69–006

106TH CONGRESS REPORT " ! HOUSE OF REPRESENTATIVES 1st Session 106–1

AMENDING SECTION 20 OF THE SMALL BUSINESS ACT AND

MAKE TECHNICAL CORRECTIONS IN TITLE III OF THE

SMALL BUSINESS INVESTMENT ACT

JANUARY 19, 1999.—Committed to the Committee of the Whole House on the State

of the Union and ordered to be printed

Mr. TALENT, from the Committee on Small Business,

submitted the following

REPORT

together with

ADDITIONAL VIEWS

[To accompany H.R. 68]

[Including cost estimate of the Congressional Budget Office]

The Committee on Small Business, to whom was referred the bill

(H.R. 68) to amend section 20 of the Small Business Act and make

technical corrections in Title III of the Small Business Investment

Act, having considered the same, report favorably thereon without

amendment and recommend that the bill do pass.

PURPOSE

The purpose of H.R. 68 is to make certain technical amendments

to Title III of the Small Business Investment Act of 1958 and

amend Section 20 of the Small Business Act. Title III authorizes

the activities of the Small Business Investment Company program.

Small Business Investment Companies (SBICs) are venture capital

firms licensed by the Small Business Administration that use SBA

guarantees to leverage private capital for investment in small businesses.

The technical corrections proposed by H.R. 68 will improve the

flexibility of the SBIC program and allow improved access to this

program by small businesses.
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NEED FOR LEGISLATION

Congress revamped the SBIC program in the 103d Congress to

provide for a new form of leverage geared specifically towards equity investment in small businesses. Over the ensuing years, as the

new program has become established, certain deficiencies have

come to light; in addition, certain statutory provisions have become

obsolete.

Moreover, the nature of the SBIC industry has changed. The result is a participating securities industry made up primarily of

smaller SBICs. The fact that these smaller SBICs are dominating

the program points to shifting dynamics in the SBIC program.

Smaller, start-up investments are more typical and, therefore, the

demand for leverage has shifted to smaller individual placements.

H.R. 68 seeks to correct these deficiencies, and remove provisions

that may produce confusion due to changes in law and the character of the SBIC program. First, H.R. 68 will modify the SBIC

program to exclude contingent obligations from the calculation of

interest in loans made by SBICs. These contingent obligations include financial tools like royalties, warrants, conversion rights and

options. Many small businesses use these devices to help buy down

the interest rates on their financings. Unfortunately, current law

has forced SBA and the SBICs to try and include these options as

part of the interest applicable for a determination of the maximum

applicable interest rate. These valuations have resulted in confusion and uncertainty for all concerned and have often resulted in

the loss of financing opportunities for small businesses.

Second, under H.R. 68, a provision in the Small Business Investment Act that reserves leverage for smaller SBICs will also be repealed. Changes in SBA policy regarding applications for leverage,

statutory changes in the availability of commitments for SBICs,

and the makeup of the industry present the possibility that that

provision may, in fact, create conflicts and confusion.

Third, H.R. 68 will increase the authorization levels for the participating securities segment of the SBIC program. The authorization levels will rise from $800 million to $1 billion in fiscal year

1999, and from $900 million to $1.2 billion in fiscal year 2000.

These increases are necessary to meet the rising demands for this

section of the SBIC program.

Fourth, H.R. 68 modifies a test for determining the eligibility of

small businesses for SBIC financing. Current statutory language

does not account for small businesses organized in pass-through

tax structures such as S corporations, limited liability companies,

and certain partnerships. These organizations do not pay taxes at

the enterprise level, but instead pass through income and the ensuing tax liabilities to their partners and shareholders. Consequently,

many of these small businesses face difficulties when the income

test is applied to them, and are often declared ineligible for financing they should receive.

Finally, H.R. 68 will allow the SBA greater flexibility in issuing

trust certificates to finance the SBIC program’s investments in

small businesses. Current law allows fundings to be issued every

six months or more frequently. This inhibits the ability of the

SBICs and the SBA to form pools of certificates that are large
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enough to generate serious investor interest. Allowing more time

between fundings will permit SBA and the industry to form larger

pools for sale in the market, thereby increasing investor interest

and improving the interest rates for the small businesses financed.

COMMITTEE ACTION

In the 105th Congress, a hearing was held on May 12, 1998, to

discuss H.R. 3412 a bill substantially similar to H.R. 68. Mr. Lee

Mercer, President of the National Association of Small Business Investment Companies, testified concerning the provisions of H.R.

3412. At that hearing, Chairman Talent questioned Mr. Mercer regarding concerns that repeal of the provision reserving leverage for

smaller SBICs might impair access to leverage for those firms. Mr.

Mercer responded that his organization, which is composed primarily of smaller SBICs, endorsed the provision. Further, he informed the Committee that, based on industry and SBA data, 80

percent of the participating securities licensees were smaller

SBICs. He also stated that demands for leverage in the participating securities were generally for small individual placements rather than any single large investments that would seriously deplete

funding. Ms. Vela ́zquez then questioned Mr. Mercer about the correction of the after-tax income test, and asked if he could supply

any specific firms who had been denied eligibility due to the current test. Mr. Mercer stated that he could not name any specific

firms but that he had heard of several such firms.

Ms. Vela ́zquez, Mr. Davis and Mrs. Kelly then asked Mr. Mercer

several questions concerning the SBIC industry’s efforts to attract

more minority and women-owned businesses for financing assistance. Mr. Mercer described a number of initiatives that his organization had started to achieve those ends. Ms. Vela ́zquez also requested that Mr. Mercer and his organization develop and provide

an outreach program for minority and women-owned businesses.

On Thursday, January 7, 1999, the Committee on Small Business held a brief hearing to consider the provisions of H.R. 68. Testifying at the hearing was Mr. Lee Mercer, President of the National Association of Small Business Investment Companies. Mr.

Mercer reiterated his testimony from the 105th Congress regarding

the beneficial effects that H.R. 68 would have on the SBIC program. He recognized the improvements in management that have

occurred in the program over recent years and strongly recommended the corrections contained in H.R. 68. Mr. Mercer explained the five provisions and the effect they would have in detail.

The hearing was in essence a reprise of the hearing held the previous year to discuss the provisions of H.R. 3412.

Mr. Hinojosa asked questions concerning the establishment of

the cost of money for the SBIC program through the secondary

market. Mr. Mercer explained that the cost was variable and fluctuated in correspondence with changes in the 10-year Treasury

rate and the varying spread requirements of institutional investors.

Ms. Napolitano also asked Mr. Mercer about the various examples

of the effect and impact of the SBIC program. There being no further questions, the hearing was gaveled to a close and the Committee moved on to consideration of H.R. 68.
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Immediately after the hearing, Chairman Talent called the Committee to order for the purpose of marking up and reporting H.R.

68. The bill was introduced, considered as read, and opened for

amendment. No amendments were offered. Mrs. Kelly then moved

to pass H.R. 68 and report it to the House. At 11:05 a.m., by a

unanimous voice vote, a quorum being present, the Committee

passed the bill, H.R. 68, and ordered it reported.

SECTION-BY-SECTION ANALYSIS

Section 1. Short title

Designates the bill as ‘‘The Small Business Investment Company

Technical Corrections Act of 1999’’.

Section 2. SBIC program

(1) Paragraph (a) of section 2 modifies section 308(i)(2) of the

Small Business Investment Act of 1958 to exclude contingent obligations from the calculation used to determine the maximum allowable interest rate in an SBIC financing. Contingent obligations

include financial tools such as options, warrants, conversion rights

and royalties. Because such devices are contingent and speculative

their correct valuation has been a problem for small businesses,

SBICs and the SBA.

(2) Paragraph (b) changes Section 20 of the Small Business Act

to increase the authorization levels for participating securities

under the SBIC program. The authorizations are increased from

$800 million to $1 billion in fiscal year 1999, and from $900 million

to $1.2 billion in fiscal year 2000.

(3) The first part of paragraph (c) removes subparagraph (13) of

Section 303(g) of the Small Business Investment Act (15 U.S.C.

683(g)). That provision reserves 50% of participating securities leverage for Small Business Investment Companies with private capital of less than $20 million until the fourth fiscal quarter. While

the Committee continues to be interested that all SBICs have access to the funding needed to complete their investments, we also

recognize that this provision is no longer necessary. Only 12 of the

60 SBICs in the participating leverage program have more than

$20 million in private capital, and the original concern that a few

large SBICs would dominate the program has proved unfounded. It

appears that most SBIC equity placements are in smaller earlystage businesses, and consequently most participating securities

SBICs are established as smaller funds.

(4) The second part of paragraph (c) establishes a test for small

businesses formed as tax ‘‘pass-through’’ entities such as S corporations or limited liability companies. Such businesses will have their

small business investment eligibility determined by multiplying

their net income by the combined federal and state corporate tax

rate and then subtracting the result from their net income. That

result will serve as the small business’ estimated ‘‘after-tax income’’

for the purpose of determining eligibility. This removes an uncertainty in the statute that means a C corporation with as much as

$9 million in pretax income could be a small business but a passthrough S corporation with $6,000,001 in income was ineligible.
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(5) The final part of paragraph (c) changes Section 320 of the

Small Business Investment Act to allow issuance of Small Business

Administration-backed trust certificates not less than every twelve

months rather than the current standard of every six months. SBA

would retain the discretion to issue guarantees and trust certificates at shorter intervals if appropriate. The chance will give SBA

increased flexibility in negotiating the terms and costs associated

with the placement of certificates, either by contract or public offering. This will ultimately benefit the small business seeking financing since the rates sought by SBICs are reflected in the rates

charged to small businesses.

CONGRESSIONAL BUDGET OFFICE COST ESTIMATE

U.S. CONGRESS, CONGRESSIONAL BUDGET OFFICE, Washington, DC, January 13, 1999.

Hon. JAMES M. TALENT, Chairman, Committee on Small Business,

House of Representatives, Washington, DC.

DEAR MR. CHAIRMAN: The Congressional Budget Office has prepared the enclosed cost estimate for H.R. 68, the Small Business

Investment Company Technical Corrections Act of 1999.

If you wish further details on this estimate, we will be pleased

to provide them. The CBO staff contact is Mark Hadley.

Sincerely,

JAMES L. BLUM

(For June E. O’Neill, Director).

Enclosure.

H.R. 68—Small Business Investment Company Technical Corrections Act of 1999

Summary: H.R. 68 would make a number of technical corrections

to the Small Business Investment Act of 1958. It would eliminate

a provision in current law that reserves funds for smaller Small

Business Investment Companies (SBICs) until the last quarter of

the fiscal year. The bill also would allow a more accurate determination of eligibility of small businesses for SBIC programs by requiring the Small Business Administration (SBA) to measure a

firm’s revenues assuming that it has paid all required income

taxes. (Certain corporate structures, such as ‘‘S’’ corporations, pass

all income through to the stockholders. Other firms do not pass

through income, but instead pay taxes at the corporate level). Finally H.R. 68 would give SBA more flexibility in issuing certificates

that help finance SBIC activities by increasing the minimum placement period for public offerings from 6 months to 12 months.

The bill would increase the authorized level of the SBIC participating securities program in 1999 and 2000. CBO estimates that

the subsidy costs of guarantees for the authorized levels would increase by about $10 million over the 1999–2004 period.

H.R. 68 would not affect direct spending or receipts; therefore,

pay-as-you-go procedures do not apply. H.R. 68 contains no intergovernmental or private-sector mandates as defined in the Un-
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funded Mandates Reform Act (UMRA) and would not affect the

budgets of state, local, or tribal governments.

Estimated cost to the Federal Government: For purposes of this

estimate, CBO assumes that the bill will be enacted by March 31,

1999. CBO further assumes appropriation of authorized amounts,

including a supplemental appropriation for increases of authorized

amounts in fiscal year 1999. The estimated budgetary impact of

H.R. 68 is shown in the following table. The costs of this legislation

fall within budget function 370 (commerce and housing credit).

[By fiscal year, in millions of dollars]

1999 2000 2001 2002 2003 2004

Authorizations of Appropriations

SBIC Participating Securities Loans: 1

Estimated authorization level ................................... 4 6 0 0 0 0

Estimated outlays ..................................................... 1 6 2 (2)00

1 Implementing H.R. 68 also would increase SBA’s costs for administering loans, but CBO estimates that the changes in administrative expenses would be less than $500,000 a year. 2 Less than $500,000.

The Federal Credit Reform Act of 1990 requires appropriation of

the subsidy costs and administrative costs for credit programs. The

subsidy cost is the estimated long-term cost to the government of

a direct loan or loan guarantee, calculated on a net present-value

basis and excluding administrative costs.

H.R. 68 would increase the authorized program level of the SBIC

participating securities program from $800 million to $1 billion in

1999 and from $900 million to $1.2 billion in 2000. Based on information from the SBA and on historical data for this program, CBO

estimates that the subsidy costs of guarantees for the authorized

levels would increase by $10 million over the 1999–2004 period.

CBO estimates that this provision would not significantly increase

the administrative costs of the agency.

Pay-as-you-go considerations: None.

Intergovernmental and private-sector impact: H.R. 68 contains

no intergovernmental or private-sector mandates as defined in

UMRA and would not affect the budgets of state, local, or tribal

governments.

Estimate prepared by: Mark Hadley.

Estimate approved by: Paul N. Van de Water, Assistant Director

for Budget Analysis.

COMMITTEE ESTIMATE OF COSTS

Pursuant to the Congressional Budget Act of 1974, the Committee estimates that the amendments to Small Business Administration authorization levels in H.R. 68 will increase appropriations by

no more than $10 million over the next five fiscal years, if fully

funded. Furthermore, pursuant to clause 3(d)(2)(A) of rule XIII of

the Rules of the House of Representatives, the Committee estimates that implementation of H.R. 68 will not significantly increase administrative costs. This concurs with the estimate of the

Congressional Budget Office.
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OVERSIGHT FINDINGS

In accordance with clause 4(c)(2) of rule X of the Rules of the

House of Representatives, the Committee states that no oversight

findings or recommendations have been made by the Committee on

Government Reform with respect to the subject matter contained

in H.R. 68.

In accordance with clause 2(b)(1) of rule X of the Rules of the

House of Representatives, the oversight findings and recommendations of the Committee on Small Business with respect to the subject matter contained in H.R. 68 are incorporated into the descriptive portions of this report.

STATEMENT OF CONSTITUTIONAL AUTHORITY

Pursuant to clause 3(d)(1) of rule XIII of the Rules of the House

of Representatives, the Committee finds the authority for this legislation in Article I, Section 8, Clause 18 of the Constitution of the

United States.

CHANGES IN EXISTING LAW MADE BY THE BILL, AS REPORTED

In compliance with clause 3 of rule XIII of the Rules of the House

of Representatives, changes in existing law made by the bill, as reported, are shown as follows (existing law proposed to be omitted

is enclosed in black brackets, new matter is printed in italic, existing law in which no change is proposed is shown in roman):

SMALL BUSINESS INVESTMENT ACT OF 1958

* * * * * * *

TITLE III—SMALL BUSINESS INVESTMENT COMPANIES

* * * * * * *

BORROWING POWER

SEC. 303. (a)***

* * * * * * *

(g) In order to encourage small business investment companies

to provide equity capital to small businesses, the Administration is

authorized to guarantee the payment of the redemption price and

prioritized payments on participating securities issued by such

companies which are licensed pursuant to section 301(c) of this Act,

and a trust or a pool acting on behalf of the Administration is authorized to purchase such securities. Such guarantees and purchases shall be made on such terms and conditions as the Administration shall establish by regulation. For purposes of this section,

(A) the term ‘‘participating securities’’ includes preferred stock, a

preferred limited partnership interest or a similar instrument, including debentures under the terms of which interest is payable

only to the extent of earnings and (B) the term ‘‘prioritized payments’’ includes dividends on stock, interest on qualifying debentures, or priority returns on preferred limited partnership interests

which are paid only to the extent of earnings. Participating securities guaranteed under this subsection shall be subject to the follow-
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ing restrictions and limitations, in addition to such other restrictions and limitations as the Administration may determine:

(1) * * *

* * * * * * *

ø(13) PARTICIPATING SECURITIES FOR SMALLER SMALL BUSINESS INVESTMENT COMPANIES.—

ø(A) IN GENERAL.—Subject to the provisions of subparagraph (B), of the amount of the annual program level of

participating securities approved in appropriations Acts,

50 percent shall be reserved for funding small business investment companies with private capital of not more than

$20,000,000.

ø(B) EXCEPTION.—During the last quarter of each fiscal

year, if the Administrator determines that there is a lack

of qualified applicants with private capital of not more

than $20,000,000, the Administrator may utilize all or any

part of the program level for securities reserved under subparagraph (A) for qualified applicants with private capital

of more than $20,000,000.¿

* * * * * * *

MISCELLANEOUS

SEC. 308. (a)***

* * * * * * *

(i)(1) The purpose of this subsection is to facilitate the orderly

and necessary flow of long-term loans and equity funds from small

business investment companies to small business concerns.

(2) In the case of a business loan, the small business investment

company making such loan may charge interest on such loan at a

rate which does not exceed the maximum rate prescribed by regulation by the Administration for loans made by any licensee (determined without regard to any State rate incorporated by such regulation). In this paragraph, the term ‘‘interest’’ includes only the maximum mandatory sum, expressed in dollars or as a percentage rate,

that is payable with respect to the business loan amount received by

the small business concern, and does not include the value, if any,

of contingent obligations, including warrants, royalty, or conversion

rights, granting the small business investment company an ownership interest in the equity or increased future revenue of the small

business concern receiving the business loan.

* * * * * * *

(j) For the purposes of sections 304 and 305, in any case in which

an incorporated or unincorporated business is not required by law

to pay Federal income taxes at the enterprise level, but is required

to pass income through to its shareholders or partners, an eligible

small business or smaller enterprise may be determined by computing the after-tax income of such business by deducting from the net

income an amount equal to the net income multiplied by the combined marginal Federal and State income tax rate for corporations.

* * * * * * *
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PERIODIC ISSUANCE OF GUARANTEES AND TRUST CERTIFICATES

SEC. 320. The Administration shall issue guarantees under section 303 and trust certificates under section 319 at periodic intervals of not less than every ø6¿ 12 months and shall do so at such

shorter intervals as it deems appropriate, taking into consideration

the amount and number of such guarantees or trust certificates.

* * * * * * *

SECTION 20 OF THE SMALL BUSINESS ACT

SEC. 20. (a)***

* * * * * * *

(d) FISCAL YEAR 1999.—

(1) PROGRAM LEVELS.—The following program levels are authorized for fiscal year 1999:

(A) * * *

* * * * * * *

(C) For the programs authorized by title III of the Small

Business Investment Act of 1958, the Administration is

authorized to make—

(i) ø$800,000,000¿ $1,000,000,000 in purchases of

participating securities; and (ii) $700,000,000 in guarantees of debentures.

* * * * * * *

(e) FISCAL YEAR 2000.—

(1) PROGRAM LEVELS.—The following program levels are authorized for fiscal year 2000:

(A) * * *

* * * * * * *

(C) For the programs authorized by title III of the Small

Business Investment Act of 1958, the Administration is

authorized to make—

(i) ø$900,000,000¿ $1,200,000,000 in purchases of

participating securities; and

* * * * * * *
(10)

ADDITIONAL VIEWS

As the Ranking Democratic Member of the Small Business Committee, I want to express my strong support for a piece of legislation that I am an original cosponsor of—H.R. 68, The Small Business Investment Company Technical Corrections Act of 1999. This

bill will make several key improvements to the Small Business Investment Company Act and create a more efficient and effective

SBIC program.

The five provisions contained in H.R. 68 include three passed by

the House early last year as H.R. 3412, The Small Business Investment Company Act of 1998. As a proponent of the SBIC program,

I was a cosponsor of that bill. It successfully passed the House of

Representatives by a unanimous vote last summer. I was also

pleased to work in conjunction with Chairman Talent to ensure

that the SBIC program was fully funded in the Fiscal Year 1999

Commerce, Justice, State Appropriations. These efforts were undertaken to make the program more efficient and responsive to the

needs of investors and small entrepreneurs.

There is no question that the value of Small Business Investment

Companies has been felt across the country. SBICs have invested

nearly $15 billion in long-term debt and equity capital to over

90,000 small businesses. Millions of jobs have been created and billions of dollars have been added to our economy. For this reason,

I believe that starting the 106th Congressional Session with an

SBIC-focused bill is important.

Building on the success of last year’s legislation, there are five

technical improvements included in H.R. 68, The Small Business

Investment Company Technical Corrections Act of 1999. The first

change provides greater flexibility for funding leverage, permitting

the Small Business Administration (SBA) to explore the broadest

range of funding mechanisms that might reduce the cost of leverage.

The next improvement establishes an assumed tax rate for small

businesses formed as pass-through entities for use in determining

eligibility for SBIC funding. This will increase the number of small

businesses that are eligible for SBIC funding.

The third change ends the requirement that the SBA reserve

50% of participating security leverage for the first three fiscal quarters of each year for SBICs with less than $20 million in private

capital. This removes an administrative burden rendered unnecessary by the commitment process. Additionally, H.R. 68 increases

the authorization level for participating securities from $800 million to $1 billion for current fiscal year 1999 and $900 million to

at least $1.2 billion for fiscal year 2000.

In particular, I would like to clarify the first provision which excludes royalty agreements from the cost of money calculations. The

manner in which the change is drafted is meant to give SBA the
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greatest flexibility possible when they promulgate regulations. Currently, SBICs may charge one maximum permissible rate of interest for straight loans—those with no contingent rights in the small

business—or a lower maximum permissible rate for hybrid loans—

those with contingent rights or other equity features. SBA has long

struggled with how to treat the value, if any, of the contingent equity features that an SBIC receives in these hybrid loan transactions.

This proposal aims to be a powerful new tool for underserved

areas in their campaign to increase access to investment capital.

However, excluding royalties is not only important for underserved

areas, it is key for any small businesses trying to attract SBIC financing.

During the past few years, the SBIC program has expanded into

new areas. In 1997 alone, we saw several ground breaking efforts

with the creation of two women owned SBICs, and the establishment of the first Hispanic owned SBIC. The corrections envisioned

by H.R. 68 are part of an ongoing process that will enable us to

provide more ground breaking efforts to serve small entrepreneurs.

NYDIA M. VELA ́ ZQUEZ.

Æ