[Federal Register Volume 77, Number 82 (Friday, April 27, 2012)]
[Rules and Regulations]
[Pages 25042-25055]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-10120]
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SMALL BUSINESS ADMINISTRATION
13 CFR Part 107
RIN 3245-AG32
Small Business Investment Companies--Early Stage SBICs
AGENCY: U.S. Small Business Administration.
ACTION: Final rule.
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SUMMARY: In this final rule, the U.S. Small Business Administration
(SBA) is defining a new sub-category of small
[[Page 25043]]
business investment companies (SBICs) which will focus on making equity
investments in early stage small businesses. By licensing and providing
SBA leverage to these ``Early Stage SBICs,'' SBA seeks to expand
entrepreneurs' access to capital and encourage innovation as part of
President Obama's Start-Up America Initiative launched on January 31,
2011. This final rule also sets forth regulations applicable to Early
Stage SBICs with respect to licensing, capital requirements, non-SBA
borrowing, examination fees, leverage eligibility, distributions, and
capital impairment. In addition, the final rule makes certain technical
changes to the SBIC regulations.
DATES: This rule is effective April 27, 2012.
FOR FURTHER INFORMATION CONTACT: Carol Fendler, Office of Investment,
(202) 205-7559 or sbic@sba.gov.
SUPPLEMENTARY INFORMATION:
I. Background Information
On January 31, 2011, President Obama announced the ``Start-Up
America Initiative'' to encourage American innovation and job creation
by promoting high-growth entrepreneurship across the country with new
initiatives to help encourage private sector investment in job-creating
startups and small firms, accelerate research, and address barriers to
success for entrepreneurs and small businesses. The SBIC program will
play a key role in accomplishing these goals by expanding access to
capital for early stage businesses.
Early stage businesses face difficult challenges accessing capital,
particularly those without the necessary assets or cash flow for
traditional bank funding. Although the venture capital industry
provided over $22 billion in financings to U.S. businesses in calendar
year 2010, this represented over a 23% decline from 2007. Less than a
third of these financing dollars went to early stage or start-up
businesses. Of the financings that went to early stage and start-up,
over two-thirds went to businesses located in three states: California,
Massachusetts, and New York. (Source: ThomsonOne VentureXpert) As a
result, less than 10% of U.S. venture financing dollars went to early
stage and start-up businesses not in those three states. SBA will seek
to expand access to capital for early stage small businesses throughout
the United States by allocating from its current debenture
authorization up to $200 million per year (up to $1 billion total over
five years) beginning in FY 2012 to Early Stage SBICs.
SBA has not typically provided leverage in the form of SBA-
guaranteed debentures to SBICs that plan to provide early stage venture
capital financing to small businesses. The standard debenture is
generally appropriate for investments in small businesses that generate
sufficient cash flow to pay interest and/or dividends, so that SBICs in
turn can make semi-annual interest payments on their debentures.
Investments in early stage companies, which typically cannot make
current interest or dividend payments, do not fit naturally with the
structure of debenture leverage.
Furthermore, early stage companies have inherently higher risk;
although they can offer potentially higher returns than later stage
equity or mezzanine debt investments, the returns are much more
volatile. Because the debenture program is required by law to operate
at zero cost, the Early Stage SBIC initiative contemplates a number of
strategies to mitigate risk and limit the initiative's impact on
leverage fees, although fee increases will still be necessary.
On December 9, 2011, SBA published a proposed rule to define an
Early Stage SBIC and to establish the features of the Early Stage SBIC
initiative. The proposed rule also included several new regulatory
provisions intended to reduce the risk that an Early Stage SBIC would
default on its leverage and to improve SBA's recovery prospects should
a default occur. The preamble to the proposed rule also discussed key
aspects of the Early Stage initiative that are not addressed in the
regulations, including the limits on the aggregate amount of debenture
leverage that will be made available to Early Stage SBICs, and SBA's
intention to make leverage available to Early Stage SBICs in two forms:
(1) A debenture that requires quarterly interest payments throughout
its term; and (2) a debenture that is issued at a discount and does not
require interest payments during the first five years of its term.
SBA received ten sets of comments on the proposed rule. Some were
general comments on the Early Stage initiative and others were specific
to individual sections of the proposed regulations. SBA discusses the
comments in the following sections.
II. General Comments
Need for Initiative. SBA received six comments that included
general statements of support for the goals of the Early Stage
initiative. These commenters agreed with SBA's assessment that there is
a gap in the availability of capital for early stage equity investing
and that the Early Stage initiative could help to provide early stage
small businesses with access to much-needed capital. However, two
commenters suggested that SBA address the needs of early stage
companies through a new program, separate from the existing SBIC
debenture program, to avoid the possibility that failures among higher
risk Early Stage SBICs could jeopardize the ability of the current
debenture program to operate on a break-even basis. As discussed in the
proposed rule, SBA considered seeking legislation to authorize a new
program specifically focused on early stage investing, but ultimately
chose to pursue an initiative through the existing debenture program
because of the compelling need to begin assisting early stage small
businesses as quickly as possible.
SBA agrees that the stability of the existing debenture program
must be maintained, and has designed the Early Stage initiative with
multiple protections to achieve that goal. These protections include:
(1) Limiting the total leverage committed to Early Stage SBICs to a
maximum of $200 million per year over a five year period; (2) limiting
the maximum leverage available to an individual Early Stage SBIC to the
lesser of $50 million or 100 percent of its Regulatory Capital (as
opposed to the lesser of $150 million or 300 percent of Regulatory
Capital for standard debenture SBICs); and (3) establishing special
distribution rules to require pro rata repayment of SBA leverage when
an Early Stage SBIC makes distributions to its investors. The higher
risks of early stage investing have been accounted for in the program
formulation model which determines the annual fee needed to keep the
debenture program's original subsidy cost at zero, as required by law.
Cost of the Initiative. SBA received four comments expressing
concern about the increased leverage fees attributable to the Early
Stage initiative. For SBA leverage commitments issued in fiscal year
2012, the initiative adds 13.7 basis points to the annual fee. For
fiscal year 2013, the impact of the initiative on the annual fee will
be slightly lower, 11.5 basis points, based on updated assumptions. The
commenters felt it was unfair or inappropriate to impose the additional
costs of the Early Stage initiative on other users of debenture
leverage. They indicated that the initiative should not be pursued
unless it could break even on a stand-alone basis. Some commenters
expressed concern not only about the added cost for fiscal year
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2012, but also about the extent to which the annual fee might increase
in future years. These commenters noted the large losses that SBA
incurred on participating securities, a type of SBA leverage that was
offered in the past to SBICs focused on equity investing, much of which
was early stage; they also speculated that fees could rise based on the
impact of the statutorily mandated ``energy saving debentures'' that
will be available to SBICs making certain types of energy-related
investments.
SBA understands that managers of a debenture SBIC may feel that
they are being unfairly required to ``subsidize'' the higher-risk
investment strategy of an Early Stage SBIC. However, debenture SBICs
already pursue a range of investment strategies that present varying
degrees of risk to SBA, yet SBA does not formulate separate fees based
on these differences; rather, the leverage fees are calculated based on
analysis of the overall SBIC program portfolio. Although the Early
Stage initiative does result in a small increase in the annual fee for
all new debenture leverage commitments, the resulting fee of roughly 80
basis points for fiscal year 2012 is well below the statutory maximum
of 1.38 percent and is also below the actual fees charged in many
previous years.
SBA notes that the fiscal year 2012 annual fee reflects the impact
of both the Early Stage initiative and the energy saving debentures. In
addition, in developing the Early Stage initiative, SBA gave extensive
consideration to the lessons learned from the participating securities
program.
Leverage availability. The proposed rule stated that SBA would
allocate up to $200 million of debenture leverage per year to Early
Stage SBICs, to a total of up to $1 billion over a five-year period.
Two commenters noted that an Early Stage SBIC may need leverage after
its fifth year of operations, because either a portion of its leverage
commitment expired or it did not obtain commitments for the full amount
of leverage it was eligible for. The commenters stated that SBA should
ensure that adequate leverage will be available for Early Stage SBICs
throughout their partnership terms.
SBA currently intends to issue commitments for Early Stage
debenture leverage only until the end of fiscal year 2016. However, SBA
recognizes that it is important for Early Stage SBICs to be able to
obtain the leverage for which they are eligible, and will explore
various options to ensure availability. These options may include
allowing an Early Stage SBIC to apply for a new leverage commitment to
replace an expired commitment, provided that SBA has the budget
authority to do so, or permitting an Early Stage SBIC to draw the
remaining balance of a leverage commitment prior to its expiration,
even if does not have a current need for the funds. Because SBA cannot
ensure that any of these options will be available in the future, Early
Stage SBICs will need to be prepared to manage their portfolios within
the existing limitations.
Capital Impairment. SBA did not propose any exceptions to the
existing Capital Impairment regulations for Early Stage SBICs. However,
SBA received two comments stating that Early Stage SBICs should receive
additional forbearance because of the kind of investments they will be
making. The commenters felt that Early Stage SBICs should benefit from
the same types of exceptions that the regulations provided for
participating securities SBICs, such as a maximum allowable Capital
Impairment Percentage (CIP) of 85 percent for the five years after a
fund's first issuance of leverage.
SBA believes that adopting this suggestion would result in an
unacceptable increase in risk. SBA incurred losses on a large majority
of participating securities SBICs that reached an 85 percent CIP, and
especially on those that reached 85 percent sooner rather than later.
However, SBA recognizes that an Early Stage SBIC is more likely than a
regular debenture SBIC to have some early losses that, combined with a
lack of current income, may put upward pressure on the CIP even though
the fund's overall portfolio ultimately proves to be sound. SBA has
considered whether there is a low-risk way to offer Early Stage SBICs
more flexibility in their CIP calculation, and believes that a change
can safely be made in the treatment of ``Class 2'' unrealized
appreciation. Class 2 appreciation arises when an SBIC holds an
investment in a company that subsequently receives a new round of
financing at a higher price, provided the new round includes a
substantial investment by a sophisticated, new, non-strategic investor
in an arm's length transaction. SBA regulations allow Class 2
appreciation (discounted by 50 percent) to offset realized losses in
the CIP computation, but in most cases only for 24 months after the new
round of financing takes place.
For Early Stage SBICs, SBA believes the 24-month limit can be made
more flexible without increasing program risk. In general, at the end
of the initial 24 months, an Early Stage SBIC with ``expiring'' Class 2
appreciation will be able to request an extension based on an
independent third-party valuation of the investment and any other
relevant information, as determined by SBA. In addition, in certain
instances, based on the valuation of the investment and other relevant
information, SBA will permit the Early Stage SBIC to use the Class 2
appreciation in its CIP computation without the 50 percent discount.
Full details of these changes are discussed in the section-by-section
analysis under new Sec. 107.1845.
SBA believes these capital impairment changes are also responsive
in part to a concern that may be implicit in two comments received on
proposed Sec. 107.1182, under which SBA has the right to require
valuations of an Early Stage SBIC's investments. In asking how SBA
plans to use these valuations and whether SBA will be bound by them,
the comments may reflect a concern that SBA is more likely to mandate
the write-down of an investment based on a valuation than it is to
allow a write-up. While SBA is not adopting a general policy of
allowing Early Stage SBICs to write up investments based on independent
valuations, this final rule does provide Early Stage SBICs with a
degree of assurance that they will continue to receive credit for their
Class 2 Appreciation when it is supported by an acceptable third party
valuation.
III. Section by Section Analysis
A. Early Stage Initiative Provisions
Section 107.50--Definitions. To implement the Early Stage
initiative, SBA proposed to add the defined term ``Early Stage SBIC''
and revise the existing defined term ``Payment Date''.
Early Stage SBIC
SBA received three sets of comments suggesting various changes to
the proposed definition. SBA particularly sought input from the public
on whether 50 percent was appropriate as the required minimum level of
early stage investments, and all comments received on the definition
focused on this issue. One commenter suggested that an Early Stage SBIC
should be required to invest at least 75 percent of its total financing
dollars in small businesses classified as ``early stage'' at the time
of the SBIC's initial investment. The commenter felt that later stage
investments would not support the intent of the initiative and could
distract SBIC managers from focusing on their early stage investments.
The commenter also viewed early stage investing as a specialized skill.
In contrast, two other commenters suggested a change in the
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definition to require at least 25 percent of all financing dollars to
be invested in later stage investments structured to produce current
income. They thought this change would reduce risk and might eliminate
the need for the interest reserve required under Sec. 107.1181, which
would increase an Early Stage SBIC's total funds available for
investment.
SBA has not adopted either of these comments because it believes
the commenters' contrasting points of view illustrate the benefits of
maintaining the flexibility that the proposed definition provided. SBA
expects that some management teams will focus exclusively on early
stage companies, while others will opt for a mixed portfolio.
Applicants may propose to manage risk in a number of different ways,
including making some later-stage investments, taking less than one
tier of leverage, or using leverage primarily for follow-on investments
in portfolio companies that are performing well. SBA believes that fund
managers are in the best position to develop an investment strategy
based on their own skills, experience and analysis of market
opportunities.
The only other comment received on the Early Stage definition was a
suggested clarification. Two commenters thought it would be helpful for
the definition to refer specifically to Sec. 107.1810(f)(11), which
specifies the time frame within which an Early Stage SBIC must satisfy
the early stage investment requirement. SBA agrees and has added a
cross-reference to the cited section.
The other key points of the definition were that: (1) An Early
Stage SBIC must be organized as a limited partnership; and (2) a small
business would be considered ``early stage'' if it has not yet achieved
positive cash flow from operations in any full fiscal year. SBA
received no comments on these aspects of the definition and is
finalizing them without change.
Payment Date
SBA proposed special distribution rules in Sec. 107.1180 which
would require Early Stage SBICs to make mandatory prepayments of
outstanding debentures at the same time they make distributions to
their private limited partners. The proposed revision of the ``Payment
Date'' definition in Sec. 107.50 designated March 1, June 1, September
1, and December 1 of each year as the dates on which debenture
prepayments could be made and required interest payments would be due.
SBA received two comments suggesting a requirement for semi-annual
interest payments (the same as for standard debentures), while
preserving the option for an Early Stage SBIC to prepay debentures and
make interest payments on a quarterly basis. The commenters reasoned
that this added flexibility would be a better fit with the type of
investing that Early Stage SBICs will do.
SBA proposed the quarterly Payment Date structure expressly to
provide Early Stage SBICs with more frequent distribution opportunities
than standard debentures afford. SBA believes that a hybrid structure
with both required and optional interest payments would result in
excessive administrative burden for SBICs, SBA, and debenture
purchasers. Accordingly, SBA is finalizing the Payment Date definition
as proposed.
Section 107.210--Minimum capital requirements for Licensees.
Proposed Sec. 107.210(a)(3) required an Early Stage SBIC to have at
least $20 million of Regulatory Capital (consisting of paid-in capital
contributions from private investors plus binding capital commitments
from Institutional Investors, as defined in existing Sec. 107.50). In
comparison, the minimum Regulatory Capital is $5 million for other
debenture SBICs and $10 million for participating securities SBICs.
Two commenters noted that SBA will consider geographic diversity as
one factor in evaluating applicants for an Early Stage SBIC license.
Based on the presumption that a fund investing in underserved areas
might be able to operate effectively with less than $20 million of
capital, they suggested language that would allow SBA to license an
Early Stage SBIC with Regulatory Capital as low as $10 million,
provided SBA is satisfied that the fund would be economically viable.
In the proposed rule, SBA specifically requested public input on
the $20 million private capital minimum. The very limited response to
this request suggests that the proposed minimum capital requirement was
acceptable to most readers. Although SBA recognizes that operating
costs differ across geographic locations, SBA's experience in the
regular debenture program has not shown a strong connection between the
geographic areas in which an SBIC plans to invest and the amount of
capital it raises. In light of historical data showing that SBA has
experienced higher loss rates on smaller SBICs, with performance
statistics improving as private capital approaches $20 million, SBA
does not see a compelling reason to reduce the minimum capital
requirement and is finalizing Sec. 107.210 as proposed.
Section 107.300--License application form and fee. Three commenters
addressed this section. One commenter expressed concern that small
businesses seeking financing from an Early Stage SBIC might be required
to pay a $25,000 fee. That is not the case; the $25,000 fee would be
paid by applicants for an Early Stage SBIC license. The other two
commenters each submitted two identical comments. First, they requested
clarification that SBA would refund the licensing fee if it did not
accept an application for processing. The proposed rule characterized
the licensing fee as ``non-refundable''; however, if SBA received an
application that could not be accepted for processing, and the
applicant did not correct the deficiencies, SBA would return the
licensing fee along with the application itself. In SBA's experience,
this situation has rarely if ever occurred and does not need to be
specifically addressed in the regulation. Consistent with current
practice, SBA will not refund the fee for an application that is
denied, withdrawn, or otherwise dismissed after being accepted for
processing.
The commenters also urged SBA to cease adding $10,000 to the
application fee because an applicant is organized as a partnership. The
intent of this comment is unclear. For many years, Sec. 107.300 has
included an additional $5,000 charge for partnerships, and the proposed
rule did not change that provision. SBA imposed this additional cost
because of the more extensive document review that a partnership
application requires. It is possible that the commenters intended to
address the $10,000 difference in the licensing fee for an Early Stage
SBIC applicant versus a regular debenture applicant ($25,000 versus
$15,000, assuming both are organized as partnerships). SBA believes the
difference is justified by processing differences between the two types
of applications, including compressed processing times for Early Stage
applications which will require SBA to supplement its licensing staff
with outside consultants. Therefore, the proposed section has been
finalized without change.
Section 107.305--Evaluation of license applicants. In the proposed
rule, SBA specifically requested input from the public on the factors
used by SBA to evaluate applicants to the SBIC program, including
applicants for an Early Stage SBIC license. These factors were grouped
in four broad categories: Management qualifications, performance of
managers' prior investments, the applicant's proposed investment
strategy, and the applicant's
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proposed organizational structure and fund economics. Only two
commenters addressed this section, submitting nearly identical
comments. SBA is finalizing the proposed section without change, for
the reasons discussed in the following paragraphs.
Proposed Sec. 107.305(a) included experience in ``implementing
best practices for investment firms'' as one aspect of management
qualifications that SBA would evaluate. The two commenters described
this criterion as an amorphous standard on which there is no consensus,
and suggested deleting it. SBA disagrees. SBA believes that many best
practices are widely acknowledged and disseminated by organizations
such as the Institutional Limited Partners Association, the National
Venture Capital Association, and the Private Equity Industry Guidelines
Group.
Proposed Sec. 107.305(b) included ``the contribution of prior
investments to the growth of portfolio company revenues and number of
employees'' as one of the factors SBA would consider in evaluating the
performance of fund managers' prior investments. The two commenters
suggested eliminating employment growth as a criterion because
investment funds do not usually track this information. SBA understands
that not all fund managers will have employment data for the companies
in which they previously invested, and will not disqualify an applicant
that does not have these data. However, job growth is a critical part
of the SBIC program's mission and SBA believes it should be considered.
In fact, the current SBIC license application (which Early Stage SBIC
will also use) already requests information on the growth of portfolio
company employees and revenues, and most applicants have been able to
provide it.
Proposed Sec. 107.305(c) included compliance with SBA regulations
as a factor in SBA's evaluation of an applicant's investment strategy;
proposed Sec. 107.305(d) similarly included regulatory compliance with
respect to an applicant's organizational structure and fund economics.
The two commenters felt that compliance was relevant only to applicants
that have previously managed an SBIC. However, the provisions relate
not to an applicant's prior funds, but to the likelihood of compliance
of the strategy and structure of the proposed new SBIC. Therefore,
these provisions pertain to all applicants.
Section 107.310--When and how to apply for licensing as an Early
Stage SBIC. Under proposed Sec. 107.310, SBA would not license two
Early Stage SBICs under common control if both would have SBA leverage
or leverage commitments outstanding at the same time. SBA received one
comment stating that Early Stage SBIC managers should be able to access
leverage across multiple funds at the same time, as this modification
would strengthen the community of investment firms and individuals that
finance early stage companies. SBA has not adopted this comment because
portfolio diversification is particularly important with only a five
year licensing period for the Early Stage initiative and a limited
total leverage allocation.
The proposed section also provided that SBA would accept Early
Stage SBIC applications only during specified periods, which would be
announced by Federal Register notice. One commenter thought, depending
on the number of applications received, that SBA might turn down
applicants even though they meet the qualification standards for
licensing. The commenter suggested that any qualified applicant that is
not given a green light to apply for an Early Stage SBIC license should
receive a green light to apply for a regular debenture SBIC license. An
Early Stage SBIC applicant that does not meet the licensing
qualification standards is not prohibited from separately pursuing a
regular debenture SBIC license.
Section 107.320--Evaluation of Early Stage SBICs. Proposed Sec.
107.320 stated that SBA would evaluate Early State SBIC applicants
using the same set of factors applicable to SBIC applicants in general,
as set forth in proposed Sec. 107.305. In addition, proposed Sec.
107.320(a) and (b) added two selection criteria specific to Early Stage
SBICs, giving SBA the right to consider: (1) Diversification of Early
Stage SBICs with respect to ``vintage year'' (the year in which an
investment fund draws its initial capital from investors), and (2)
diversification of Early Stage SBICs with respect to geographic
location. SBA received no comments specific to this section and is
finalizing it without change.
Section 107.565--Restrictions on third-party debt of Early Stage
SBICs. Proposed Sec. 107.565 required an Early Stage SBIC to obtain
SBA approval to have, incur or refinance any third-party debt, whether
secured or unsecured. The proposed rule made an exception for
``accounts payable from routine business operations''. Two commenters
were concerned that ``routine business operations'' could be
interpreted too narrowly; one asked whether it would include certain
legal expenses or specialized audit work performed as part of an Early
Stage SBIC's due diligence on a potential investment. SBA considers the
ordinary expenses of operating an SBIC to come within this exception
and other extraordinary expenses would require SBA's prior approval.
SBA is finalizing Sec. 107.565 as proposed.
Section 107.585--Voluntary decrease in Licensee's Regulatory
Capital. The proposed rule required any reduction of Regulatory Capital
under Sec. 107.585 by an Early Stage SBIC to be approved by SBA in
writing. SBA received two comments suggesting that an Early Stage SBIC
that has repaid all of its leverage should be exempt from this prior
approval requirement. The requested exemption is available under
existing Sec. 107.1000(b), which applies to all SBICs (including Early
Stage SBICs) with no outstanding leverage.
Section 107.692--Examination fees. SBA received two comments
addressing this section. Both suggested that partnership SBICs should
not be charged an additional $10,000 examination fee; however, neither
the existing regulations nor the proposed rule included such a fee. The
proposed amendments to Sec. 107.692, which SBA is finalizing without
change, require an Early Stage SBIC to pay an examination fee that is
10 percent higher than the base fee until all debenture leverage has
been repaid and no further leverage will be issued. The existing
regulation also includes a 5 percent addition to the base fee for
partnerships. The maximum base fee is $14,000, so the 5 percent and 10
percent premiums combined cannot exceed $2,100. SBA charges more for
partnerships based on the documentation that must be reviewed; for
Early Stage SBICs, SBA expects that the value of unrealized investments
will require more review than is needed for other debenture SBICs.
Section 107.1120--General eligibility requirements for Leverage.
Proposed paragraph (k) of this section provided for a new certification
by Early Stage SBICs seeking an SBA leverage commitment or draw. The
Early Stage SBIC would be required to certify that it will provide at
least 50 percent of the aggregate dollar amount of its financings to
``early stage'' companies, in accordance with the Early Stage SBIC
definition in Sec. 107.50. The proposed certification was not specific
as to when the early stage investment requirement would be met, and two
commenters suggested that the clarity of the provision would be
improved by adding a cross-reference to the timing requirements in
Sec. 107.1810(f)(11). SBA agrees and has revised the final rule
accordingly.
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Section 107.1150--Maximum amount of leverage for a section 301(c)
licensee. In this section, SBA proposed special limits on the maximum
amount of leverage that will be available to an Early Stage SBIC. Among
other limitations, the maximum leverage that an Early Stage SBIC could
have outstanding at any time would be limited to 100 percent of its
paid-in private capital (``Leverageable Capital'') or $50 million,
whichever is less. SBA received two comments suggesting that Early
Stage SBICs should be able to obtain additional leverage if they invest
in low income geographic areas. This benefit is available to other
SBICs under existing Sec. 107.1150(c). SBA has not adopted this
comment based on its concern that increasing the leverage for which an
Early Stage SBIC is eligible would result in increased risk and could
ultimately increase the leverage fees that all debenture SBICs must
pay.
Section 107.1180--Required distributions to SBA by Early Stage
SBICs. In this section, SBA proposed to add distribution requirements
that would apply only to Early Stage SBICs. To reduce the risk of the
Early Stage initiative, the proposed rule required an Early Stage SBIC
to make a distribution to SBA whenever it made a distribution to its
investors. Distributions could be made on any quarterly Payment Date
(March 1, June 1, September 1, or December 1). SBA would apply any such
distribution to the repayment of the SBIC's outstanding debentures. The
Early Stage SBIC would have to be current on its debenture interest and
fees before making a distribution. SBA received two comments pointing
out a possible conflict in the proposed regulatory language. They noted
that proposed Sec. 107.1180 used the existing defined term
``Distribution'', which includes ``any transfer of cash or non-cash
assets to SBA, its agent or Trustee''. Thus, the definition could be
presumed to include payments of interest and fees to SBA, which
therefore would be subject to the various restrictions on Distributions
in the proposed rule. To avoid any confusion, SBA has revised Sec.
107.1180(a) to clarify that Early Stage SBIC with outstanding leverage
may pay interest, annual fees, and maturing debenture principal
pursuant to the terms of its debentures, and that these payments are
not subject to the ``Distribution'' requirements in Sec. 107.1180.
SBA also received two comments on the provision in proposed Sec.
107.1180(b) that allowed debentures issued by Early Stage SBICs to be
prepaid in whole but not in part. The commenters asked how SBA would
handle a distribution if the amount received was not sufficient to pay
off a debenture in full. SBA has experience with this issue through the
participating securities program, which includes many SBICs that have
also issued debentures. These SBICs have pre-planned their
distributions so that the amount payable to SBA will be the amount
needed to pay off one or more debentures in full. SBICs have the
flexibility to issue debentures in fairly small increments, and most do
so; as a result, it should not be difficult to arrange a distribution
so that debenture prepayments work out properly.
Proposed Sec. 107.1180(d) stated that SBA's share of a
distribution would depend on the Early Stage SBIC's ``highest ratio''
of outstanding leverage to Leverageable Capital, and its Capital
Impairment Percentage (CIP), as determined under existing Sec.
107.1840. At a CIP of less than 50 percent, distributions would be
allocated pro rata (based on the ``highest ratio'') between SBA (up to
the amount of the outstanding debenture leverage) and the Early Stage
SBIC's investors. However, if the CIP reached 50 percent or more, SBA
would receive 100 percent of any distribution until all outstanding
debentures have been repaid. If the Early Stage SBIC reduced its CIP
below 50 percent, it could resume distributions to its investors.
SBA received one comment on these distribution priority provisions.
The commenter stated that for Early Stage SBICs that maintain a low
ratio of leverage to Leverageable Capital (for example, funds that
raise $2 or $3 of private capital for every $1 of leverage), SBA should
not take all distributions when the CIP reaches 50 percent because the
SBA leverage would still be fully protected. The commenter proposed a
variable formula to determine the CIP at which SBA would be entitled to
priority in distributions, suggesting that this change would make the
Early Stage initiative more attractive to potential investors. SBA
believes that a variable threshold introduces too much complexity, but
also agrees that an Early Stage SBIC that takes substantially less than
one tier of leverage does represent a lower risk to SBA and should
receive the benefit of more favorable distribution rules. Accordingly,
SBA is revising Sec. 107.1180(d) so that SBA will be entitled to 100
percent of distributions only if the CIP is 50 percent or greater and
the Early Stage SBIC's highest leverage ratio is greater than 0.5. In
other words, an Early Stage SBIC that uses at least $2 of private
capital for every $1 of leverage will be permitted to continue making
pro rata distributions to SBA and its private investors even if its CIP
reaches or exceeds 50 percent, as long as it does not have a condition
of capital impairment under Sec. 107.1830.
Section 107.1181--Interest reserve requirements for Early Stage
SBICs. Two commenters addressed this section, which required an Early
Stage SBIC to maintain funds in reserve to cover interest and Charges
on each of its outstanding debentures over the first five years of its
term.
The proposed rule provided an exception to the interest reserve
requirement for leverage in the form of a discounted debenture, which
will not require cash interest payments during the first five years of
its term. Instead, the proceeds received by the Early Stage SBIC when
the debenture is issued will be discounted; over the first five years
following issuance, the carrying value of the debenture will accrete
until it reaches face value, and semi-annual interest payments will be
required beginning in year six.
For standard debentures, the proposed rule required a reserve
sufficient to pay interest and Charges for the first 21 Payment Dates
following issuance of a debenture, and both commenters thought the
correct period should be 20 Payment Dates, to correspond to a five year
period. However, SBA notes that the first of the 21 Payment Dates will
come at the end of a ``stub period'' that is less than a full quarter.
The proposed rule correctly provided for the stub period followed by 20
quarters.
Both commenters suggested that SBA should consider permitting Early
Stage SBICs to issue discounted debentures as an alternative to the
reserve requirements. SBA clearly stated its intention to do so in the
preamble to the proposed rule. In the proposed and final rules, Sec.
107.1181(a) states that the reserve requirement applies only to
debentures that require periodic interest payments to SBA during the
first five years of their term.
Finally, both commenters recommended that the regulation state
explicitly that the required reserve on a debenture will be reduced
each time the issuing Early Stage SBIC makes an interest payment. SBA
believes this point is implicit in the regulation (it was also made
explicitly in the preamble to the proposed rule), but has added it to
the final rule for avoidance of doubt.
Section 107.1182--Valuation requirements for Early Stage SBICs
based on Capital Impairment Percentage. This section would require an
Early Stage SBIC to notify SBA in writing if it has a Capital
Impairment Percentage of at least 50 percent, even
[[Page 25048]]
if its maximum allowable CIP is higher. When SBA receives this
notification, or makes its own determination that the CIP is at least
50 percent, SBA would have the right to require the Early Stage SBIC to
engage a third party valuation expert, acceptable to SBA, to perform
valuations of some or all of the licensee's investments, as determined
by SBA. Two commenters asked how SBA plans to use the valuations, and
whether Early Stage SBICs will be able to contest them. SBA has not
adopted standard procedures for acting upon third-party valuations, in
part because valuations are often provided in ranges and have varying
degrees of uncertainty associated with them. SBA will use the
valuations as additional data points to assess the Early Stage SBIC's
financial condition and the repayment prospects of outstanding SBA
leverage, as it currently does with valuations for other debenture
SBICs. SBICs always have the right to provide additional information if
they disagree with a valuation.
Section 107.1810--Events of default and SBA's remedies for
Licensee's noncompliance with terms of Debentures. SBA proposed four
changes in this section that would apply only to Early Stage SBICs. SBA
received no specific comments on this section and is finalizing it as
proposed. The change is a revision of Sec. 107.1810(f)(2), which
provides that an improper distribution made by an SBIC is an event of
default. In the final rule, Sec. 107.1810(f)(2)(iv) adds distributions
by Early Stage SBICs, as permitted under proposed Sec. 107.1180, to
the list of specific distributions that would not be considered
improper distributions.
Second, under Sec. 107.1810(f)(11), it is an event of default if
an Early Stage SBIC fails to meet the requirement to invest at least 50
percent of its financing dollars in early stage companies, as defined
under the proposed Early Stage SBIC definition in Sec. 107.50. This
provision would require an Early Stage SBIC to meet the 50 percent
requirement as soon as the total dollars invested to date are equal to
or greater than Regulatory Capital. Third, under proposed new Sec.
107.1810(f)(12), it would be an event of default if an Early Stage SBIC
fails to maintain the interest reserve required under proposed Sec.
107.1181, as discussed earlier in this preamble.
The conditions in proposed Sec. 107.1810(f)(11) and (f)(12) would
both be in the category of events of default with opportunity to cure.
If the Early Stage SBIC fails to cure to SBA's satisfaction, SBA could
invoke the remedies in existing Sec. 107.1810(g), which include the
right to declare outstanding debenture leverage immediately due and
payable.
Finally, Sec. 107.1810(j) provides SBA with additional remedies to
help maximize recoveries from Early Stage SBICs that have been
transferred to a liquidation status. Under this section, if SBA must
honor its guarantee and pay the interest and principal of an Early
Stage SBIC's debentures, upon such payment SBA has the right to
prohibit the SBIC from making additional investments without SBA
approval (except for any investments the SBIC had already legally
committed itself to make); to prohibit Distributions by the SBIC to any
party other than SBA until all leverage and other amounts due to SBA
have been repaid; to require all the SBIC's investor commitments to be
funded at the earliest time(s) permitted under the SBIC's limited
partnership agreement and other applicable documents; to review and re-
determine the SBIC's approved Management Expenses (as defined in
existing Sec. 107.520); and to the appointment of SBA or its designee
as receiver for the SBIC. The receivership would be for the purpose of
continuing the SBIC's operations; the appointment of a liquidating
receiver is governed by existing provisions of the Small Business
Investment Act and is not affected by this rule.
Section 107.1830--Licensee's Capital Impairment--definitions and
general requirements. As discussed in the preamble to the proposed
rule, SBA did not propose to change the maximum permitted Capital
Impairment Percentages set forth in Sec. 107.1830. Under the existing
regulation, the maximum allowable CIP for a debenture SBIC with one
tier of leverage or less is 70 percent. SBA received one comment
suggesting that the maximum allowable CIP should be raised to 80
percent for an Early Stage SBIC with a highest leverage ratio of 0.4 or
less. SBA agrees that a lower leverage ratio corresponds to lower
credit risk, but has declined to adopt this suggestion, primarily
because the CIP formula already allows a fund with a low leverage ratio
to incur substantially higher dollar losses than a more highly
leveraged fund of the same size before becoming impaired. For example,
an Early Stage SBIC with $30 million of private capital and $30 million
of leverage (i.e., a leverage ratio of 1.0) would be impaired (based on
a CIP of 70 percent) if it incurred total net losses of $21 million. In
contrast, an Early Stage SBIC with $40 million of private capital and
$20 million of leverage (i.e., a leverage ratio of 0.5), and the same
$21 million of losses, would have a CIP of only 52.5 percent and would
not be impaired.
Section 107.1840--Computation of Licensee's Capital Impairment
Percentage. SBA did not propose any changes to this section, but is
making one change in this final rule in response to comments regarding
the need for more flexible capital impairment regulations for Early
Stage SBICs. As discussed under ``General Comments'' in section II of
this preamble, SBA is adding an exception for Early Stage SBICs that
affects the way Class 2 appreciation is accounted for in the
computation of the Capital Impairment Percentage. In Sec.
107.1840(d)(3)(iii) and (d)(4), the final rule provides for the
exception and refers the user to new Sec. 107.1845 for the applicable
information.
Section 107.1845--Computation of Capital Impairment Percentage for
Early Stage SBICs. This new section provides the specific details of a
change in the treatment of Class 2 appreciation for Early Stage SBICs.
This section represents an exception, for Early Stage SBICs only, to
certain provisions of existing Sec. 107.1840(d). Under Sec.
107.1840(d)(3), appreciation qualifies as Class 2 only if it is based
on a financing that occurred within 24 months of the date when the SBIC
is computing its CIP, or if the financed small business meets a test
for positive net operating cash flow. Under Sec. 107.1840(d)(4), an
SBIC can use 50 percent of its Class 2 appreciation in the calculation
of its ``adjusted unrealized gain'', which in turn is the amount that
the SBIC can use to offset realized losses in the CIP computation.
Under Sec. 107.1845, at the end of the initial 24 months, an Early
Stage SBIC with ``expiring'' Class 2 appreciation will be able to
request an extension. In considering this request, SBA may obtain its
own valuation of the investments or require the Early Stage SBIC to
obtain a valuation performed by an independent third party acceptable
to SBA. SBA may also consider any other information that it deems
relevant. If supported by the valuation and other information, SBA may
grant an extension allowing the Early Stage SBIC to use all or part of
the orginal Class 2 appreciation for up to an additional 24 months;
reasons for granting a shorter or no extension might include a high
degree of uncertainty associated with the valuation or the expectation
that events occurring within a shorter period will further clarify or
determine a company's value. At the end of any extension period, the
Early Stage SBIC could request a further extension, repeating the
original steps. SBA may
[[Page 25049]]
reconsider its approval of an extension at any time based on new
information that may affect the value of an investment.
At the time of any extension request, an Early Stage SBIC will also
be able to request an exception to the requirement to discount Class 2
appreciation by 50 percent in the ``adjusted unrealized gain''
calculation. SBA may grant this exception based on its consideration of
relevant information, including its determination that the appreciation
on the Early Stage SBIC's investment, based on its current fair value,
is at least two times the original Class 2 appreciation. If the
exception is granted, the Early Stage SBIC will be able to use the
original Class 2 appreciation in its CIP computation without the 50
percent discount, for the duration of the extension period.
B. Technical Changes to Regulations
Section 107.130--Requirement for qualified management. SBA proposed
one clarification in this section, which has been finalized without
change. The revision makes clear that a licensed SBIC (including an
Early Stage SBIC) must have qualified management not only when applying
for a license, but as long as it holds the license.
Section 107.1130--Leverage fees and additional charges payable by
Licensee. This section, which SBA is finalizing as proposed, includes
two changes to bring the regulation into conformity with statutory
requirements for determining the annual Charge to be paid by SBICs on
their outstanding SBA leverage.
IV. Justification for Immediate Effective Date
The Administrative Procedure Act (APA), 5 U.S.C. 553(d)(3),
requires that ``publication or service of a substantive rule shall be
made not less than 30 days before its effective date, except * * * as
otherwise provided by the agency for good cause found and published
with the rule.''
The purpose of this provision is to provide interested and affected
members of the public sufficient time to adjust their behavior before
the rule takes effect. In the case of this rulemaking, however, there
should be no need for any member of the public, including any SBIC, to
make any changes in order to prepare for the rule taking effect. This
rule implements changes to the SBIC program to stimulate private sector
investment in early stage companies, which are expected to contribute
to the important goals of creating jobs and fostering innovation. Any
further delay in making leverage available to Early Stage SBICs will
only hold back the potential benefits of investment in early stage
small businesses. SBA therefore finds that there is good cause for
making this rule effective immediately instead of observing the 30-day
period between publication and effective date.
Compliance With Executive Orders 12866, 12988 and 13132, the Paperwork
Reduction Act (44 U.S.C. Ch. 35) and the Regulatory Flexibility Act (5
U.S.C. 601-612)
Executive Order 12866
The Office of Management and Budget has determined that this rule
is a ``significant'' regulatory action under Executive Order 12866. In
the proposed rule, SBA set forth its initial regulatory impact
analysis, which addressed the following: (1) Necessity of the
regulation; (2) alternative approaches to the proposed rule; and (3)
the potential benefits and costs of the regulation. SBA received
comments which addressed both alternative approaches to and potential
costs of the regulation. Those comments are discussed in the final
Regulatory Impact Analysis set forth below:
1. Necessity of Regulation
The Small Business Investment Act of 1958 identifies the SBIC
program's mission as follows: ``to stimulate and supplement the flow of
private equity capital and long-term loan funds which small business
concerns need for the sound financing of their business operations and
for their growth, expansion, and modernization, and which are not
available in adequate supply * * *'' Based on venture capital industry
data (ThomsonOne VentureXpert), SBA believes that early stage
businesses lack access to needed financing capital. Although the
venture industry provided over $22 billion in financings to U.S.
businesses in calendar year 2010, this represented over a 23% decline
from 2007. Less than a third of these financing dollars went to early
stage or start-up businesses. Given the decline in venture capital
financings over the past 3 years, SBA seeks to expand access to early
stage businesses by implementing an initiative to provide up to $1
billion in debenture leverage over five years (beginning in FY 2012) to
a limited number of SBICs focused on early stage investments.
If SBA debenture leverage is to be used to finance early stage
small businesses, the high risk associated with such investments
indicates the need for more protections than those provided by the
standard SBIC debenture and current regulations to mitigate risk and
cost to the taxpayer. This final rule includes a number of regulatory
changes to manage the risks associated with an early stage portfolio,
including: (1) Limiting leverage for an individual Early Stage SBIC to
100 percent of Regulatory Capital or $50 million, whichever is less;
(2) establishing special distribution rules to require repayment of
leverage whenever an Early Stage SBIC makes distributions to its
investors; and (3) implementing risk monitoring actions appropriate to
SBA's leverage guarantor/creditor status. Even with these actions, in
order to maintain an initial subsidy rate of zero for the debenture
program while limiting the increase in leverage fees, SBA can only
issue leverage to Early Stage SBICs as a very small percentage of its
portfolio.
2. Alternative Approaches to Regulation
SBA considered several alternatives to these regulations. The first
alternative was for SBA not to pursue the Early Stage initiative and
continue with its current credit policy of not providing debenture
leverage to SBICs that focus on early stage equity investing. SBA
rejected this alternative because of the critical need for early-stage
funding, particularly in the $1 to $5 million range that fits well with
SBA's small business size standards.
SBA also considered seeking legislation for a new program
specifically focused on investing in early stage small businesses.
Although such an alternative could have provided an opportunity to
introduce useful risk-management provisions, such as SBA profit
sharing, SBA chose not to pursue this alternative because of the
compelling need to begin assisting early stage small businesses as
quickly as possible. A third alternative was for SBA to modify its
credit policies to license and approve leverage to qualified early
stage focused SBICs without changes in program regulations or in the
terms of debenture leverage. SBA believes that doing so would not be
financially responsible and would present an excessively high risk of
losses to the taxpayer. Ultimately, SBA decided that it could
responsibly license a limited number of early stage SBICs after
implementing appropriate regulatory changes to manage the associated
risk.
In proposing the definition for an Early Stage SBIC, SBA considered
both the type of investment that should qualify as ``early stage'' and
whether an Early Stage SBIC's portfolio should be limited to early
stage investments exclusively. Many small businesses in the earliest
stages of product
[[Page 25050]]
development (``seed stage'' companies) could benefit from access to
additional capital. However, SBA chose not to limit the Early Stage
initiative to seed stage investments because of their high risk and the
long holding periods they typically require. Although Early Stage SBICs
would not be prohibited from investing in seed stage companies, to use
SBA debenture leverage successfully they will likely need to start
generating cash returns on investments within 4 to 6 years after
licensing. This timing concern is also why the proposed definition
required only 50 percent of an Early Stage SBIC's portfolio to be in
early stage investments. SBA received one comment suggesting that Early
Stage SBICs should be required to invest at least 75% of their
investment dollars in early stage small businesses. However, two other
commenters believed not only that the 50% requirement was sufficient,
but that SBA should also consider requiring an Early Stage SBIC to
invest at least 25% of its total financing dollars in current pay
investments in later stage businesses. The commenters felt this would
decrease the risks of Early Stage SBICs, thereby lowering the costs,
and could perhaps offset the need for an interest reserve. SBA believes
these varying points of view illustrate that fund managers are in the
best position to identify the portfolio mix that would be best suited
to their skills and experience, and has finalized the Early Stage SBIC
definition as proposed.
In determining the maximum amount of leverage for which an Early
Stage SBIC would be eligible, SBA decided that a one-to-one match
between leverage and private capital (one ``tier'' of leverage) would
provide the best balance between program cost and attractiveness to
fund managers and investors. A second tier of leverage would result in
a much higher projected loss rate, and a correspondingly greater
increase in annual leverage fees for all debenture SBICs receiving new
leverage commitments. SBA also considered a model in which SBA would
have provided only half a tier of leverage. This lower ratio of
leverage to private capital would have a much lower impact on leverage
fees but would be unlikely to attract some high quality fund managers
and investors.
SBA also considered various dollar limits on the maximum leverage
available to an Early Stage SBIC, in order to avoid an excessive
concentration of risk in a small number of funds. A low dollar limit
could allow more funds to be licensed, but could be unattractive to
stronger applicants with the ability to raise and deploy larger amounts
of capital. SBA believes the proposed limit of $50 million is
sufficient to attract high quality applicants. SBA also believes that
$50 million of leverage, in combination with at least $50 million of
private capital, is more than adequate to support a primarily early
stage portfolio, with most financings expected to be in the $1 to $5
million range.
3. Potential Benefits and Costs
SBA anticipates that this rule will provide significant benefit to
early stage small businesses seeking investments by Early Stage SBICs.
In estimating the impact, SBA considered that $1 billion in anticipated
leverage will be matched by a minimum of $1 billion in private capital
over the next 5 years, beginning in FY 2012. SBA expects that Early
Stage SBICs will invest over a 5 to 7 year period after licensing.
Allowing for payment of management expenses and interest, SBA estimates
that the $1 billion in leverage guaranteed by the Early Stage
initiative will result in approximately $125 million annually in
financings to small businesses over an 8 to 10 year period.
As stated in the proposed rule, Early Stage debentures will impose
additional cost in the form of increased annual fees on all debenture
SBICs seeking new leverage commitments. The estimated cost has been
incorporated into the program formulation model which determines the
annual fee needed to keep the debenture program's original subsidy cost
at zero, as required by law. For FY 2012, SBA has budgeted $150 million
in leverage commitments to Early Stage SBICs, within the anticipated
appropriated SBIC Debenture loan levels, representing approximately 7
percent of total expected debenture commitments. This 7 percent
allocation would increase the annual fee on all new debenture
commitments by approximately 13.7 basis points. For FY 2013, SBA has
budgeted $200 million in leverage commitments to Early Stage SBICs,
representing approximately 8.3 percent of all new expected debenture
commitments. This 8.3 percent allocation would increase the annual fee
on all new debenture commitments by approximately 11.5 basis points
using updated model assumptions. The fee increases reflect the
additional risk associated with the early stage equity investments
contemplated by the Early Stage initiative. Early stage investing is
higher-risk than the typical SBIC portfolio, and would have required
fees in excess of statutory caps if operated on a stand-alone basis. To
align fees and costs to the taxpayers with the overall policy goals,
the Early Stage initiative incorporates terms designed to mitigate
risk, and is limited to no more than $200 million per fiscal year to
keep the annual fees at reasonable levels. The cost is expected to vary
each year based on the factors and assumptions used to develop the
annual fee, including the total amount of debenture leverage
commitments estimated, the amount committed to Early Stage SBICs, and
interest rates.
Executive Order 12988
This action meets applicable standards set forth in section 3(a)
and 3(b)(2) of Executive Order 12988, Civil Justice Reform, to minimize
litigation, eliminate ambiguity, and reduce burden. The action does not
have retroactive or presumptive effect.
Executive Order 13563
A description of the need for this regulatory action and benefits
and costs associated with this action is included above in the
Regulatory Impact Analysis under Executive Order 12866.
In connection with the launch of the President's ``Start-Up America
Initiative'', SBA announced its commitment to making financing
available to early stage small businesses through the SBIC program. In
an effort to engage interested parties in this regulatory action, SBA
has since made presentations at SBIC association meetings, Start-up
America-related public events, and venture capital industry forums to
discuss both the market need for new sources of early stage financing
and key issues associated with the design of the Early Stage
initiative. SBA announced a series of public Webinars regarding the
Early Stage Initiative during the comment period. 76 FR 81430 (December
28, 2011). SBA also placed explanatory material on its Web site to
assist the public with understanding the program, as proposed. http://www.sba.gov/content/early-stage-small-business-investment-company-sbic-inititative. The public Webinars attracted a range of participants,
including individuals with prior experience managing either
participating securities SBICs or non-SBIC equity funds; SBIC industry
service providers; and current debenture program participants. The
Webinar presentations provided a general introduction to the SBIC
program as well as to the goals and proposed structure of the Early
Stage initiative. Among other things, participants asked questions
about the timetable for implementing the initiative, when an Early
Stage SBIC applicant would have
[[Page 25051]]
to complete its fundraising, and procedures for submitting license
application and obtaining a leverage commitment. Participants were
broadly supportive of using the SBIC program to expand the financing
options available to early stage small businesses, while adding key
protective provisions to manage program risk.
Executive Order 13132
SBA has determined that this final rule will not have substantial,
direct effects on the States, on the relationship between the national
government and the States, or on the distribution of power and
responsibilities among the various levels of government. Therefore, for
the purposes of Executive Order 13132, Federalism, SBA has determined
that this final rule has no federalism implications warranting the
preparation of a federalism assessment.
Paperwork Reduction Act, 44 U.S.C. Ch. 35
SBA has determined that this final rule will not impose additional
reporting or recordkeeping requirements. Early Stage SBIC applicants
will submit the same license application form as other SBIC program
applicants (OMB Control Number 3245-0062). Post-licensing, Early Stage
SBICs will have the same recordkeeping and reporting requirements as
any other licensed SBIC.
Regulatory Flexibility Act, 5 U.S.C. 601-612
When an agency promulgates a rule, the Regulatory Flexibility Act
(5 U.S.C. 601-612) requires the agency to prepare a final regulatory
flexibility analysis (FRFA) describing the potential economic impact of
the rule on small entities and alternatives that may minimize that
impact. Section 605 of the RFA allows an agency to certify a rule, in
lieu of preparing a FRFA, if the rulemaking is not expected to have a
significant economic impact on a substantial number of small entities.
This final rule affects all SBICs issuing debentures, of which there
are approximately 150, most of which are small entities. Therefore, SBA
has determined that this final rule will have an impact on a
substantial number of small entities. However, SBA has determined that
the impact on entities affected by the rule will not be significant.
SBA intends to maintain the SBIC program's initial subsidy cost to
taxpayers at zero by charging up front and annual fees on its leverage.
SBA calculates the annual fee each year using historical data to assess
the appropriate fee to offset expected losses. The actual costs for
SBIC guarantees may be higher or lower, and SBA will monitor program
performance closely. Because SBA expects Early Stage SBICs to be
riskier than standard SBICs, the annual fees needed to keep the
debenture program's original subsidy cost at zero are higher than if
there were no Early Stage SBICs. For FY 2012, SBA estimates $150
million in leverage commitments to Early Stage SBICs, which increases
the annual fee charged to all SBICs seeking new debenture commitments
by approximately 13.7 basis points. For FY 2013, SBA estimates $200
million in leverage commitments to Early Stage SBICs, which increases
the annual fee charged to all SBICs seeking new debenture commitments
by approximately 11.5 basis points. Since annual leverage fees were
introduced in FY 1998, the annual fee has ranged from a high of 100
basis points (1 percent) to a low of 29 basis points, with a 13-year
median of 88 basis points. Although the cost will vary in the future
based on economic factors and assumptions used to develop the annual
fee, SBA expects the fee to remain under 1 percent, comparable to
historical annual fees and below the statutory maximum of 1.38 percent.
For debenture leverage committed and drawn by SBICs in FY 2012, SBA
estimates that the sum of the debenture interest rate plus the annual
fee will be in the vicinity of 5 percent. Debenture SBICs typically use
the proceeds of debenture leverage to make loans to small businesses at
interest rates in the 12 to 16 percent range, providing them with a
significant spread over their cost of funds. Accordingly, the
Administrator of the SBA hereby certifies that this final rule will not
have a significant impact on a substantial number of small entities. In
the proposed rule, SBA solicited comments from the public regarding any
perceived significant impact, either on SBICs or on companies that
receive funding from SBICs, and received none.
List of Subjects in 13 CFR Part 107
Investment companies, Loan programs--business, Reporting and
recordkeeping requirements, Small businesses.
For the reasons stated in the preamble, SBA amends part 107 of
title 13 of the Code of Federal Regulations as follows:
PART 107--SMALL BUSINESS INVESTMENT COMPANIES
0
1. The authority citation for part 107 continues to read as follows:
Authority: 15 U.S.C. 681 et seq., 683, 687(c), 687b, 687d, 687g,
687m and Pub. L. 106-554, 114 Stat. 2763; and Pub. L. 111-5, 123
Stat. 115.
0
2. Amend Sec. 107.50 by adding a definition of ``Early Stage SBIC''
and revising the definition of ``Payment Date'' to read as follows:
Sec. 107.50 Definition of terms.
* * * * *
Early Stage SBIC means a Section 301(c) Partnership Licensee,
licensed pursuant to Sec. 107.310 of this part, in which at least 50
percent of all Loans and Investments (in dollars) must be made to Small
Businesses that are ``early stage'' companies at the time of the
Licensee's initial Financing (see also Sec. 107.1810(f)(11)). For the
purposes of this definition, an ``early stage'' company is one that has
never achieved positive cash flow from operations in any fiscal year.
* * * * *
Payment Date means:
(1) For a Participating Securities issuer, each February 1, May 1,
August 1, and November 1 during the term of a Participating Security,
or
(2) For an Early Stage SBIC, each March 1, June 1, September 1, and
December 1 during the term of a Debenture.
* * * * *
0
3. Amend Sec. 107.130 by revising the first sentence to read as
follows:
Sec. 107.130 Requirement for qualified management.
When applying for a license, and while you have a license, you must
show, to the satisfaction of SBA, that your current or proposed
management team is qualified and has the knowledge, experience and
capability necessary for investing in the types of businesses
contemplated by the Act, the regulations in this part 107, and your
business plan. * * *
0
4. Amend Sec. 107.210 by revising paragraph (a)(1) subject heading and
the first sentence of its introductory text and by adding a paragraph
(a)(3) to read as follows:
Sec. 107.210 Minimum capital requirements for Licensees.
(a) * * *
(1) Licensees other than Participating Securities issuers and Early
Stage SBICs. Except for Participating Securities issuers and Early
Stage SBICs, a Licensee must have Regulatory Capital of at least
$5,000,000. * * *
* * * * *
[[Page 25052]]
(3) Early Stage SBICs. An Early Stage SBIC must have Regulatory
Capital of at least $20 million.
* * * * *
0
5. Amend Sec. 107.300 by revising the introductory text and adding a
paragraph (d) to read as follows:
Sec. 107.300 License application form and fee.
The license application must be submitted on SBA Form 2181 together
with all applicable exhibits on SBA Form 2182 and a non-refundable
processing fee computed as follows:
* * * * *
(d) All applicants seeking to be licensed as Early Stage SBICs will
pay the fee for a Partnership Licensee plus an additional $10,000 fee,
for a total of $25,000.
0
6. Add Sec. 107.305 to subpart C to read as follows:
Sec. 107.305 Evaluation of license applicants.
SBA will evaluate a license applicant based on the submitted
application materials, any interviews with the applicant's management
team, and the results of background investigations, public record
searches, and other due diligence conducted by SBA and other Federal
agencies. SBA's evaluation will consider factors including the
following:
(a) Management qualifications, including demonstrated investment
skills and experience as a principal investor; business reputation;
adherence to legal and ethical standards; record of active involvement
in making and monitoring investments and assisting portfolio companies;
successful history of working as a team; and experience in developing
appropriate processes for evaluating investments and implementing best
practices for investment firms.
(b) Performance of managers' prior investments, including
investment returns measured both in percentage terms and in comparison
to appropriate industry benchmarks; the extent to which investments
have been realized as a result of sales, repayments, or other exit
mechanisms; and the contribution of prior investments to the growth of
portfolio company revenues and number of employees.
(c) Applicant's proposed investment strategy, including clarity of
objectives; strength of management's rationale for pursuing the
selected strategy; compliance with this part 107 and applicable
provisions of part 121 of this chapter; fit with management's skills
and experience; and the availability of sufficient resources to carry
out the proposed strategy.
(d) Applicant's proposed organizational structure and fund
economics, including compliance with this part 107; soundness of
financial projections and underlying assumptions; a compensation plan
that provides managers with appropriate economic incentives; a
reasonable basis for allocations of profits and fees to Persons not
involved in management; and governance procedures that provide
appropriate checks and balances.
0
7. Add Sec. 107.310 to subpart C to read as follows:
Sec. 107.310 When and how to apply for licensing as an Early Stage
SBIC.
From time to time, SBA will publish a Notice in the Federal
Register, inviting the submission of applications for licensing as an
Early Stage SBIC. SBA will not consider an application from an Early
Stage SBIC applicant that is under Common Control with another Early
Stage SBIC applicant or an existing Early Stage SBIC (unless it has no
outstanding Leverage or Leverage commitments and will not seek
additional Leverage in the future). Applicants must comply with both
the regulations in this part 107 and any requirements specified in the
Notice, including submission deadlines. The Notice will specify
procedures for a particular application period.
0
8. Add Sec. 107.320 to subpart C to read as follows:
Sec. 107.320 Evaluation of Early Stage SBICs.
SBA will evaluate an Early Stage SBIC license applicant based on
the same factors applicable to other license applicants, as set forth
in Sec. 107.305, with particular emphasis on managers' skills and
experience in evaluating and investing in early stage companies. In
addition, SBA reserves the right to maintain diversification among
Early Stage SBICs with respect to:
(a) The year in which they commence operations, and
(b) Their geographic location.
0
9. Add Sec. 107.565 to subpart E to read as follows:
Sec. 107.565 Restrictions on third-party debt of Early Stage SBICs.
If you are an Early Stage SBIC and you have outstanding Leverage or
a Leverage commitment, you must get SBA's prior written approval to
have, incur, or refinance any third-party debt other than accounts
payable from routine business operations.
0
10. Amend Sec. 107.585 by revising the first sentence to read as
follows:
Sec. 107.585 Voluntary decrease in Licensee's Regulatory Capital.
You must obtain SBA's prior written approval to reduce your
Regulatory Capital by more than two percent in any fiscal year, unless
otherwise permitted under Sec. Sec. 107.1560 and 107.1570, provided
however, that if you are an Early Stage SBIC, you must obtain SBA's
prior written approval for any reduction of your Regulatory Capital,
including any reduction pursuant to a Distribution under Sec. 107.1180
of this part. * * *
0
11. Amend Sec. 107.692 by redesignating paragraphs (c)(4) and (5) as
paragraphs (c)(5) and (6), adding a new paragraph (c)(4), and revising
the table in paragraph (d) to read as follows:
Sec. 107.692 Examination fees.
* * * * *
(c) * * *
* * * * *
(4) If you are an Early Stage SBIC with outstanding Leverage or
Leverage commitments, you will pay an additional charge equal to 10% of
your base fee;
* * * * *
(d) * * *
----------------------------------------------------------------------------------------------------------------
Amount of Amount of
discount-- % addition-- %
Examination fee discounts of base Examination fee additions of base
examination examination
fee fee
----------------------------------------------------------------------------------------------------------------
No prior violations........................... 15 Partnership or limited liability 5
company.
Responsiveness................................ 10 Participating Security Licensee. 10
Records/Files at multiple 10
locations.
Early Stage SBIC................ 10
----------------------------------------------------------------------------------------------------------------
[[Page 25053]]
* * * * *
0
12. Amend Sec. 107.1120 by adding paragraph (k) to read as follows:
Sec. 107.1120 General eligibility requirements for Leverage.
* * * * *
(k) If you are an Early Stage SBIC, certify in writing that in
accordance with Sec. 107.1810(f)(11), at least 50 percent of the
aggregate dollar amount of your Financings will be provided to ``early
stage'' companies as defined under the definition of Early Stage SBIC
in Sec. 107.50 of this part.
0
13. Amend Sec. 107.1130 by revising the first sentence of paragraph
(d)(1) and the first sentence of paragraph (d)(2) to read as follows:
Sec. 107.1130 Leverage fees and additional charges payable by
Licensee.
* * * * *
(d) * * *
(1) Debentures. You must pay to SBA a Charge, not to exceed 1.38
percent per annum, on the outstanding amount of your Debentures issued
on or after October 1, 1996, payable under the same terms and
conditions as the interest on the Debentures. * * *
(2) Participating Securities. You must pay to SBA a Charge, not to
exceed 1.46 percent per annum, on the outstanding amount of your
Participating Securities issued on or after October 1, 1996, payable
under the same terms and conditions as the Prioritized Payments on the
Participating Securities. * * *
* * * * *
0
14. Amend Sec. 107.1150 by revising the first sentence of the
introductory text, redesignating paragraphs (c) and (d) and paragraphs
(d) and (e), respectively, and adding a new paragraph (c) to read as
follows:
Sec. 107.1150 Maximum amount of Leverage for a Section 301(c)
Licensee.
A Section 301(c) Licensee, other than an Early Stage SBIC, may have
maximum outstanding Leverage as set forth in paragraphs (a) through (c)
of this section. An Early Stage SBIC may have maximum outstanding
Leverage as set forth in paragraph (d) of this section. * * *
* * * * *
(c) Early Stage SBICs. Subject to SBA's credit policies, if you are
an Early Stage SBIC:
(1) The total amount of any and all Leverage commitments you
receive from SBA shall not exceed 100 percent of your highest
Regulatory Capital or $50 million, whichever is less;
(2) On a cumulative basis, the total amount of Leverage you have
issued shall not exceed the total amount of capital paid in by your
investors; and
(3) The maximum amount of Leverage you may have outstanding at any
time is the lesser of:
(i) 100 percent of your Leverageable Capital, or
(ii) $50 million.
0
15. Amend subpart I of part 107 by adding an undesignated center
heading and Sec. Sec. 107.1180, 107.1181, and 107.1182 to read as
follows:
Subpart I--SBA Financial Assistance for Licenses (Leverage)
* * * * *
Special Rules for Leverage Issued by an Early Stage SBIC
Sec.
107.1180 Required distributions to SBA by Early Stage SBICs.
107.1181 Interest reserve requirements for Early Stage SBICs.
107.1182 Valuation requirements for Early Stage SBICs based on
Capital Impairment Percentage.
* * * * *
Sec. 107.1180 Required distributions to SBA by Early Stage SBICs.
(a) Distribution requirement. If you are an Early Stage SBIC with
outstanding Leverage, you may make Distributions to your investors and
to SBA only as permitted under this section. See also Sec. 107.585.
For the purposes of this section, ``Distributions'' do not include
required payments to SBA of interest and Charges and payments of
Leverage principal at maturity, all of which shall be paid in
accordance with the terms of the Leverage. You may make a Distribution
on any Payment Date. Unless SBA permits otherwise, you must notify SBA
in writing of any planned distribution under this section, including
computations of the amounts distributable to SBA and your investors, at
least 10 business days before the distribution date.
(b) How SBA will apply Distributions. Any amounts you distribute to
SBA, or its designated agent or Trustee, under this section will be
applied to repayment of principal of outstanding Debentures in order of
issue. You may prepay any Debenture in whole, but not in part, on any
Payment Date without penalty.
(c) Condition for making a Distribution. You may make a
Distribution under this section only if you have paid all interest and
Charges on your outstanding Debentures that are due and payable, or
will pay such interest and Charges simultaneously with your
Distribution.
(d) SBA's share of Distribution. For each proposed Distribution,
determine SBA's share of the Distribution as follows:
(1) Determine the highest ratio of outstanding Leverage to
Leverageable Capital that you have ever attained (your ``Highest
Leverage Ratio''). For the purpose of determining your Highest Leverage
Ratio, any deferred interest Debentures issued at a discount must be
included in the computation at their face value.
(2) Determine SBA's percentage share of cumulative Distributions:
(i) If your Capital Impairment Percentage under Sec. 107.1840 is
less than 50 percent as of the Distribution date or your Highest
Leverage Ratio equals 0.5 or less, except as provided in paragraph
(d)(2)(iii) of this section, SBA's percentage share of cumulative
Distributions equals:
[Highest Leverage Ratio/(Highest Leverage Ratio + 1)] x 100
For example, if your Highest Leverage Ratio equals 1, then SBA's share
of any distribution you make will be 50 percent.
(ii) If your Capital Impairment Percentage under Sec. 107.1840 is
50 percent or greater as of the Distribution date and your Highest
Leverage Ratio is greater than 0.5, SBA's percentage share of
cumulative Distributions equals 100 percent.
(iii) If you have a condition of Capital Impairment under Sec.
107.1830 and your Highest Leverage Ratio equals 0.5 or less as of the
Distribution date, SBA's percentage share of cumulative Distributions
equals 100 percent.
(3) Multiply the sum of all your prior Distributions and your
current proposed Distribution (including Distributions to SBA, your
limited partners and your General Partner) by SBA's percentage share of
cumulative Distributions as determined in paragraph (d)(2) of this
section.
(4) From the result in paragraph (d)(3) of this section, subtract
the sum of all your prior Distributions to SBA under this Sec.
107.1180.
(5) The amount of your Distribution to SBA will be the least of:
(i) The result in paragraph (d)(4) of this section;
(ii) Your current proposed Distribution; or
(iii) Your outstanding Leverage.
(e) Additional Leverage prepayment. On any Payment Date, subject to
the terms of your Leverage, you may make a payment to SBA to be applied
to repayment of the principal of one or more outstanding Debentures in
order of issue, without making any Distribution to your investors.
[[Page 25054]]
Sec. 107.1181 Interest reserve requirements for Early Stage SBICs.
(a) Reserve requirement. If you are an Early Stage SBIC with
outstanding Leverage, for each Debenture which requires periodic
interest payments to SBA during the first five years of its term, you
must maintain a reserve sufficient to pay the interest and Charges on
such Debenture for the first 21 Payment Dates following the date of
issuance. This reserve may consist of any combination of the following:
(1) Binding unfunded commitments from your Institutional Investors
that cannot be called for any purpose other than the payment of
interest and Charges to SBA, or the payment of any amounts due to SBA;
and
(2) Cash maintained in a separate bank account or separate
investment account permitted under Sec. 107.530 of this part and
separately identified in your financial statements as ``restricted
cash'' available only for the purpose of paying interest and Charges to
SBA, or for the payment of any amounts due to SBA.
(b) The required reserve associated with an individual Debenture
shall be reduced on each Payment Date upon payment of the required
interest and Charges. If you prepay a Debenture prior to the 21st
Payment Date following its date of issuance, the reserve requirement
associated with that Debenture shall be correspondingly eliminated.
(c) Your limited partnership agreement must incorporate the reserve
requirement in paragraph (a) of this section.
Sec. 107.1182 Valuation requirements for Early Stage SBICs based on
Capital Impairment Percentage.
(a) If you are an Early Stage SBIC, you must compute your Capital
Impairment Percentage and determine whether you have a condition of
Capital Impairment in accordance with Sec. Sec. 107.1830 and 107.1840
of this part.
(b) You must promptly notify SBA in writing if your Capital
Impairment Percentage is at least 50 percent, even if your maximum
permitted Capital Impairment Percentage is higher.
(c) Upon receipt of your notification under paragraph (b) of this
section, or upon making its own determination that your Capital
Impairment Percentage is at least 50 percent, SBA has the right to
require you to engage, at your expense, an independent third party,
acceptable to SBA, to prepare valuations of some or all of your Loans
and Investments, as designated by SBA.
0
16. Amend Sec. 107.1810 by revising paragraphs (f)(2)(ii) and (iii)
and adding paragraphs (f)(2)(iv), (f)(11), (f)(12), and (j) to read as
follows:
Sec. 107.1810 Events of default and SBA's remedies for Licensee's
noncompliance with terms of Debentures.
* * * * *
(f) * * *
(2) * * *
(ii) Payments from Retained Earnings Available for Distribution
based on either the shareholders' pro-rata interests or the provisions
for profit distributions in your partnership agreement, as appropriate;
(iii) Distributions by Participating Securities issuers as
permitted under Sec. Sec. 107.1540 through 107.1580; and
(iv) Distributions by Early Stage SBICs as permitted under Sec.
107.1180.
* * * * *
(11) Failure by an Early Stage SBIC to meet investment
requirements. You are an Early Stage SBIC and, beginning on the first
fiscal quarter end when your cumulative total Financings (in dollars)
are at least equal to your Regulatory Capital, you have not made at
least 50 percent of such Financings to Small Businesses that at the
time of your initial Financing were ``early stage'' companies, as
defined under the definition of Early Stage SBIC in Sec. 107.50 of
this part.
(12) Failure by an Early Stage SBIC to maintain required interest
reserve. You are an Early Stage SBIC and you fail to maintain a
sufficient reserve to pay interest and Charges on your Debentures as
required under Sec. 107.1181 of this part.
* * * * *
(j) Additional SBA remedies applicable to Debentures issued by
Early Stage SBICs. If you are an Early Stage SBIC, upon SBA's payment
pursuant to its guarantee of any of your Debentures, SBA shall have the
following additional rights and you consent to SBA's exercise of any or
all of such rights:
(1) To prohibit you from making any additional investments except
for investments under legally binding commitments you entered into
before such payment by SBA and, subject to SBA's prior written
approval, investments that are necessary to protect your investments;
(2) Until all Leverage is repaid and amounts related thereto are
paid in full, to prohibit Distributions by you to any party other than
SBA, its agent or Trustee;
(3) To require all your commitments from investors to be funded at
the earliest time(s) permitted in accordance with your Articles;
(4) To review and re-determine your approved Management Expenses;
and
(5) To the appointment of SBA or its designee as your receiver
under section 311(c) of the Act for the purpose of continuing your
operations.
0
17. Amend Sec. 107.1840 by revising paragraph (d)(3)(iii) and
paragraph (d)(4) introductory text to read as follows:
Sec. 107.1840 Computation of Licensee's Capital Impairment
Percentage.
* * * * *
(d) * * *
(3) * * *
(iii) Except as provided for Early Stage SBICs in Sec. 107.1845,
such financing occurred within 24 months of the date of the Capital
Impairment computation, or the Small Business's pre-tax cash flow from
operations for its most recent fiscal year was at least 10 percent of
the Small Business's average contributed capital for such fiscal year.
(4) Except as provided for Early Stage SBICs in Sec. 107.1845,
perform the appropriate computation from the following table:
* * * * *
0
18. Add Sec. 107.1845 to read as follows:
Sec. 107.1845 Determination of Capital Impairment Percentage for
Early Stage SBICs.
This section applies to Early Stage SBICs only. Except as modified
by this section, all provisions of Sec. 107.1840 apply to an Early
Stage SBIC.
(a) To determine your Class 2 Appreciation under Sec.
107.1840(d)(3), use the following provisions instead of Sec.
107.1840(d)(3)(iii):
(1) Such financing occurred within 24 months of the date of the
Capital Impairment computation. At the end of the 24 month period
following the financing, you may request SBA's written approval to
retain the use of the original Class 2 Appreciation on the investment
for up to 24 additional months.
(2) In considering your request, SBA may obtain its own valuation
of the investment, require you to obtain a valuation performed by an
independent third party acceptable to SBA, and may consider any other
information that it deems relevant. To the extent that the valuation
and any other relevant information conclusively support the original
Class 2 appreciation, SBA may approve an extension to use all or part
of the original Class 2 Appreciation for up to an additional 24 months
(the ``extension period'').
(3) At the end of any extension period, you may submit a new
request to retain the use of the original Class 2 Appreciation,
repeating the steps in paragraphs (a)(1) and (2) of this section.
[[Page 25055]]
(4) SBA may reconsider its approval to retain the use of the
original Class 2 Appreciation at any time based on information that may
affect the value of an investment.
(b) Any time you submit a request for SBA approval to retain the
use of the original Class 2 Appreciation under paragraph (a) of this
section, you may also request SBA's written approval to modify your
computation of Adjusted Unrealized Gain under Sec. 107.1840(d)(4) as
provided in paragraph (c) of this section.
(c) If SBA determines that the appreciation on an investment, based
on its current fair value, is at least two times the original Class 2
Appreciation on the investment, SBA may allow you, based on relevant
information, to compute your Adjusted Unrealized Gain for the duration
of the extension period as follows:
(1) Compute Adjusted Unrealized Gain in accordance with Sec.
107.1840(d)(4).
(2) If your result in paragraph (c)(1) of this section was computed
using the first line of the table in Sec. 107.1840(d)(4):
(i) Calculate 50 percent of the original Class 2 Appreciation on
the individual investment that is the subject of this paragraph (c),
and
(ii) Add it to the result from paragraph (c)(1) of this section to
determine your Adjusted Unrealized Gain.
(3) If your result in paragraph (c)(1) of this section was computed
using the second line of the table in Sec. 107.1840(d)(4):
(i) Calculate 50 percent of the original Class 2 Appreciation on
the individual investment that is the subject of this paragraph (c).
(ii) Subtract your Class 1 Appreciation from your Net Appreciation,
and multiply the result by 50 percent.
(iii) Add the lesser of (c)(3)(i) and (ii) of this section to the
result from paragraph (c)(1) of this section to determine your Adjusted
Unrealized Gain.
Karen G. Mills,
Administrator.
[FR Doc. 2012-10120 Filed 4-26-12; 8:45 am]
BILLING CODE 8025-01-P