs may receive funding by selling
4-percent preferred stock to SBA.  SBICs, in comparison, receive
neither the interest rate subsidy nor the opportunity to sell
4-percent preferred stock. 

SBA's Investment Division, as part of its role in administering both
the SBIC and SSBIC programs, is responsible for conducting biennial
examinations of SBICs and SSBICs.  These examinations focus on the
investment companies' financial condition, SBA's financial risk with
regard to the investment companies, and SBICs' and SSBICs' compliance
with provisions of the Small Business Investment Act and SBA's
regulations.  In general, the time and resources devoted to an
examination depend upon the regulatory history of the SBIC or SSBIC
and the amount of SBA's outstanding funding. 


--------------------
\6 Other similar SBA programs have a different requirement.  For
example, section 8(a) of the Small Business Act, as amended,
established the Minority Small Business and Capital Ownership
Development Program or 8(a) Program.  The 8(a) Program is intended
exclusively to help small businesses owned and controlled by
"socially and economically disadvantaged" individuals.  (Emphasis
provided.)

\7 Amending the Small Business Investment Act of 1958, H.R.  Rep. 
No.  92-1428, 92nd Cong., 2nd Sess.  (Sept.  21, 1972). 

\8 Determination of "Disadvantaged Small Business Concern," SBA
Policy and Procedural Release #2017 (May 1, 1980). 


   SSBICS DO NOT COMPLY WITH
   REQUIREMENTS FOR DOCUMENTING
   ELIGIBILITY
------------------------------------------------------------ Letter :3

Many SSBICs do not comply with SBA's guidance on documenting the
eligibility of the small businesses they finance.  Often SSBICs do
not complete eligibility profiles, or they rely upon a single factor
in determining eligibility.  We estimate that SSBICs did not prepare
eligibility profiles for 37 percent of all of the small businesses in
their portfolios.  Of the 29 SSBICs for which we reviewed eligibility
profiles, 10 had none for businesses in their portfolio, 6 had
completed the profiles for some of the businesses in their portfolio,
and the remaining 13 had completed the profiles for all of the
businesses in their portfolio. 

Even when SSBICs do prepare eligibility profiles, many of these
profiles cite only one factor as the basis for eligibility. 
Specifically, we estimate that 62 percent of all of the small
businesses receiving financing for which profiles were prepared were
deemed eligible on the basis of one factor only.  For those profiles
having only a single factor cited, minority status was the factor
most often cited, appearing in an estimated 72 percent of these
profiles. 

Overall, minority status was the most often cited factor--cited alone
or in combination with other factors for an estimated 67 percent of
all of the small businesses financed by SSBICs.  The next most often
cited factor was limited education--cited alone or in combination
with other factors for an estimated 24 percent of all of the small
businesses financed. 

Some SSBIC owners and managers believe that documenting eligibility
and basing eligibility upon a composite of factors are not needed in
all instances.  About 17 percent of the SSBIC officials we spoke with
said that they do not document eligibility in a profile statement as
SBA requires.  In our discussions with SSBIC owners and managers,
some volunteered that they saw no need for such documentation when
the business is owned by a minority.  In fact, the managers/owners of
all 10 of the SSBICs having no eligibility profiles said that all or
nearly all of their businesses were eligible on the basis of their
minority status.  This perception is not new.  In 1979, we reported
that two of the nine SSBIC officials we spoke with thought that
minorities, by virtue of that fact alone, were disadvantaged.\9

In fact, even within SBA, criteria for establishing eligibility is
not consistent.  That is, in a June 1993 memo, SBA's Deputy Associate
Administrator for Investment instructed examiners that small business
owners who are members of a designated group such as Black-,
Hispanic-, or Asian-Americans are assumed to be socially
disadvantaged, and no additional information need be considered.\10
This instruction, however, is not consistent with SBA's guidance to
SSBICs, which instructs them to use a composite of factors to
determine that a small business is owned by a person who is socially
or economically disadvantaged.  More recently, in an attempt to
clarify the determination that a business is disadvantaged, SBA
proposed to an SSBIC industry group criteria that would presume that
members of designated minority groups are socially disadvantaged.  No
action was taken on this proposal, though SBA is currently exploring
changes to its criteria for establishing social or economic
disadvantage. 


--------------------
\9 Efforts to Improve Management of the Small Business Administration
Have Been Unsatisfactory--More Aggressive Action Needed
(GAO/CED-79-103, Aug.  21, 1979). 

\10 The June 1993 memo to examiners was written in anticipation of
changes--which have not yet been made--to SBA's criteria for
establishing social disadvantage.  These changes would allow citing
membership in a designated minority group alone as the basis for
eligibility.  See app.  II. 


   CONCLUSIONS
------------------------------------------------------------ Letter :4

SSBICs often do not comply with SBA's guidance for documenting and
determining the eligibility of the businesses they finance.  SBA's
requirement that examiners accept eligibility determinations based
upon minority status alone continues to be inconsistent with SBA's
instructions to SSBICs to use a composite of factors as a basis for
determining eligibility.  Consequently, examiners would not be
expected to detect instances in which SSBICs are financing small
businesses that may not be socially or economically disadvantaged
according to the criteria in the instructions to SSBICs. 


   RECOMMENDATION
------------------------------------------------------------ Letter :5

The Administrator of SBA should resolve the inconsistency between its
guidance to SSBICs and SBA examiners as to whether minority status
alone is sufficient to establish eligibility.  If the agency deems
that minority status alone is sufficient to establish eligibility, it
should modify Policy Release 2017 to instruct SSBICs of this. 
However, should the agency continue to instruct SSBICs to use a
composite of factors in determining the eligibility of the businesses
they finance, then SBA should instruct examiners to look for such a
composite when assessing SSBICs' compliance with SBA's requirements
for documenting and determining eligibility. 


   AGENCY COMMENTS
------------------------------------------------------------ Letter :6

We discussed the contents of this report with SBA's Associate
Administrator for Investment and the Directors of the Office of
Examinations and Office of Investment.  They generally concurred with
the factual content of the report.  They did suggest several
clarifications, which we have incorporated.  As requested, we did not
obtain written comments from SBA. 


   SCOPE AND METHODOLOGY
------------------------------------------------------------ Letter :7

To assess SSBICs' compliance with SBA's requirements for documenting
businesses' eligibility, we selected a random sample of 30 SSBICs. 
We interviewed the SSBICs' owners or managers about their familiarity
with SBA's policy on eligibility, the bases they use for establishing
the eligibility of the businesses in their portfolio, and their
methods for documenting eligibility.  We then set about reviewing the
eligibility profiles prepared by all but one of these SSBICs.\11 When
the SSBIC had 20 or fewer businesses in its portfolio, we examined
all of the eligibility profiles prepared for these businesses.  For
SSBICs with a larger portfolio, we selected a random sample of 20
businesses in their portfolio.  From our review, we estimated the
percentage of small businesses for which SSBICs prepared eligibility
profiles and cited various factors justifying businesses'
eligibility.  As with all estimates, these estimates are subject to a
margin of error, which varies for each estimate.  We prepared our
estimates at the 95-percent confidence level.  All of our estimates
and their margin of error are included in appendix III.  We also
reviewed SBA's policy and procedures for documenting eligibility and
reviewed the legislative history of the amendments creating the SSBIC
program.  Our analysis of SSBICs' compliance with SBA's guidance
laying out eligibility criteria was limited to reviewing eligibility
profiles maintained by SSBICs.  We did not verify the accuracy of the
information contained in these profiles.  Our work was conducted
between December 1993 and March 1994. 


--------------------
\11 As explained earlier, the records of one SSBIC were not available
for review. 


---------------------------------------------------------- Letter :7.1

While GAO's policy is to allow requesters to restrict further
distribution of a report for up to 30 days, we will be contacting
your office to arrange for an earlier release of this report to other
interested parties.  This work was performed under the direction of
Judy A.  England-Joseph, Director, Housing and Community Development
Issues, who may be reached at (202) 512-7631 if you or your staff
have any questions.  Major contributors to this report are listed in
appendix IV. 

Sincerely yours,

Keith O.  Fultz
Assistant Comptroller General




(See figure in printed edition.)Appendix I
"SBA POLICY AND PROCEDURAL RELEASE
#2017"
============================================================== Letter 



(See figure in printed edition.)




(See figure in printed edition.)Appendix II
SBA'S MEMO TO EXAMINERS ON
DETERMINATIONS THAT BUSINESS
OWNERS ARE SOCIALLY DISADVANTAGED
============================================================== Letter 



(See figure in printed edition.)


SCOPE AND METHODOLOGY
========================================================= Appendix III

To assess Specialized Small Business Investment Companies' (SSBIC)
compliance with requirements for determining and documenting
eligibility and to obtain data on the bases used for determining
eligibility, we interviewed owners or managers of 30 randomly
selected SSBICs and used a two-stage cluster sample of SSBICs and the
businesses they finance.  For each of the 30 SSBICs, we interviewed
the owners or managers about their familiarity with SBA's policy on
eligibility, the bases they use for establishing the eligibility of
the businesses in their portfolio, and their methods for documenting
eligibility.  These same 30 randomly selected SSBICs served as the
first stage of the two-stage cluster sample described below. 

First, we randomly selected the 30 SSBICs out of the universe of 99
SSBICs.  We then obtained eligibility profiles for randomly selected
small businesses in each of the SSBICs' portfolios.  When the SSBIC
had 20 or fewer small businesses in its portfolio, we examined all of
the eligibility profiles prepared for these businesses.  For SSBICs
with a larger portfolio, we selected a random sample of 20 businesses
in their portfolio.  The 30 randomly selected SSBICs represent the
first stage of the two-stage cluster sample, and the small businesses
sampled represent the second stage of the sample.  We chose this
approach as appropriate for constructing a sample because the 99
SSBICs closely resembled one another but were in separate locations. 
The files for one of the sampled SSBICs were inaccessible because
this SSBIC was in liquidation.  This reduced our sample size for
SSBICs to 29, and we proportionally reduced our population size to
96.  The 29 randomly selected SSBICs financed a total of 916 small
businesses.  From the 916, we sampled a total of 381 small
businesses.  Initially, we looked at whether or not a profile was
available for each small business, and then, if a profile was
available, we looked at the criteria used to determine eligibility. 

Because we used random samples at both stages to develop our
estimates, each estimate has a measurable precision, or sampling
error, which may be expressed as a plus/minus figure.  A sampling
error indicates how closely we can reproduce from a sample the
results that we would obtain if we were to take a complete count of
the universe using the same measurement methods.  By adding the
sampling error to and subtracting it from the estimate, we can
develop upper and lower bounds for each estimate.  This range is
called a confidence interval.  Sampling errors and confidence
intervals are stated at a certain confidence level--in our case, 95
percent.  This confidence level of 95 percent means that in 95 out of
100 instances, the sampling procedure we used would produce a
confidence interval containing the universe value we are estimating. 
We calculated the sampling errors at the 95-percent confidence level
for those statistical estimates used in this report.  The upper and
lower bounds of the confidence intervals for the estimates in this
report are shown in table III.1. 



                         Table III.1
           
              Documentation of Small Businesses'
                         Eligibility

                               Estimated          Confidence
                           percentage of     interval at the
                        small businesses          95-percent
Characteristic of               with the    confidence level
documentation             characteristic        (percentage)
----------------------  ----------------  ------------------
No eligibility profile              36.8        15.1 to 58.5
 prepared
Minority status cited               67.4        45.2 to 89.6
 alone or in
 combination with
 other factors as the
 basis for eligibility
Limited education                   23.5         9.7 to 37.3
 cited alone or in
 combination with
 other factors
Only one factor cited               62.0        42.2 to 81.8
 as the basis for
 eligibility
Minority status cited               71.9        53.2 to 90.6
 alone
------------------------------------------------------------

MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix IV

RESOURCES, COMMUNITY, AND ECONOMIC
DEVELOPMENT DIVISION, WASHINGTON,
D.C. 

Mathew J.  Scire

DALLAS REGIONAL OFFICE

Carol Anderson-Guthrie
Richard B.  Smith
Kirk D.  Menard
Donna Berryman

CHICAGO REGIONAL OFFICE

Rose M.  Schuville

LOS ANGELES REGIONAL OFFICE

Eric D.  Johns

NEW YORK REGIONAL OFFICE

John E.  Thompson

SAN FRANCISCO REGIONAL OFFICE

Stephen R.  Myerson

