[Federal Register Volume 61, Number 21 (Wednesday, January 31, 1996)]
[Rules and Regulations]
[Pages 3177-3189]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: X96-10131]



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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 revises the regulations found at 13 CFR Part 
107, governing the Small Business Investment Company (SBIC) Program. It 
eliminates inconsistencies, clarifies procedures, accommodates program 
experience and industry changes, and provides for more efficient 
program operation. It also clarifies and shortens regulations where 
appropriate, eliminates redundant provisions, consolidates and 
reorganizes sections and clarifies ambiguous language.

EFFECTIVE DATE: This final rule is effective January 31, 1996.

FOR FURTHER INFORMATION CONTACT:
Leonard Fagan, Office of Investment; telephone no. (202) 205-6510.

SUPPLEMENTARY INFORMATION: In response to a Memorandum from President 
Clinton for all federal agencies to simplify their regulations, SBA 
published a proposed rule on November 28, 1995, to revise the 
regulations governing the SBIC program. See 60 FR 58530 (November 28, 
1995). The public was afforded a thirty-day period in which to submit 
comments on the proposed rule to SBA. During that period, SBA received 
over 30 letters containing over 200 comments. After giving careful 
consideration to the comments and concerns raised in those letters, SBA 
is today finalizing the proposed rule with certain modifications 
discussed below. Only those sections which have changed, which were 
commented on or which 

[[Page 3178]]
need some clarification will be discussed.
    In accordance with 5 U.S.C. 553(d)(3), SBA has determined that good 
cause exists to make this rule effective upon publication. Ample notice 
of material changes has been given the interested public through 
proposed rules published in the Federal Register inviting public 
comment and through distribution of draft rules before publication of 
the proposed rules. All comments received from the interested public 
have been carefully considered. Representatives of the entities 
affected by this rule concur with an immediate effective date. Almost 
all regulatory changes will relieve restrictions or merely reorganize 
and simplify text. To the extent there are substantive changes 
contained in these rules, SBA believes no prejudice will occur to 
affected entities by making the rules immediately effective. The 
affected entities will have had an adequate opportunity to take any 
necessary steps to be in compliance with the rules by the effective 
date, but to the extent that may not be the case, any instance of non-
compliance with a changed regulatory provision during the first 30 days 
after publication will be treated with such liberality as may be needed 
to avoid prejudice. New fees imposed through these rules will not be 
enforced until at least 30 days after publication.

General Comments

    Those comment letters which addressed the proposed renumbering, 
reorganization and rewrite of Part 107 were overwhelmingly 
complimentary. Some felt the proposed regulations were a vast 
improvement over the old, while others commended SBA on its efforts to 
simplify and streamline the regulations. Most agreed that the 
reorganization and stylistic revisions will make Part 107 easier to 
follow and understand. As one commenter stated, ``Practicality and 
common sense really pervade these new proposals.''

Part I

1. Subpart A--Introduction to Part 107

    SBA agrees with the comment received on proposed Sec. 107.20, 
suggesting that it is unnecessary to specifically mention Section 
301(d) Licensees when discussing the fact that all Licensees must 
comply with all applicable regulations. The section has been revised 
and finalized accordingly.

2. Subpart B--Definition of Terms Used in Part 107

a. ``Associate''
    (1) Several commenters suggested that the proposed language 
defining ``any person regularly serving a Licensee in the capacity of 
attorney at law'' as an Associate was ambiguous and could be construed 
too broadly. SBA agrees and will return to the language in the current 
definition which states that an Associate includes ``any Person 
regularly serving a Licensee on retainer in the capacity of attorney at 
law''. The definition is finalized accordingly.
b. ``Control''
    The proposed definition of ``Control'' has been adopted with a 
change suggested by one commenter. In the proposed rule, Control could 
be achieved through possession of the ``power to veto'' the direction 
of the management and policies of a concern; in the final rule, the 
reference to veto power is deleted. The commenter's concern was that 
this phrase could be interpreted so broadly as to prohibit normal 
covenants necessary to protect a Licensee's investments. This was not 
SBA's intention; furthermore the Agency believes that its concerns 
about negative Control of Small Businesses are sufficiently addressed 
by the reference in the definition to ``indirect'' Control, as well as 
by the ``presumption of Control'' provisions under Sec. 107.865(b).
c. ``Control Person''
    Under the existing regulations, a Person with at least a 40 percent 
limited partnership interest in a Licensee's general partner is a 
Control Person. Paragraph (4) of the proposed definition would apply 
the same criterion to a limited partner in the Licensee itself. One 
commenter objected to the entire concept of classifying a limited 
partner as a Control Person, suggesting that the provision contradicts 
established partnership principles and could threaten a limited 
partner's limited liability status. SBA does not believe that a 
regulatory definition would have this effect; furthermore, the Agency 
has stated previously that the definition of Control Person is intended 
to cover persons in a position to exercise influence, but not 
necessarily control, over a Licensee. Nevertheless, in response to the 
concern expressed, SBA has increased the ownership percentage required 
to classify a limited partner (of either a Licensee or its general 
partner) as a Control Person from 40 percent to 50 percent.
d. ``Disadvantaged Businesses''
    SBA received one comment objecting to the proposed language 
requiring that a Disadvantaged Business be managed ``on a day to day 
basis'' by persons who meet the criteria for social or economic 
disadvantage. The commenter considered this phrase an unwarranted 
expansion of the definition. SBA disagrees; the requirement that 
disadvantaged owners be actively involved in the management of their 
companies reflects long-standing SBA policy and is consistent with the 
Agency's statutory mandate for all of its programs for Disadvantaged 
Businesses. Accordingly, the definition is finalized as proposed.
e. ``Equity Capital Investment''
    SBA received one comment suggesting that ``a preferred stock 
investment with the liquidating dividend payable to the extent of 
available assets'' should be considered an Equity Capital Investment. 
SBA's interpretation of the Small Business Investment Act of 1958, as 
amended (``Act'') is that dividends may be payable only to the extent 
of retained earnings; this treatment is consistent with the statutory 
language concerning subordinated debt instruments, which can qualify as 
Equity Capital Investments if, among other things, they ``provide for 
interest payments contingent upon and limited to the extent of 
earnings.'' Accordingly, the definition is finalized without change.
f. ``Institutional Investor''
    In the proposed rule, SBA added language to the definition of 
``Institutional Investor'' to clarify that an entity cannot satisfy the 
net worth test on the basis of unfunded commitments from its investors. 
One commenter suggested that this language be dropped and that such 
commitments be recognized. SBA disagrees with this suggestion because 
it increases the government's financial risk. SBA has protections in 
place which allow it to require Institutional Investors to fund their 
commitments to a Licensee under certain circumstances; however, it is 
unlikely that such requirements could be extended to investors who are 
one or more levels removed from the Licensee. Therefore, the proposed 
definition is adopted as final.
g. ``Start-Up Financing''
    The proposed rule did not make any changes in this definition, but 
used it in a new context--it was proposed that Licensees be permitted 
to take temporary Control of Start-Up Financing under Sec. 107.865(d). 
In this context, 

[[Page 3179]]
several commenters felt that the definition was too narrow in terms of 
the types of businesses covered, the length of time the business had 
been in existence, and the exclusion of businesses formed to acquire 
existing businesses. SBA agrees that a broader definition is 
appropriate for purposes of Sec. 107.865 and is not objectionable for 
purposes of determining Capital Impairment, the other context in which 
it appears. Accordingly, the final rule largely eliminates these 
restrictions. A business formed as an acquisition company can qualify 
as long as the acquired company meets the criteria for a Start-Up 
Financing.
    The limitations on sales revenue and cash flow have also been 
modified: Under paragraph (3) of the proposed definition, companies 
could not have ``sales exceeding $5,000,000 or positive cash flow in 
any fiscal year.'' The final rule prohibits ``sales exceeding 
$3,000,000 or positive cash flow from operations in any of the past 
three fiscal years.'' SBA believes the lower sales ceiling is more 
appropriate to a true start-up company; the other changes respond to 
comments received.
h. ``Unrealized Appreciation''
    The proposed definition is adopted with one minor editorial change.
i. ``Unrealized Depreciation''
    The proposed definition is adopted with one minor editorial change.
j. ``Qualified Non-Private Funds''
    The proposed definition, which appears in Sec. 107.230(d), is 
adopted without change. SBA received one comment objecting to the 
language that permits government grants to nonprofit entities to be 
Qualified Non-Private Funds ``if SBA determines that such funds have 
taken on a private character and the nonprofit corporation or 
institution is not a mere conduit.'' SBA believes the language is an 
appropriate interpretation of the Act; in particular, the ``private 
character'' standard is specifically cited in the legislative history.

3. Subpart C--Qualifying for an SBIC License

a. Organizing a Licensee
    Comments received on proposed Sec. 107.100 and Sec. 107.110 
questioned why Section 301(c) and Section 301(d) Licensees could not be 
formed as limited liability companies. Limited liability companies are 
not a permitted form of organization recognized by the Act. Therefore, 
the rule is adopted as proposed.
b. 1940 Act and 1980 Act Companies
    SBA received several comments on proposed Sec. 107.115, all of 
which objected to the restriction against licensing 1940 Act or 1980 
Act companies that elect to be taxed as regulated investment companies 
under section 851 of the Internal Revenue Code. SBA is persuaded that 
Licensees would not be denied the ability to access capital by using 
these structures. Therefore, the final rule allows Licensees to 
organize as or convert to 1940 Act or 1980 Act Companies, and to elect 
to be taxed as regulated investment companies. The regulation also 
clarifies that when the tax code conflicts with SBA regulations or 
guidelines governing distributions, the SBA requirements will apply 
unless the Licensee requests and receives a waiver in accordance with 
the regulations.
c. SBA Approval of Initial Management Expenses
    Proposed Sec. 107.140, which requires all new SBIC license 
applicants (not just applicants planning to issue Participating 
Securities) to obtain SBA approval of their initial Management 
Expenses, is adopted with one change: This section will not apply to 
non-leveraged Licensees, which present no financial risk to the Agency.
d. Management and Ownership Diversity
    Proposed Sec. 107.150, which requires all license applicants 
planning to obtain Leverage to have diversity between management and 
ownership, is adopted without change. SBA received one comment that 
applicants should be permitted in all cases to satisfy the diversity 
requirement on a ``look through basis'' (that is, at the parent level). 
This option is available to Licensees if SBA approves; however, as 
stated in the preamble to the proposed rule, the Agency believes it 
must have discretion in this area in order to assure that a Licensee 
has genuine diversity, as opposed to an ownership structure that 
provides ``technical'' diversity but does not satisfy the intent of the 
regulation.
e. Special Rules for Partnership Licensees
    Proposed Sec. 107.160(b), allowing an Entity General Partner to be 
organized for the sole purpose of serving as the general partner of one 
or more licensees, is adopted without change. SBA considered the 
comment suggesting that an Entity General Partner not be precluded from 
other activities, but rejected the suggestion due to the complexity of 
examining a general partner involved in both SBA and non-SBA related 
activities. The Agency believes that this would result in an undue 
burden both on its examiners and on the Entity General Partner.
f. Minimum Capital Requirements for Licensees
    SBA received one comment on proposed Sec. 107.210(b) (which did not 
contain any substantive changes) suggesting that the Regulatory Capital 
requirement for Section 301(d) Licensees be inclusive, not exclusive 
of, unfunded commitments. This comment is inconsistent with SBA's 
interpretation of the minimum capital requirements of the Act; 
therefore, the proposed rule has been adopted as final without change.
g. Special Minimum Capital Requirements for Licensees Issuing Leverage
    A comment received on proposed Sec. 107.220(b) argued in favor of 
omitting the ``special'' minimum capital requirements which require any 
company licensed after the regulation is finalized to have Regulatory 
Capital of at least $5,000,000 in order to apply for Debentures, unless 
it demonstrates to SBA's satisfaction that it can be financially viable 
over the long term with a lower amount. The same commenter also 
suggested revising the ``grandfather'' provisions in Sec. 107220(c)(1), 
which allow certain existing Licensees that do not meet the current 
minimum capital requirements to receive additional Leverage if they are 
profitable. The commenter wrote that other criteria besides 
profitability should be considered.
    SBA is finalizing both provisions as proposed. The Agency considers 
these standards to be vital to the continuing success of the SBIC 
program. As stated in the preamble to the proposed rule, a review of 
the financial performance of Licensees supports the conclusion that 
higher levels of Regulatory Capital significantly reduces the 
likelihood of unprofitable operations over the long term. As to 
Sec. 107.220(c), the profitability criterion has been used since 1990, 
and SBA continues to believe that profitability is the best and most 
objective indicator of future successful operations.
    SBA has made two editorial changes to proposed Sec. 107.220(c)(2). 
Proposed paragraph (c)(2)(i), which deals with Debentures maturing 
before December 31, 1995, has been deleted because it is not longer 
applicable. Proposed paragraph (c)(2)(ii) has been incorporated into 
paragraph (c)(2) and revised by replacing ``a term of three years'' 
with ``a term to be determined by 

[[Page 3180]]
SBA.'' This change has been made because three-year Leverage is not 
routinely available at this time.
h. Limitations on Accepting Non-Cash Capital Contributions
    The heading of proposed Sec. 107.240 has been revised to read 
``Limitations on including non-cash capital contributions in Private 
Capital'', which is more consistent with the substance of the section. 
One commenter suggested that the section be revised to state that 
Licensees may still accept non-cash assets that cannot be included in 
Private Capital. SBA did not adopt this suggestion, primarily because 
of its concerns about liabilities that may be associated with 
unapproved non-cash assets. Therefore, except for the change in the 
section heading, proposed Sec. 107.240 is finalized without change.
i. Issuance of Stock Options by Licensees
    SBA agrees with the comment that proposed Sec. 107.250(a), which 
states that a Licensee may issue stock options, is unnecessary and has 
deleted it in the final rule. The deletion does not affect a Licensee's 
ability to issue stock options.
j. License Application Form & Fee
    A comment received on proposed Sec. 107.300 objected to the 
increase in the license fee for partnerships that plan to issue 
participating securities, particularly those using the standard 
partnership agreement annex already approved by SBA. SBA proposed the 
fee increase in order to reflect the Agency's costs of processing 
applications. Pursuant to applicable statutory provisions, the 
Administration has taken into consideration direct and indirect costs 
to SBA of necessary services performed, value to the recipients, the 
public policy interest served and other pertinent factors involved. 
After due consideration, SBA believes the increase in fees to be 
justified and is finalizing Sec. 107.300 as proposed.

4. Subpart D--Changes in Ownership, Control, or Structure of Licensee; 
Transfer of License

a. Changes in Control/SBA Prior Approval
    Section 107.410 requires SBA's prior approval for a change of 
Control while Sec. 107.440 sets out the standards governing SBA's 
approval. One commenter suggested that a grandfather clause be adopted 
for these sections. The effect of such a clause would be to allow an 
existing Licensee to undergo a change of Control without having to meet 
the increased minimum capital requirements currently in effect. SBA 
believes that a grandfather clause is not necessary because the Agency 
will apply the capital adequacy and financial viability standards of 
Secs. 107.200 and 107.220 in evaluating an application for a change of 
Control. Therefore, both sections are finalized without change.
b. Restrictions on Common Control or Ownership of Two (or More) 
Licensees
    SBA agrees with the comment that Sec. 107.460, which requires SBA 
approval of common Control or ownership of two or more Licensees, 
should not be applicable to unleveraged Licensees, so long as none of 
the Licensees involved has any Leverage. This change has been 
incorporated in the final rule.

5. Subpart E--Managing the Operations of a Licensee

a. Identification as a Licensee
    SBA received one comment which argued the difficulty of identifying 
an SBIC as a Federal Licensee on each Financing document. SBA agrees, 
and has decided to revise proposed Sec. 107.501 to state that before 
extending Financing or collecting an application fee from a Small 
Business, a Licensee must obtain a written statement from the concern 
acknowledging its awareness that it is dealing with a Federally 
licensed SBIC.
b. Licensee's Adoption of an Approved Valuation Policy
    Many comments on proposed Sec. 107.503(c) objected to the language 
which sated that ``SBA reserves the right to review or independently 
establish valuations of your Loans and Investments''. All the 
commenters agreed that SBA should only become involved in a specific 
valuation if that valuation is in violation of the agreed upon 
valuation policy. The proposed language was intended to address SBA's 
continuing concerns regarding certain instances of egregious non-
compliance with agreed-upon valuation policies, and the difficulties it 
has encountered in its attempts to take action regarding such non-
compliance. However, in recognition of the legitimate concerns of 
Licensees, SBA is revising Sec. 107.503. In the final rule, the 
language cited at the beginning of this paragraph has been replaced by 
the following: ``If SBA reasonably believes that your valuations, 
individually or in the aggregate, are materially misstated, it reserves 
the right to require you to engage, at your expense, an independent 
third party, acceptable to SBA, to substantiate the valuations.''
    In addition, purposed Sec. 107.503(d)(4) has been revised by adding 
the word ``adverse'' before the word ``change'', so that only material 
adverse changes in valuations must be reported quarterly to SBA.
c. SBA Approval of Licensee's Investment Adviser/Manager
    SBA agrees with the comment on proposed Sec. 107.510 that annual 
approval of the management contract by the Licensee's board of 
directors is unnecessary. The proposed rule has been revised and is 
finalized accordingly.
d. Restrictions on Investments of Idle Funds by Leveraged Licensees
    With one change, proposed Sec. 107.530 regarding idle funds is 
adopted as proposed. The section has been amended to permit Licensees 
to maintain a reasonable petty cash fund.
e. Limitations on Secured Third-Party Debt
    As discussed in the preamble to the proposed rule, proposed 
Sec. 107.550(a) was intended primarily as a restatement of the existing 
regulation requiring leveraged Licensees to obtain SBA approval before 
incurring secured third-party debt. The only change was the requirement 
that Licensees also obtain SBA approval before expanding the scope of a 
security interest or lien associated with existing debt. Based on some 
of the comments received, SBA realized that paragraph (a) was being 
misinterpreted. In particular, it was not SBA's intention to require 
approval each time a Licensee wants to draw down an approved line of 
credit. Nor did SBA intend to require Licensees to obtain approval to 
substitute one asset or group of assets for another as the subject of a 
security interest, as long as the values are comparable. In the final 
rule, proposed Sec. 107.550(a) has been split into two paragraphs and 
revised to clarify the intent.
    Two comments were received on proposed Sec. 107.550(c), suggesting 
that the limitation of the security interest to 125 percent of a 
proposed borrowing against a Licensee's investor commitments is 
impractical. SBA recognizes that some Licensees may not be able to 
borrow under this provision. However, it is only with reluctance that 
the Agency has permitted any third-party borrowing against investor 
commitments, since these are the same commitments that SBA may look to 
at some point to protect its own financial interests. Therefore, SBA is 
finalizing this provision (renumbered as Sec. 107.550(d)) without 
change.

[[Page 3181]]

    Proposed Sec. 107.550(d) stated the conditions under which SBA will 
provide a 30-day turnaround on applications for approval of secured 
third-party debt. One of these conditions was that the security 
interest be limited to the assets acquired with the borrowed funds, or 
an asset coverage ratio of no more than 1.25:1. SBA agrees with the 
commenters who suggested that the coverage ratio is unrealistically 
low, and is revising the ratio to 2:1 in the final rule (with this 
paragraph renumbered as Sec. 107.550(e)).
f. Subordination of SBA's Creditor Position
    Proposed Sec. 107.560 is adopted without change. One commenter 
argued that without a specific definition of subordination, expressed 
in a formal subordination agreement, Licensees would find it impossible 
to obtain third-party debt. SBA's experience with the subordination 
regulation, which was first adopted in 1991, is that lenders have been 
willing to work out the details of subordination agreements with SBA on 
an individual basis. Nevertheless, SBA is sympathetic to Licensees' 
desire to understand the Agency's specific concerns in this area, and 
will attempt to develop guidelines for a subordination agreement that 
would be generally acceptable to SBA.
g. Activity Requirement
    SBA received several comments on proposed Sec. 107.590 suggesting 
that the activity test is unnecessary, or should be revised, or should 
not apply to non-leveraged Licensees.
    SBA strongly believes that some form of activity test is necessary 
for both leveraged and non-leveraged Licensees. Companies are licensed 
with the understanding that they will help to fulfill the public 
purpose of the program, which is to further the growth and development 
of small businesses. Clearly, an inactive Licensee is not contributing 
to this goal. Furthermore, an inactive Licensee, even if it is non-
leveraged, imposes some degree of administrative burden on SBA.
    In response to the comments concerning the specific structure of 
the activity requirements, SBA has made a number of changes intended to 
make the test more practical and to modify provisions that were subject 
to interpretation. In the proposed rule, the basic activity test (in 
Sec. 107.590(a)) required a Licensee to satisfy two criteria dealing 
with investment activity and percentage of assets maintained as idle 
funds. In the final rule, a Licensee must satisfy only one of the 
criteria to be considered active.
    In paragraph (b)(1), the proposed rule stated that certain 
``recent'' cash inflows would be disregarded in determining whether a 
Licensee is active. In the final rule, ``recent'' has been replaced by 
a specific time period (within nine months of the Licensee's fiscal 
year end).
    In paragraph (b)(3), under the proposed rule, one of the criteria 
for an exception to the activity requirements was that a Licensee have 
``no remaining unfunded commitments from investors''. SBA agrees with 
the commenter who suggested that this standard was too narrow, and has 
revised the provision to include Licensees with unfunded commitments 
equal to no more than 20 percent of their Regulatory Capital.
    Finally, in Sec. 107.590(d), SBA has added a phase-in period for 
new Licensees, recognizing that the activity test is not relevant to 
those companies that have been in operation for less than 18 months.

6. Subpart F--Recordkeeping, Reporting, and Examination Requirements 
for Licensees

a. Information Required From Portfolio Concerns
    With some minor changes, Sec. 107.620 is adopted as proposed. SBA 
is not adopting the suggestion of one commenter that paragraphs (a) and 
(b), which require Licensees to obtain certain information from Small 
Businesses before extending Financing and on a periodic basis 
thereafter, should not apply to non-leveraged Licensees. Although one 
of the aims of these paragraphs is to mitigate SBA's financial risk, 
they are also intended to insure that Licensees are operating in a 
manner consistent with the goals of the Act. SBA agrees with the 
comment that paragraph (b)(2), which requires that the information 
submitted to the Licensee be certified by the chief financial officer, 
general partner, or proprietor of the Portfolio Concern, should be 
expanded to permit certification by the chief executive officer, 
President, or Treasurer. The section is finalized accordingly.
b. Requirements for Licensees To File Annual Financial Statements
    Except as hereafter noted, SBA adopts as final proposed 
Sec. 107.630, which deals with the requirements for filing annual 
financial statements with SBA. Based on comments received, SBA has 
added language to Sec. 107.630(a) clarifying that the portion of SBA 
Form 468 containing economic information on the Licensee's portfolio 
companies may be filed up to two months later than the remainder of the 
form; this reflects SBA's current policy. In Sec. 107.630(b), a cross 
reference to Sec. 107.1220 has been added to clarify the reporting 
requirements for Licensees with outstanding Leverage commitments.
    One commenter suggested that the ``economic impact'' information 
required by proposed Sec. 107.630(e) places an unfair burden on the 
Licensee. SBA is finalizing this paragraph as proposed; the information 
requirement is not new, having been in effect since April 25, 1994, and 
Sec. 107.630(e) is actually worded more narrowly than the current 
regulation that it replaces. While SBA considers the economic impact 
information to be vitally important to the mission and future of the 
SBIC program, the Agency recognizes that this information is not always 
easy to obtain. SBA has generally accepted Licensees' good faith 
efforts to provide the required data and will continue to do so to the 
extent possible.
    Proposed Sec. 107.630(a)(2) would have required a Licensee's 
independent public accountant to carry errors and omissions insurance 
in an amount acceptable to SBA, or be self-insured and have net worth 
acceptable to SBA. This proposal elicited comment from representatives 
of the accounting profession who objected to SBA's attempt to create a 
``deep pocket'' for recovery of damages, as well as concern from a few 
other commenters that the amount of insurance required be more clearly 
defined. SBA is sensitive to concerns that this requirement may prevent 
many smaller, but highly competent, practitioners from performing SBIC 
audits; however, the Agency also must consider its need to control 
financial risk. Furthermore, SBA feels that the ability of a firm to 
obtain some amount of insurance can be, in itself, a useful indicator 
of professional standing. After careful consideration of the issue, SBA 
is finalizing Sec. 107.630(a)(2) to require the independent public 
accountant to have errors and omissions insurance of at least 
$1,000,000, or to be self-insured and have a net worth of at least 
$1,000,000, unless SBA approves otherwise. This wording will give SBA 
the flexibility to make exceptions for firms that do not meet the 
insurance requirement but have strong track records as auditors of 
SBICs or similar entities.
c. Changes Not Subject to SBA Prior Approval
    Proposed Sec. 107.680 has been finalized with one change. A 
commenter suggested that this section, which 

[[Page 3182]]
requires SBA's post approval of certain changes in the Licensee's 
operations, capitalization, and management, should not apply to non-
leveraged Licensees. SBA does not entirely agree, particularly with 
regard to changes that cause Licensee to operate in a different way 
than was contemplated at the time it was licensed. However, for 
Licensees that have no outstanding Leverage or Earmarked Assets, SBA 
believes safety and soundness considerations do not require post 
approval of directors and officers (other than the Licensee's chief 
operating officer), and that it is sufficient for such Licensees to 
notify SBA of any changes.
d. Responsibilities of Licensee During Examination
    Proposed Sec. 107.691 included a provision requiring a Licensee and 
its independent public accountant to agree that the accountant's 
working papers would be made available to SBA upon request for 
examination purposes. One commenter stated that this requirement would 
not be objectionable if SBA provided assurance that any workpapers 
requested would be treated as confidential under the Freedom of 
Information Act (FOIA) or similar laws. An accountant's working papers 
relating to an individual Licensee are indeed protected from disclosure 
under the exemptions available under FOIA. Since these exemptions are 
statutory, SBA believes it is unnecessary to restate them in the 
regulations, and Sec. 107.691 is finalized as proposed.
e. Examination Fees
    SBA received more than ten comments on proposed Sec. 107.692. All 
of the comments objected to the increase in the examination fees to be 
charged to SBICs. Many stated that the cost of an SBA examination would 
far exceed the cost of their annual audit, even though the procedures 
involved are more limited. Further, some felt that unleveraged 
licensees would bear an unfair portion of the overall fees due to the 
fact that the fees are to be assessed on total assets of the Licensee. 
Unleveraged (usually bank owned) SBICs tend to have the largest amount 
of total assets yet have no federal funds at risk. Therefore, it was 
argued that the cost of enforcement should weigh more heavily against 
leveraged Licensees.
    As stated in the preamble to the proposed rule, the proposed fee 
schedule was designed to produce total revenue sufficient to cover the 
current direct costs to SBA of conducting examinations. SBA considers 
examinations to be a key element in maintaining the integrity of the 
SBIC program. However, based on the comments, SBA is persuaded that the 
proposed fees were too high in general, and that the increases were 
particularly excessive for the largest Licensees. In the final rule, 
the examination fees have been lowered significantly, although they 
still represent an increase over the current levels.

7. Subpart G--Financing of Small Business by Licensees

a. Ineligible Small Businesses
    Under proposed Sec. 107.720 (a) through (i), SBA lists those Small 
Businesses which are ineligible for SBIC Financing and certain 
exceptions to those restrictions. Except for the revisions discussed 
below, this section is finalized as proposed.
    SBA received seventeen comments on this proposal. One comment 
questioned whether Sec. 107.720 as a whole should be applicable to non-
leveraged Licensees. Another suggested deletion of the prohibition in 
Sec. 107.720(a) against financing relenders or reinvestors as this type 
of financing could result in jobs and the payment of taxes. Neither of 
these comments were adopted because the provisions in question are 
mandated by the Act.
b. Passive Businesses
    One of the criteria defining a passive business in proposed 
Sec. 107.720(b) is that the business ``is not engaged in a regular and 
continuous business operation''. The proposed rule goes on to state 
that the ``mere receipt of payments * * * such as * * * lease 
payments'' would not be considered a regular and continuous business 
operation. One commenter asked how this definition would apply with 
respect to taxi medallion financing, an industry in which several SBICs 
already have millions of dollars invested. It is common practice in 
this industry for medallion owners to lease their medallions rather 
than employ taxi drivers directly.
    SBA's previously-stated position regarding taxi medallion lending 
is that Licensees may finance medallion owners who lease the medallions 
to others, but only if such owners are actively engaged in day to day 
management activities. These include supervision of lessees and 
responsibility for vehicle maintenance, insurance, and compliance with 
local laws and regulations. Owners who lease their medallions and 
receive payments without such active involvement will continue to be 
considered passive businesses under the final rule.
    Two comments objected to proposed Sec. 107.720(b)(1)(ii), which 
would define as passive any companies whose employees are not carrying 
on the majority of the day to day operations. The commenters argued 
that many businesses use third parties, including independent 
contractors and ``leased'' employees, to carry on day to day 
operations. SBA recognizes that such arrangements are now common and 
are not necessarily an indicator of a passive business. The final rule 
has been revised to define a business as passive if ``its employees are 
not carrying on the majority of day to day operation, and the company 
does not provide effective control and supervision, on a day to day 
basis, over persons employed under contract''.
    Proposed Sec. 107.720(b)(2) was a restatement of the existing 
``holding company'' exception to the passive business rule, under which 
Licensees could finance a passive business if it passed through all the 
proceeds to a wholly-owned active business. A number of comments 
suggested that the provision could allow something less than 100 
percent of the proceeds to be passed through without compromising the 
intent of the regulations. SBA agrees and has changed the final rule to 
require pass-through of ``substantially all'' the proceeds. The 
commenters also suggested deletion of the requirement that the active 
business be wholly-owned. SBA agrees that this restriction is not 
necessary. Instead, the final rule allows the financing of a passive 
business ``if, for all Financings extended, it passes substantially all 
the proceeds through the same eligible Small Business that is not 
passive'' (italic are added). This revision clarifies that a holding 
company must pass the Financing proceeds to only one Small Business, 
not to multiple businesses or to a series of different businesses if 
Financing is extended on more than one occasion.
c. Real Estate Businesses
    SBA agrees with a comment which suggested that proposed 
Sec. 107.720(c)(2) is too restrictive, in that it prohibits financing 
the acquisition of unimproved realty if the business does not intend to 
build on the property, even if the business intends to use it for 
another legitimate business purpose such as a parking lot for customers 
and employees, SBA did not intend to prohibit financing for this 
purpose and the final rule has been revised accordingly.

[[Page 3183]]

d. Project Financing
    One comment objected to the prohibition against project financing 
in proposed Sec. 107.720(d). As stated in the preamble to the proposed 
rule, though this prohibition does not appear in the current 
regulations, it has been in effect as a matter of policy for more than 
ten years. SBA views project financing as essentially short term and 
therefore, inconsistent with the Act. SBA considers this prohibition 
important and is therefore finalizing the rule without change.
e. Foreign Investments
    With one change, proposed Sec. 107.720(g) is adopted as final. The 
proposed rule generally would have prohibited financing a Small 
Business if more that 40 percent of its employees or tangible assets 
were located outside the United States. In response to comments 
suggesting that this percentage was too low, SBA has increased the 
allowable percentage to 49 percent in the final rule.
f. Conflicts of Interest
    SBA received seven comments on proposed Sec. 107.730. The proposed 
rule is adopted with changes to meet some of the concerns in the 
comment letters. One comment suggesting that the conflict of interest 
prohibitions not be applicable to unleveraged Licensees was rejected by 
SBA. Such an exception would be inconsistent with the purpose of the 
Act.
    Two commenters were concerned that proposed Sec. 107.730(a)(2), 
which deals with providing Financing to an Associate of another 
Licensee, would unduly restrict co-investing. In particular, the 
concern was whether the regulation could be construed to mean that if a 
Licensee brought an investor group involving another Licensee and its 
Associates into one of its investments, it would be prohibited from any 
future participation in investments initiated by that investor group. 
This interpretation is contrary to SBA's intent, which was to prohibit 
quid pro quo financing arrangements that would allow Licensees to 
accomplish indirectly what they are not permitted to do directly--
provide Financing to an Associate. SBA does not consider it necessary 
to revise paragraph (a)(2) to clarify the intent, since the language is 
essentially unchanged from the previous regulations.
    Proposed Sec. 107.730(d) set forth provisions governing investments 
in the same Small Business by a Licensee and its Associates, either 
simultaneously or at different times. In general, Licensees were 
required to demonstrate that the terms and conditions of such 
investments were fair and equitable to the Licensee. The proposed rule 
identified certain categories of Financing with Associates requiring 
SBA approval, and others that would be exempt from this requirement. 
Two comments suggested that the exemption in paragraph (d)(3)(iv) 
should be expended to include all situations where the Licensee is 
nonleveraged, regardless of the status of the Associate. SBA believes 
the exceptions provided are adequate and is not adopting this 
suggestion.
    Proposed Sec. 107.730(e)(1) would require a Licensee to obtain 
SBA's written approval for an Associate to participate in the 
management of a Portfolio Concern if the Associate has an actual or 
potential equity interest in the Portfolio Concern that exceeds 3 
percent. Comments received suggested that 5 percent is a more generally 
accepted standard used by other federal regulatory agencies in similar 
circumstances. SBA agrees and is revising the final rule accordingly.
    One comment was received urging the elimination of the publication 
requirement of proposed Sec. 107.730(g), which requires SBA to publish 
notice of exemptions requested under Sec. 107.730. The concern was that 
this requirement could slow down Financings, work a hardship on the 
Small Business or potentially disclose confidential information to 
competitors. Although SBA is sympathetic to these concerns, the 
publication requirement is mandated by the Act and cannot be deleted.
g. Overline Limitation
    Three comments were received on proposed Sec. 107.740. One 
commenter suggested that the ``overline'' limits not be imposed on non-
leveraged Licensees. This exemption has been effective since April 1994 
and was included in the proposed rule. The other comments dealt with 
paragraph (c), which allows Licenses to compute an ``increased limit'' 
if they have unrealized gains on Publicly Traded and Marketable 
securities. Both commenters advocated a more liberal cure period if a 
Licensee has overline violations resulting from a drop in the value of 
its securities. Because of the inherent volatility of publicly traded 
securities, SBA does not consider it prudent to encourage the use of 
the increased limit and is finalizing the proposed rule without change.
h. Change of Ownership
    The comments received on proposed Sec. 107.750 addressed the 
definitions of ``debt'' (paragraph (c)(2)) and ``equity'' (paragraph 
(c)(3)) used in determining whether the Small Business has an 
acceptable debt to equity ratio. It was suggested that the definition 
of ``debt'' (which, in this section, generally means long-term debt) 
specifically exclude any liabilities under a non-compete covenant with 
the seller. SBA chose not to add this automatic exclusion because such 
covenants are unique to the circumstances of each transaction. It was 
also suggested that the definition of ``equity'' should include 
subordinated notes payable to the seller. Such notes are specifically 
excluded from the definition of debt; to also include them in equity 
would further reduce the debt to equity ratio. SBA believes this result 
is inconsistent with the intent of the regulation and is finalizing the 
section as proposed.
i. Change in Size or Activity of a Portfolio Concern--Affect on 
Licensee
    SBA did not propose any change in the provisions governing 
additional investment in a Portfolio Concern that no longer meets the 
size standard. However, one commenter suggested that proposed 
Sec. 107.760(a) should be revised to allow a Licensee to make 
additional investments in such a concern either to honor a Commitment 
it has made or to protect its investment. The proposed rule already 
allows a Licensee to make follow-on investments without restriction in 
any Portfolio Concern up to the time it makes a public offering, so the 
commenter's suggestion would be relevant only after that time. SBA has 
added language to the final rule permitting a Licensee to honor a 
Commitment made before a public offering, since it would be legally 
bound to do so in any case. However, the Agency believes the 
``protection of investment'' standard is so broad as to be inconsistent 
with the goals of the program and has not adopted this change.
    In response to a comment, proposed Sec. 107.760(b) is being adopted 
as final with one non-substantive change. Paragraphs (b)(2) and (b)(3), 
which state that violations under paragraph (b) constitute default by 
the Small Business and allow the Licensee to pursue certain remedies, 
have been deleted. SBA agrees that these provisions cover matters that 
should be left to the Licensee and that it is unnecessary to include 
them in the regulations.
j. Definition of ``Equity Securities''
    SBA received two comments on the definition of Equity Securities in 
proposed Sec. 107.800. One suggested that the definition should include 
warrants 

[[Page 3184]]
and options. SBA agrees and has revised the section accordingly. The 
other commenter sought clarification of the statement that the presence 
of certain default or redemption provisions would cause a security, 
even if it has the legal form of equity, to be considered a Debt 
Security ``for all regulatory purposes''. SBA's intent was that such a 
security would be treated as a Debt Security only for purposes of 
Sec. 107.855, the Cost of Money regulations. The final rule is revised 
accordingly.
k. Options Received From Small Businesses
    Except for the following changes and revisions, proposed 
Sec. 107.815(b) is adopted as final. This section restricts the ability 
of a Licensee's employees, officers, directors, or general partners to 
receive options in a Small Business Financed by the Licensee. Under the 
proposed rule, such persons could receive options only if they 
participated in the Financing on the same terms and conditions as the 
Licensee (paragraph (b) (1)) or if approved by SBA (paragraph (b) (2)).
    Three comments were received on this section. Two suggested that 
paragraph (b) not be applicable to non-leverage SBICs and SBA agrees. 
The provision is revised accordingly.
    Two commenters suggested that the regulations should permit the 
receipt of stock options as compensation of service as a board member, 
as this is a common practice in the industry and is beneficial to the 
Small Business. SBA agrees and has added Sec. 107.815(b)(3) to the 
final rule to permit this practice, with the condition that the 
compensation paid must not exceed that paid to other outside board 
members. In the absence of such board members, fees must be reasonable 
when compared with amounts paid to outside directors of similar 
companies.
l. Guarantees of the Obligations of Small Businesses
    SBA received one comment seeking to clarify that if a Licensee 
invests in a Small Business and also guarantees its debt obligation, 
the guaranty should count against the overline limitation only to the 
extent of the Licensee's risk over and above its original investment. 
The situation described by the commenter is covered by 
Sec. 107.820(a)(2), which states that a guaranty consisting only of ``a 
pledge of the Equity Securities of the issuer'' does not count towards 
the overline limitation.
m. Commitments to Small Businesses
    SBA received one comment suggesting that proposed Sec. 107.825 be 
deleted, a second suggesting that it be moved back to the definitions 
section, and a third seeking clarification as to whether ``reasonable 
conditions precedent'' to a Licensee's obligation to fund its 
commitment can include ``completion of due diligence which confirms the 
accuracy of the initial business plan''.
    SBA is not deleting the defined term ``Commitment'' from the 
regulations because it is used in several important contexts (see, for 
example, the new provision in Sec. 107.860(g) that allows a Licensee to 
charge a ``breakup fee'' if a Small Business accepts its Commitment and 
then fails to close because it has accepted funds from another source). 
SBA agrees that proposed Sec. 107.825 properly belongs in the 
definitions section and has revised the final rule accordingly.
    SBA has addressed the meaning of ``reasonable conditions 
precedent'' in an earlier preamble and will repeat that discussion 
here: Although SBA is reluctant to provide a list of reasonable 
conditions precedent in the regulation for fear that such list might be 
regarded as an exclusive one, it is willing to describe ``reasonable 
conditions precedent'' in general terms. A ``reasonable condition 
precedent'' is one that does not lie within the Licensee's ability to 
cause or prevent. ``Completion of due diligence with results 
satisfactory to the Licensee'' is an example of a condition precedent 
that lies within the Licensee's control. On the other hand, 
requirements that a disinterested person verify the value of the Small 
Businesses' assets or its net worth, or that there be no adverse change 
in the Small Businesses' financial condition between the date of the 
commitment and the scheduled disbursement date, or that the Small 
Business do or achieve something that lies reasonably within its 
capacity would all be considered a ``reasonable condition precedent.''
n. Purchasing Securites From an Underwriter
    Comments received on proposed Sec. 107.828 requested relief for 
non-leveraged Licensees, reduction or elimination of recordkeeping 
requirements and reconsideration of fee limitations for Associate 
underwriters. SBA believes certain constraints on purchasing securities 
from underwriters are warranted in keeping with the purpose of the Act, 
but has made some revisions in response to the comments. Non-leveraged 
Licensees have been exempted from the recordkeeping requirements in 
paragraph (b) and the fee restrictions in paragraph (c). For leveraged 
Licensees, paragraph (c) has been revised to permit a Licensee to pay 
``reasonable and customary'' commissions and expenses to an Associate 
underwriter, provided the Licensee is purchasing no more than 25 
percent of the total offering.
    In the final rule, this section is renumbered as Sec. 107.825.
o. Minimum Term of Financing
    The comments received on proposed Sec. 107.830 strongly supported 
the changes made with regard to the minimum term of Financings for 
Section 301(d) Licensees. One commenter suggested allowing Section 
301(c) Licensees to have up to 25 percent of their investments with 
less than a five year term as long the weighted average duration of the 
portfolio is at least five years. SBA believes such a provision is not 
in keeping with the intent of the Act and would impose a burdensome 
recordkeeping requirement. Accordingly, SBA is finalizing the proposed 
rule without change.
p. Exceptions to Minimum Term of Financing
    One commenter requested a clarification of proposed Sec. 107.835, 
which allows a Licensee to make Short-term Financings (with terms less 
than five years) under certain circumstances. The commenter asked 
whether the provision in paragraph (c), which limits the dollar amount 
of Short-Term Financings to 20 percent of total Loans and Investment 
applies only to that paragraph or to all of Sec. 107.835, as has been 
the case in the past. It was SBA's intent to apply the 20 percent limit 
only to paragraph (c), which deals with Short-Term Financing for the 
purpose of financing a change in ownership under proposed Sec. 107.750. 
Therefore, the section is finalized as proposed. However, as stated in 
the preamble to the proposed rule, Licensees should bear in mind that 
the purpose of the SBIC program, as stated in the Act, is to provide 
equity capital and long-term loan funds to Small Businesses. Thus, 
Licensees should not plan to have the bulk of their portfolios in 
short-term investments; to do so would constitute engaging in 
activities not contemplated by the Act.
q. Maximum Term of Financing
    All of the comments received on proposed Sec. 107.840 suggested 
that the general rule which requires a maximum term of not longer than 
20 years for any 

[[Page 3185]]
Financing should apply only to Loans and Debt Securities. SBA agrees 
and has revised the final rule accordingly.
r. Redemption of Equity Securities
    Two comments were received on proposed Sec. 107.850. One commenter 
suggested that book value should be a permitted basis for determining 
the redemption price of an Equity Security under 
Sec. 107.850(b)(2)(ii). SBA agrees and has revised the final rule 
accordingly.
    The other commenter stated that Sec. 107.850(b)(1) should be 
broadened to allow accumulated dividends to be included in the 
redemption price of an Equity Security. SBA is not adopting this 
change. A Licensee is already permitted to structure its investments in 
this manner; the only consequence is that such investments are subject 
to the Cost of Money rules. Furthermore, as long as the dividends are 
payable only from earnings, such investments are not precluded from 
qualifying as Equity Capital Investments.
s. Cost of Money
    Under proposed Sec. 107.855, SBA sought to substantively revise 
some of the Cost of Money rules and to clarify others. SBA received six 
comments on this section, two of which advocated deleting the entire 
section and letting the market control. While the proposed rule gave 
Licensees considerable more flexibility than in the past, the Agency 
believes that some Cost of Money rules are necessary to provide a 
measure of protection for Small Businesses. The commenters generally 
applauded the increase in the minimum ``Cost of Money ceiling'' for 
Loans in Sec. 107.855(c); however, some argued that the ceiling for 
Debt Securities should also be raised. SBA believes that the proposed 
five percentage point difference between Loans and Debt Securities is 
justified because Loans do not allow for the Licensee to obtain any 
equity interest in the Small Business, and is finalizing this provision 
without change.
    One comment stated that it was very important for Licensees to be 
able to establish the Cost of Money ceiling for a Financing as of the 
date a Commitment is issued, not as of the date of the first closing as 
proposed in Sec. 107.855(b). The commenter explained that if rates went 
up between a Commitment date and a closing date, they would be able to 
increase the rate quoted in the Commitment. However, if rates went 
down, they would be forced by regulations to close at the lower rate. 
SBA is persuaded that Licensees should have flexibility in this area 
and has revised this paragraph to allow the ceiling to be set either at 
the time the Commitment is issued or as of the date of the first 
closing of the Financing.
    A Licensee is permitted to compute its Cost of Money ceiling based 
on either the current Debenture rate on its own ``Cost of Capital'' as 
determined under proposed Sec. 107.855(d). SBA received one comment 
suggesting that non-leveraged Licensees should be permitted to compute 
a Cost of Capital based on their non-SBA borrowings. The proposed rule 
would permit this practice and is therefore finalized without change.
    Proposed Sec. 107.855(g)(10) would allow a Licensee to charge a 
higher interest rate when a Small Business is in default. For this 
purpose, ``default'' is defined to include failure to provide 
information required under SBA regulations. One commenter pointed out 
that this appears to require Small Businesses to have knowledge of SBA 
regulations, and that it is the responsibility of Licensees to put all 
necessary default provisions in the Financing documents. SBA agrees and 
has deleted the reference to SBA regulations from the final rule.
    Proposed Sec. 107.855(i)(3) would allow Licensees to charge a one-
time ``bonus'' at the end of a loan instead of taking equity in the 
Small Business. One commenter suggested that the bonus not be limited 
to one time only, and that the bonus be computable on the earlier of 
five years or when the debt was originally due.
    SBA proposed the bonus to allow Licensees to obtain an adequate 
return on Financings of companies that do not want to give up equity. 
The Agency believes the proposed rule provides Licensees with 
sufficient flexibility and is not adopting the suggested changes. 
However, SBA is clarifying Sec. 107.855(i)(1) in the final rule to 
state that the bonus is computable ``on or after the date that the 
Financing is repaid in full or was originally scheduled to be repaid in 
full, whichever is earlier''.
    SBA has also made an editorial change in Sec. 107.855(i)(3), which 
states that a bonus must be contingent upon factors that reflect the 
performance of the Small Business. As an example, the proposed rule 
stated that net income and operating cash flow were generally 
acceptable factors, while gross revenue and gross profit were generally 
unacceptable. One commenter interpreted ``gross profit'' as pretax 
profit and suggested that this should be acceptable. SBA's 
interpretation of ``gross profit'' was the difference between sales and 
cost of goods sold, also known as ``gross margin''; to avoid confusion, 
the latter term is used in the final rule.
s. Financing Fees Charged to Small Businesses
    Two comments received on proposed Sec. 107.860 dealt with problems 
faced by Licensees in their dealings with Small Businesses that apply 
for Financing. According to the comments received, it is not unusual 
for a Small Business to use a Licensee's Commitment to solicit 
competing offers. Also, there are a number of frivolous ``shoppers'' 
who will use a Licensee's time and resources with no genuine intent of 
closing a transaction. One such commenter suggested that Licensees be 
permitted to address these problems by charging a ``break-up'' fee if a 
Small Business fails to close a Financing because it has accepted funds 
from another source. SBA is persuaded that the break-up fee represents 
a reasonable protection for Licensees and has finalized Sec. 107.860 
with a new paragraph (g) containing this provision. The permitted fee 
is the same as the closing fee the Licensee would have been permitted 
to charge under Sec. 107.860 (c) or (d).
    Another comment questioned whether the ``application fee'' and the 
``closing fee'' had to be two distinct fees separately identified, or 
whether they could both be collected together at closing. To clarify 
SBA's intent, language has been added to paragraph (a) of the final 
rule stating that the application fee may be collected at closing or at 
any time before closing.
t. Control of a Small Business
    Twelve comments were received on proposed Sec. 107.865. One comment 
objected to paragraph (b) which establishes a ``presumption of 
Control'' based on a Licensee's percentage of ownership, stating that 
this paragraph represented a ``poor and onerous change'', and further 
noting that investor groups typically own 75 percent of a business by 
the second or third round of Financing. In response, SBA, wishes to 
point out that the proposed provisions concerning the presumption of 
Control are exactly the same as those in the previous regulations. 
However, proposed paragraph (c) was added to identify specific 
conditions that would permit the presumption of Control to be rebutted. 
By defining such conditions, the provision was actually intended to 
make it easier for a Licensee to co-invest.
    With respect to proposed Sec. 107.865(c), two commenters argued 
that the ``presumption of Control'' should be 

[[Page 3186]]
rebutted if management can elect 25 percent of the board seats. SBA 
believes 40 percent is an appropriate standard for an automatic 
rebuttal; Licensee can still seek to rebut the presumption based on 
other evidence if this test is not met. Accordingly, proposed 
paragraphs (b) and (c) are finalized without change.
u. Temporary Control
    Proposed Sec. 107.865(d) set out those circumstances under which a 
Licensee may take temporary Control of a Small Business, and includes 
the provision: ``(1) Where reasonably necessary for the protection of 
your investment under circumstances where a Small Business is 
threatened with insolvency or closure.'' Several commenters suggested 
that by the time insolvency or closure occurs, it is often too late to 
``protect their investment''. SBA agrees and has revised the final rule 
to delete all of the language after the word ``investment'' in 
Sec. 107.865(d)(1). However, SBA advises Licensees that mere 
disagreement with the management of a Small Business does not provide 
grounds for taking temporary Control under this provision; rather, the 
Licensee must be facing a clearly identifiable risk of financial loss.
    In response to another comment, proposed Sec. 107.865(d)(3) has 
been revised by deleting the world ``original'', which SBA agrees is 
unnecessary. Another comment requested that temporary Control be 
permitted if a Licensee satisfies either of the criteria in paragraph 
(d)(3) instead of both. SBA considers the language in the proposed rule 
to be appropriate and has not adopted the comment.
    Proposed paragraph (d)(4) would allow a Licensee to take temporary 
Control if the Financing is a Start-up Financing and the Licensee (or 
investor group including the Licensee) is the concern's major source of 
capital. It was suggested by one commenter that this paragraph should 
also allow temporary Control if the Financing is a ``change of Control 
of a Small Business pursuant to proposed Sec. 107.750.'' SBA believes 
that the proposed temporary Control provisions give Licensees 
sufficient protection and flexibility, and is finalizing 
Sec. 107.865(d) without change.
    SBA received three comments on proposed Sec. 197.865(e)(3) 
questioning the reduction from seven years to five years of the time 
limit for maintaining temporary Control (subject to an extension 
granted by SBA in extraordinary circumstances). One comment suggested 
going back to seven years, one questioned the necessity of any time 
limit (due to the fact that it is inherent in the venture business to 
want to exit investments as soon as possible), and one suggested 
language stating that SBA would grant an extension if a Licensee can 
establish ``that the relinquishment of Control will materially impair 
the value'' of its investment.'' SBA rejects all three of these 
suggestions and is finalizing Sec. 107.865(e)(3) as proposed. Control 
is prohibited under the Act and SBA believes that exceptions to this 
prohibition must be narrowly tailored. The Agency considers the five 
year period sufficient in most cases and can grant exceptions if 
circumstances warrant.
v. Management Fees for Services Provided to Small Businesses
    Three comment letters were received regarding proposed 
Sec. 107.900. While one commenter approved the liberalization of the 
rules governing management services provided to Small Businesses, it 
was suggested that greater liberalization is still needed. The other 
two commenters argued in favor of expanding the criteria under which a 
Licensee could provide management services to a Financed Small Business 
without SBA approval. Specifically, they focused on the requirement 
that the Services be provided only on an hourly fee basis. They 
explained that the current trend is moving away from hourly billing 
toward ``project fees'' and that hourly billing has been perceived as 
being both inefficient and unfair. They further noted that while this 
issue can be resolved by acquiring SBA's prior written approval 
pursuant to proposed Sec. 107.900(c), this process is both time 
consuming and burdensome. SBA has reexamined this issue in light of the 
comments received and recognizes the reasonableness of this suggestion. 
Therefore, proposed Sec. 107.900 is revised to allow a Licensee to 
charge on a project fee or other reasonable basis. However, the burden 
of proof will be on the licensee to demonstrate, upon request, that 
fees charged to not exceed prevailing rates charged for comparable 
services by other organizations in the geographic area of this Small 
Business.
    Paragraph (b), concerning fees for service as a board member, is 
revised in the final rule in accordance with comments received, to 
allow for fees to be paid in the form of cash, warrants or other 
consideration. In addition, the following language is added at the end 
of the last sentence of paragraph (b): ``* * * or, in the absence of 
outside board members, amounts reasonable when compared to similar 
companies with outside board members.''
    Proposed Sec. 107.900(e)(2) discusses transaction fees which may be 
charged a Small Business by a Licensee's Associate for services 
performed in connection with a public or private offering made by the 
Small Business or the sale of all or part of the business. The comment 
received on this paragraph suggested that the 95 percent unrelated 
revenue test was too restrictive and would force Small Businesses to 
hire outside investment bankers who would be unfamiliar with the 
company, which could result in higher fees. SBA is persuaded by this 
argument and has deleted this provision from paragraph (e)(2).
    Except for the revisions discussed above, Sec. 107.900 has been 
finalized as proposed.

8. Subpart H--Non-Leveraged Licensees--Exceptions to Regulations

    Two comments were received on proposed Sec. 107.1000. One 
specifically praised the flexibility embodied in the proposal, which 
provides a consolidated listing of those regulatory provisions from 
which a non-leveraged Licensee would be exempt. The other comment 
listed a number of sections from which non-leveraged Licensees should 
be exempt, but these largely involved statutory requirements. As 
discussed throughout this preamble, some additional provisions have 
been added to this section. In addition to the exemptions in the 
proposed rule, the final rule exempts non-leveraged Licensees from:
    (1) The recordkeeping requirements and fee limitations in 
Sec. 107.825(b) and (c) for securities purchased through or from an 
underwriter;
    (2) The requirement to obtain SBA's prior approval of initial 
Management expenses under Sec. 107.140 and increases in Management 
Expenses under Sec. 107.520;
    (3) The prior approval requirement in Sec. 107.815(b) for options 
obtained from a Small Business by the Licensee's management or 
employees; and
    (4) The requirement to obtain post approval for new directors and 
new officers, other than the Licensee's chief operating officer. A 
notification requirement has been substituted.

9. Subpart I--SBA Financial Assistance for Licensees (Leverage)

a. Types of Leverage Available
    Only one comment was received on proposed Sec. 107.1100 which 
strongly supported the language clarifying that a Section 301(d) 
Licensee may apply for both Debenture and Participating Security 
Leverage. The section is therefore finalized without change.

[[Page 3187]]

b. General Eligibility Requirements for Leverage
    One comment was received on proposed Sec. 107.1120, objecting to 
the presumption that only Licensees with $5 million or more of 
Regulatory Capital are financially viable. The commenter stated that 
this represents a 300 percent increase for Section 301(d) Licensees, is 
not warranted and threatens the financial viability of Section 301(d) 
Licensees. As stated previously in this preamble, SBA considers the 
minimum capital requirements to be vital to the sound operation of the 
SBIC program.
c. Requirement To File Quarterly Financial Statements
    Proposed Sec. 107.1220 requires that Licensees file quarterly, 
unaudited financial statements on SBA Form 468 (short form) within 30 
days of the end of the quarter, so long as any part of SBA's Leverage 
commitment is outstanding to the Licensee. A commenter suggested, and 
SBA agrees, that this section should be revised to clarify that the 
quarterly filing requirement does not apply at the Licensee's fiscal 
year end, which is covered by the annual filing of Form 468 under 
Sec. 107.630. The section is revised and finalized accordingly.
d. Draw-downs by Licensee Under SBA's Leverage Commitment
    All three of the comment letters received on proposed Sec. 107.1230 
objected to one of the requirements listed under the ``procedures for 
funding draws'' in paragraph (d). As proposed, paragraph (d)(3) would 
require a Licensee, when requesting a ``draw'' pursuant to SBA's 
Leverage commitment, to furnish a statement to SBA ``that the proceeds 
are needed to fund one or more particular Small Business, including the 
name and address of each Small Business, and the amount and anticipated 
closing date of each proposed financing.'' One commenter labeled this 
paragraph an ``unnecessary burden requiring an act of prophecy.'' All 
agreed that as investors, they are not motivated to draw capital and 
not invest it, but that they may be looking at many investments at the 
time of the request, expecting to make one or more investments based 
upon proposals outstanding or being negotiated, and not all close. It 
was further pointed out that some negotiations may delay closing or 
alter amounts actually invested.
    SBA considered this issue at length. As participants in the SBIC 
program are aware, there is insufficient Leverage currently available 
to meet demand, and no change is expected in the near future. This 
places SBA in the position of having to allocate the limited Leverage 
available among all the eligible applicants. Under these conditions, 
SBA finds it useful to be able to review each Licensee's track record 
in closing its anticipated investments as part of its evaluation of the 
Licensee's need for Leverage in comparison with others. Thus, SBA is 
not willing to delete the requirement for information on specific 
planned Financings at this time.
    Nevertheless, SBA is sympathetic to the commenters' concerns and is 
open to future changes in this area, particularly if Leverage ceases to 
be in short supply. In the final rule, the information requirements in 
paragraph (d)(3) are preceded by the phrase ``if required by SBA''. 
This language gives the Agency the flexibility to drop these 
requirements in the future if conditions warrant, without having to 
revise the regulations.
e. Participating Securities--Requirement To Make Equity Capital 
Investments
    Under proposed Sec. 107.1500(b)(4), which was unchanged from the 
existing regulations, Licensees issuing Participating Securities would 
have been required to make Equity Capital Investments equal to the 
total amount of Participating Securities issued, and also to maintain 
Equity Capital Investments in an amount equal to their outstanding 
Participating Securities. SBA received a comment arguing strongly that 
the requirement to maintain a certain level of Equity Capital 
Investments should be deleted. The commenter's concern was that it is 
impossible to predict when investments will be liquidated and that a 
Licensee might fall into violation due to circumstances largely beyond 
its control.
    SBA appreciates the commenter's concern. However, section 303(g)(4) 
of the Act specifically requires Licensees to ``maintain an amount 
equal to the outstanding face value'' of Participating Securities in 
Equity Capital Investments. Therefore, this requirement cannot be 
abandoned, and the section is finalized as proposed. However, in 
considering waiver requests, the Agency will give weight to 
circumstances which suggest that noncompliance is the result of factors 
not readily controllable by the Licensee.
f. Participating Securities--Liquidity Requirement
    Proposed Sec. 107.1505(a) contained language giving SBA the right 
to make the final determination of a Licensee's liquidity impairment. 
SBA received a comment suggesting that this language be deleted. SBA is 
persuaded that Licensees are unlikely to be motivated to manipulate the 
liquidity computation in order to make distributions that would leave 
them without sufficient liquidity to continue their operations; 
therefore, this language has been deleted from the final rule.
g. Participating Securities--Computation of Earmarked Profit (Loss)
    In proposed Sec. 107.1510(d), SBA attempted to provide a simplified 
formula for the computation of Earmarked Profit (Loss) without changing 
the substance of the calculation. One comment pointed out that the 
revised language, which referred to ``Net Income (Loss) as reported on 
SBA Form 468'', created ambiguity with respect to the treatment of user 
fees paid to SBA and partnership syndication costs incurred by 
Licensees. Licensees have presented these items on Form 468 using a 
variety of accounting treatments, and in some cases have not made them 
a component of Net Income (Loss).
    SBA believes that Licensees should be permitted to treat both user 
fees and syndication costs as expenses for the purpose of determining 
Earmarked Profit (Loss). Accordingly, the final rule states that for 
the purpose of determining Net Income (Loss) in the Earmarked Profit 
formula, user fees and commitment fees paid to SBA, as well as 
partnership syndication costs, must be capitalized and amortized on a 
straight-line basis over five year. In all other respects, Net Income 
(Loss) must be as reported on SBA Form 468.
h. Participating Securities--Base for Profit Participation
    Proposed Sec. 107.1530(c) presented the formula for the Base on 
which a Licensee computes SBA Profit Participation. There was no change 
proposed in the formula; however, SBA received one comment pointing out 
a situation in which the formula produces an unintended result. If a 
Licensee were to compute and distribute Profit Participation for an 
interim period, and then experience losses during the remainder of its 
fiscal year which partially offset the interim profit, the later losses 
could not be included in Unused Losses for the purpose of determining 
the Base going forward. SBA agrees with the need for a technical 
correction of the Unused Loss definition, and is finalizing 
Sec. 107.1530(c) with the necessary revision.

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i. Participating Securities--``PLC Ratio'' Used in Profit Participation 
Rate Formula
    Proposed Sec. 107.1530(e)(2) set forth the conditions under which a 
Licensee can reduce its PLC Ratio by increasing its Leverageable 
Capital. A reduction of the PLC Ratio has the effect of reducing the 
Licensee's Profit Participation Rate. One commenter suggested that a 
Licensee should be permitted to include a Leverageable Capital increase 
in the ratio without express SBA approval, provided the increase was 
the result of the takedown of commitments or the conversion to cash of 
non-cash assets included in Private Capital. Language to this effect 
was previously included in the regulations and was inadvertently 
dropped from the proposed rule. It has been restored in the final 
version of Sec. 107.1530(e)(2).
j. Participating Securities--Adjustment of Interim Profit Participation 
Calculations for Changes in the Year-End Profit Participation Rate
    SBA received a comment suggesting that proposed Sec. 107.1530(h)(3) 
be deleted. This provision, which was unchanged from the existing 
regulations, stated that if a Licensee computing Profit Participation 
had previously made an interim computation during the same fiscal year, 
it would be required to adjust the interim amount to account for any 
subsequent increases in the Profit Participation Rate. The commenter 
pointed out that the provision was inconsistent with the mechanics of 
Sec. 107.1530(h) (1) and (2), which resulted in automatic adjustment of 
interim computations for subsequent increases or decreases in the 
Licensee's Profit Participation Rate.
    SBA agrees that the provisions are inconsistent; however, the 
preamble to the April 8, 1994 final rule concerning the Participating 
Securities program (59 FR 16898) makes the following statement: ``Any 
computation of Profit Participation made as of the close of an interim 
fiscal quarter is subject to adjustment whenever any subsequent interim 
distributions are contemplated, and at the end of the fiscal year, in 
order to account for any increase in the Profit Participation Rate. If 
the Profit Participation Rate decreases as a result of an approved 
increase in Leverageable Capital, Profit Participations already 
computed for any interim periods shall not be adjusted.''
    Thus, with respect to the original intent of the regulations, the 
error in the proposed rule is found not in paragraph (h)(3), but in 
paragraphs (h)(1) and (h)(2), which incorrectly adjust interim Profit 
Participation computations for decreases in the Rate as well as 
increases. Accordingly, in the final rule, SBA has revised paragraph 
(h) so that an adjustment takes place only when the Profit 
Participation Rate increases.
k. Participating Securities--Basis for Distribution of Prioritized 
Payments and Adjustments
    Proposed Sec. 107.1540(a), which is essentially the same as the 
existing regulation, would require a Licensee to distribute the balance 
in its Distribution Account (consisting of Earned Prioritized Payments 
and earned Adjustments) annually, based on its profits as determined 
under Sec. 107.1520. One commenter pointed out that ``no distinction is 
made in Sec. 107.1520 between cash and non-cash earnings. Consequently, 
this provision effectively requires that a Licensee make an annual 
distribution of cumulative profits to pay Prioritized Payments even if 
the Licensee did not receive cash for all or a portion of these 
profits.'' The commenter suggested that distributions should be 
required only for profits earned by the Licensee in cash.
    SBA appreciates the concern expressed, but has decided to finalize 
this section as proposed. The Agency believes that Licensees are 
sufficiently protected by the provision in Sec. 107.1540(a) that makes 
all distributions under Sec. 107.1540 conditional upon the satisfaction 
of the liquidity requirement in Sec. 107.1505. Thus, a Licensee that 
had received only non-cash income likely would be precluded from making 
a distribution.
l. Payment of Prioritized Payments on Participating Securities in Order 
of Issue Date
    Under proposed Sec. 107.1540(c), Licensees would be required to pay 
Prioritized Payments on their Participating Securities in order of the 
securities' issue dates. One commenter pointed out that this would 
impose a substantial burden by requiring Licensees to maintain detailed 
sub-accounts to track the Accumulated Prioritized Payments associated 
with each individual Participating Security, and would not provide any 
benefit to the Agency. SBA agrees that this provision is unnecessary 
and has deleted it in the final rule.
m. Participating Securities--Computation of ``Maximum Tax Liability''
    Proposed Sec. 107.1550(b) set forth the formula used to compute a 
Licensee's Maximum Tax Liability, from which the Licensee calculates 
its permitted tax distribution. One element in the formula is ``total 
ordinary income'' allocated to Licensee's investors for Federal income 
tax purposes. One commenter sought clarification as to whether this 
phrase was intended to represent ordinary income less ordinary 
deductions. That is the interpretation intended by SBA, and the 
paragraph has been revised in the final rule to clarify the meaning.
    With respect to the same paragraph, the commenter also suggested 
that ``total ordinary income'' be defined to exclude expenses that 
partners may not be able to deduct fully under the tax law. SBA 
believes this suggestion is inconsistent with the Act, which refers to 
``income allocated to each partner or shareholder * * * for Federal 
income tax purposes'' and does not provide for any adjustment for 
nondeductible expenses. Furthermore, the Agency finds no compelling 
reason to provide all investors with an additional benefit based on the 
possibility that some may face limitations on their deductions.
n. Participating Securities--Payment Dates
    SBA received several comments concerning the Participating Security 
distribution regulations (Secs. 107.1540 through 107.1570) which would 
require Licensees to make distributions only on quarterly Payment 
Dates. All the commenters objected to the inflexibility of these 
provisions. As stated in the preamble to the proposed rule, the Payment 
Dates represent the dates on which Trust Certificate holders receive 
interest payments and any returns of principal to which they are 
entitled. Because Participating Securities can be redeemed only on 
Payment Dates, the proposed rule limited Licensees' distributions to 
these dates to avoid certain problems, such as the question of who is 
responsible for Prioritized Payments on a Participating Security during 
the interval between the making of a distribution and the actual 
redemption of the Participating Security with the proceeds of the 
distribution.
    However, SBA recognizes that the loss of flexibility under the 
Payment Date structure can have a significant negative impact on both 
the Licensee and the Agency, particularly in the case of distributions 
to be made in the form of securities. In this instance, the 
restrictions may force the Licensee to hold securities for a 
substantial period of time, during which the Licensee and its investors 
(including SBA) would be subject to a high degree of market risk.
    Because of time constraints, SBA is unable to modify the Payment 
Date restrictions in this final rule. However, 

[[Page 3189]]
the Agency intends to seek a solution that will provide Licensees with 
greater flexibility in making distributions of securities, and to 
publish a proposed rule dealing with this problem as soon as possible.
    One change concerning the timing of distributions is being 
incorporated in the final rule. In the preamble to the proposed rule, 
SBA indicated that it was willing to consider allowing tax 
distributions under Sec. 107.1550 to be made during some window period 
between the February 1 and May 1 Payment Dates, in order to allow 
investors to receive cash before their Federal tax filing deadlines. 
Based on the comments received, SBA is finalizing Sec. 107.1550(d) with 
revised language permitting a tax Distribution to be made between March 
1 and April 15 by a Licensee with a December 31 year end. Licensees 
still must pay all Prioritized Payments before being eligible to make a 
tax distribution.
o. Trust Certificates
    During the comment period, SBA reviewed proposed Secs. 107.1600 
through 107.1680 pertaining to Trust Certificates guaranteed by SBA to 
fund Leverage. Section 321 of the Act and the documentation of the 
Trust Certificates are very specific with respect to the terms and 
conditions. SBA has chosen to shorten these sections by eliminating 
language contained in the statute or detailed in the Trust 
Certificates. None of the changes made to the proposed Secs. 107.1600 
through 107.1680 are substantive. In the final rule, Trust Certificates 
are covered in renumbered Secs. 107.1600 through 107.1640.
p. Miscellaneous Leverage Provisions
    In the final rule, SBA has eliminated proposed Sec. 107.1700(a) and 
(c) as redundant and unnecessary language. Section 321(a) of the Act is 
specific with respect to SBA's unconditional guarantee and the 
requirement for a bond. SBA will continue to provide for an 
unconditional guarantee. The bonding requirement has been eliminated in 
this section as well as in the Trust Certificate sections because the 
bond is required by statute.

10. Subpart J--Licensee's Noncompliance With Terms of Leverage

a. Capital Impairment
    SBA received one comment on proposed Sec. 107.1840(d)(6), which 
would have required a Licensee, in computing its Capital Impairment 
Percentage, to reduce its ``Adjusted Unrealized Gain'' by the amount of 
any borrowing or other obligation associated with portfolio securities 
that were the source of the Unrealized Appreciation used as the basis 
for determining the Adjusted Unrealized Gain. The commenter correctly 
pointed out that the reduction should be limited to the extent of the 
Unrealized Appreciation. SBA agrees and has finalized the provision 
accordingly.

11. Appendices to Part 107

    The existing regulations include two appendices: Appendix I, 
Accounting Standards and Financial Reporting Requirements for Small 
Business Investment Companies, and appendix II, Valuation Guidelines 
for SBICs. SBA has decided to delete the appendices from Part 107, and 
will publish them in a different format at a later date. Although they 
are no longer part of the regulations themselves, both the accounting 
standards and the valuation guidelines remain applicable to all 
Licensees.

Compliance With Executive Orders 12612, 12778, and 12866, the 
Regulatory Flexibility Act (5 U.S.C. 601, et seq.), and the 
Paperwork Reduction Act (44 U.S.C. Ch. 35)

    SBA certifies that this final rule will not be a significant 
regulatory action for purposes of Executive Order 12866 because it will 
not have an annual effect on the economy of more than $100 million, and 
that it 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, et seq.
    The primary purpose of the rule is to streamline the regulations 
governing the SBIC program by eliminating obsolete regulations and 
reorganizing the remainder in a more logical and readable format.
    Two areas of the regulations will have some economic effect, 
including possible effects on small entities. First, license 
application fees and examination fees will be raised. An SBIC license 
applicant will pay a fee of $10,000 to $20,000, compared with the 
current $5,000. This increase is not significant relative to the 
private capital of an average Licensee, which exceeds $10 million. Exam 
fees will continue to be based on the total assets of a Licensee, but 
at higher rates. The largest Licensees, generally those with several 
hundred million dollars of assets, could experience fee increases of 
$20,000 or more; however, the number of such Licensees is currently 
very small.
    Second, the changes in the regulations governing ``Cost of Money'' 
(the maximum amount a Licensee can charge on loans and debt securities) 
will potentially affect the borrowing costs of small entities. Although 
the interest rate on loans is determined primarily by market forces, 
the final rule will raise the interest rate ceiling on loans extended 
by Licensees from 15 percent to 19 percent. The total amount of loans 
provided to small businesses by Licensees is approximately $240 million 
per year. Even if the additional four percentage points were charged on 
the entire balance of such loans, the annual economic impact would be 
less than $10 million.
    For purposes of the Paperwork Reduction Act, 44 U.S.C. Ch. 35, SBA 
certifies that this final rule contains no new reporting or record 
keeping requirements that have not already been approved by the Office 
of Management and Budget. The ``Financing Eligibility Statement'' (SBA 
Form 1941) which is required under Sec. 107.610 has already been 
approved by OMB under Control Number 3245-0301.
    For purposes of Executive Order 12612, SBA certifies that this rule 
does not have any federalism implications warranting the preparation of 
a Federalism Assessment.
    For purposes of Executive Order 12778, SBA certifies that this rule 
is drafted, to the extent practicable, in accordance with the standards 
set forth in Section 2 of that Order.

List of Subjects in 13 CFR Part 107

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

    For the reasons set forth above, SBA hereby revises Part 107 of 
Title 13 of the Code of Federal Regulations to read as follows:
BILLING CODE 8025-01-M