[Federal Register Volume 59, Number 63 (Friday, April 1, 1994)]
[Unknown Section]
[Page 0]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 94-7847]
[[Page Unknown]]
[Federal Register: April 1, 1994]
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SMALL BUSINESS ADMINISTRATION
Specialized Small Business Investment Companies
AGENCY: Small Business Administration.
ACTION: Notice.
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SUMMARY: The Small Business Administration (SBA) has completed the 3%
Preferred Stock Repurchase Pilot Program for Small Business Investment
Companies licensed under section 301(d) of the Small Business
Investment Act (15 U.S.C. 681(d)) (Specialized SBICs or SSBICs), and
now will offer each currently licensed SSBIC that was not in the Pilot
Program the opportunity to apply for the repurchase of its 3% preferred
stock held by SBA. This Notice sets forth the guidelines SBA is
intending to follow in its implementation of this Repurchase Program.
DATES: This Notice is effective on April 1, 1994 Written comments on
this Notice must be received no later than May 2, 1994.
ADDRESSES: Written comments should be sent to Robert D. Stillman,
Associate Administrator for Investment, U.S. Small Business
Administration, suite 6300, 409 Third Street SW., Washington, DC 20416.
FOR FURTHER INFORMATION CONTACT:George Dale, Investment Division, U.S.
Small Business Administration, 409 Third Street SW., Washington, DC
20416, (202) 205-7595.
SUPPLEMENTARY INFORMATION: On June 19,1992, SBA published a Notice in
the Federal Register (the Pilot Notice) announcing the commencement of
the 3% Preferred Stock Repurchase Pilot Program for Small Business
Investment Companies licensed under section 301(d) of the Small
Business Investment Act of 1958, as amended (Specialized SBICs or
SSBICs). See 57 FR 27503.
Policy Statement
The policy for the Repurchase Program was stated in the Pilot
Notice, and is repeated verbatim as follows:
``SBA's policy is to administer the Repurchase Program in such a
way as to maximize the capacity of SSBICs to provide financing to
businesses owned by persons whose participation in the free enterprise
system is hampered by social or economic disadvantage
SBA will structure each transaction with the aim of:
1. Encouraging and facilitating the investment of new private
capital into SSBICs;
2. Conserving the cash resources of each participant;
3. Conserving the borrowing potential of each participant;
4. Conserving the direct and guaranty budget of the Specialized
SBIC program;
5. Improving the financial status of the participating SSBICs;
6. Rehabilitating (where necessary) weak SSBICs to improve their
financial and operating effectiveness without undue risk to SBA; and
7. Discouraging voluntary liquidations of SSBICs and the premature
surrender of licenses.
The methodology of computing the price at which the 3% preferred
stock is sold back to an SSBIC will be a function of four factors
independent of any SSBIC, and four factors that are variable with each
SSBIC. The independent factors are:
1. Average SBIC Treasury-based 10 year rate,
2. Barron's Junk Bond Spread over Treasury,
3. Preferred stock dividend rate (3%), and
4. The adjustment to the price for non-marketability of shares.
The four factors that are variable with each individual SSBIC are:
1. Number of years that dividends are in arrears,
2. Financial rating of SSBIC, as rated by SBA,
3. Ability of SSBIC to have paid dividends, and
4. Par value of stock to be purchased.
The above policy will be executed in such a way as to prevent
windfall opportunities to SSBICs, their managements, or owners; and to
avoid transfer of cash flows from SSBICs into SBA to the detriment of
the program's effectiveness and liquidity.''
Implementation of the Repurchase Program
In accordance with the Pilot Notice, SBA selected nine Specialized
SBICs which had indicated an interest in participating in the Pilot
Program. The nine licensees represented a cross-section of the
industry, including both financially distressed and non-distressed
companies. SBA considered and structured each repurchase transaction in
accordance with the policy restated above.
Of the nine companies selected to participate in the Pilot Program,
six have completed the repurchase of their stock. Of the remaining
three companies, one withdrew voluntarily, one never submitted an
application, and one was denied participation because of regulatory
violations which would not have been cured by the repurchase.
As stated in the Pilot Notice, the objective of the Pilot Program
was to test SBA's Repurchase Program procedures and to suggest changes
that might facilitate future transactions. Many of the issues raised
during the Pilot Program concerned the following:
1. Development of a formula for determining the repurchase price;
2. Special considerations dependent on the financial condition of
SSBICs;
3. Application of the Repurchase Program to companies which are
involved in change of ownership transactions; and
4. Methods and conditions of financing the repurchase. Approaches
to these issues, and their resolution for the Repurchase Program, are
described below:
1. Repurchase Price Formula
A repurchase price formula was developed in general accordance with
the methodology included in the policy statement repeated above, and
applied to the particular situation of each of the pilot participants.
The formula for the preferred share price was a substitute for fair
market value, since there is no market for these shares. Based on the
recommendations of two independent expert studies, the formula for
computing the percentage of par value to be used in the Pilot Program
was the sum of three elements:
(1) The percentage of par which represented the differential
between an instrument paying 3% and the ``all-in'' cost of the June
1991 SBIC funding rate. This differential represented a discount from
par, since a 3% return was significantly below the market rate at June
1991. The percentage of par value remaining after subtracting the
discount computed to 32.05%.
(2) An adjustment based on the financial rating of the particular
SSBIC, plus an adjustment based on a junk bond spread over Treasures,
plus an adjustment for lack of marketability of the 3% preferred stock.
In practice, these adjustments added only 2% to 4% to the price for
individual companies in the Pilot Program.
(3) The third element represented the present value of the benefit
to the SSBIC from deferring payment of preferred dividends which it had
the capacity to pay.
In view of the very small effect of the second element on overall
valuation, the complexity of its computation, and the extent of
financial data and analysis required for its determination, SBA has
decided to substitute a fixed input of 3% for the Repurchase Program.
This was the midpoint of the range of adjustments for this element in
the Pilot Program.
SBA also determined that the third element may be duplicative of
the continuing obligation of a licensee to pay accrued dividends under
certain conditions enumerated herein. Consequently, only the first two
elements will be utilized in determining the price for the preferred
shares being repurchased.
For the Repurchase Program, SBA intends to fix the sum of the two
elements at 35% of par value, using the June 1991 interest rate inputs
in recognition of the extended delay in completing the Pilot Program.
Thus, the price to be paid by any SSBIC repurchasing 3% preferred stock
under this Program will be 35% of par. This compares with a range of
repurchase prices calculated for all of the pilot participants of
34.6554% to 36.2257% of par value.
To avoid a windfall, and to assure the desired result of retaining
funds in an active SSBIC program, repurchases below par during the
Pilot Program were made on condition that if the licensee became
inactive or was liquidated during a five year period following the
repurchase, SBA would have a preferred liquidating interest in the
licensee. SBA intends to continue this practice for the remainder of
the Repurchase Program, as described below under ``Other critical terms
of the repurchase transactions.''
2. Special Considerations Dependent Upon Financial Condition of SSBIC
SBA's evaluation of the Pilot Program has led it to conclude that
in order to be consistent with the stated policy objectives of the
Program, the amount and the timing of any required payment of accrued
dividends should be related to the financial strength of the particular
SSBIC purchasing its preferred stock from SBA.
For an SSBIC which has no practical prospect of making dividend
payments, the Repurchase Program will assist in strengthening the
licensee's financial condition and enabling it to attract new capital.
For those SSBICs which are financially strong enough to make
dividend payments, the program objectives are met if the deferral or
reduction of dividend payments provides an incentive for the SSBIC to
remain active in its investment program, and to defer distributions to
its shareholders.
Accordingly, the following guidelines have been developed to
distinguish between the two categories of SSBICs and to provide for the
treatment of accrued dividends for each category:
(a) Companies which lack any reasonable prospect of paying accrued
dividends are defined as those which, as of the licensee's fiscal year
end immediately preceding the publication of this Notice, have
undistributed realized losses and a capital impairment percentage (as
defined in 13 CFR part 107) of at least 10%. These licensees are
referred to as ``distressed'' for purposes of the Repurchase Program.
For distressed licensees, the accrued dividends will be extinguished
completely at the time of repurchase. This will remove a contingent
liability which would otherwise impede their efforts to raise new
capital. In the distressed licensee's repurchase agreement with SBA,
the company will agree to remain active for a five year period and to
be subject to the guidelines for change of ownership transactions
discussed below.
(b) For the remaining ``non-distressed'' SSBICs, which have a
reasonable prospect of being able to pay accrued dividends, forgiveness
of the dividends by SBA will be used as an inducement to defer
distributions of cash out of the program, either to SBA or the owners.
In these cases, forgiveness is conditioned on their agreement to remain
active in the SSBIC program for a five year period, during which time
the accrued dividends are reduced on a straight-line basis over a
period of five years or the term of any debt incurred to finance the
repurchase, whichever is longer. Distributions to owners may be made
only after paying the remaining dividends payable to SBA. The licensee
will agree to be subject to the guidelines for change of ownership
transactions discussed below.
3. Change of Ownership Transactions
For SSBICs that engage in a change of ownership either before or
after the repurchase of their 3% preferred stock, it is necessary to
avoid having the benefits of the repurchase result in a windfall to the
seller or buyer, rather than increasing the funds available for
investment by the SSBIC. To avoid having a prospective repurchase of 3%
preferred stock affect the purchase price of the company, the following
policy has been adopted:
(a) Where the selling SBIC is ``distressed'', the dividends accrued
at the time of repurchase will be forgiven. The preferred stock may be
repurchased at the formula price, subject to the agreement of the
purchaser to operate as an active SSBIC, and if operations are
discontinued or the SSBIC liquidated within five years, to pay SBA the
amount of its liquidating interest, as described under ``Other critical
terms of the repurchase transactions'' below.
(b) Where the selling SSBIC is not ``distressed'', the remaining
balance of accrued dividends as of the date of the change of ownership
must be paid before any future distributions are made by the licensee.
In addition, the purchaser must agree to the conditions concerning
active operation described in the preceding paragraph.
4. Financing the Repurchase
Since the purpose of the Repurchase Program is to strengthen the
financial condition of SSBICs, the most desirable source of financing
for the repurchase transaction is new capital invested in the SSBIC.
Financing with cash already in the SSBIC is inconsistent with the
policy of avoiding the transfer of cash flows from SSBICs into the SBA.
Experience in the Pilot Program, however, confirmed that new capital is
not available to all participants, particularly those which are in
financial distress. Consequently, payment of the repurchase price for
the participating companies was structured in one of four ways: (1) All
cash, following the raising of new capital, (2) a promissory note
payable to SBA in exchange for the preferred stock, (3) all cash, from
third-party unsecured financing, or (4) a combination of any of the
above.
Where borrowings from SBA or third parties are used to finance the
repurchase, they are intended to provide interim financing while
permanent equity capital is raised. SBA loans made for this purpose
will be at an interest rate which is 2% higher than the Treasury rate
for a comparable maturity, and any such loans must fully amortize if
longer than five years. SBA loans will provide the Agency with a
security interest in the licensee's assets and will contain restrictive
covenants and conditions.
Long-term financing by SBA in the form of guaranteed debentures or
4% preferred stock is intended to be used to increase the capacity of
SSBICs to invest or lend money to small businesses; consequently, it is
inappropriate to use these as sources of financing for the preferred
stock repurchase.
SBA shall, in its sole discretion, determine the form of payment it
will accept for a licensee's 3% preferred stock, including cash or an
amortizing or non-amortizing note, or a combination thereof.
Third party debt used for the repurchase must be unsecured since
granting a security interest in the SSBIC's assets reduces the value of
SBA's liquidating interest.
For licensees financing their repurchase through SBA or a third
party, the liquidating interest held by SBA will amortize over a period
of five years or the term of the repurchase debt, whichever is longer.
It is contemplated that the SSBIC will increase its private capital
by an amount equal to the repurchase price, either from the proceeds of
new capital invested in the SSBIC since April 1, 1993 or through the
permanent capitalization of retained earnings available for
distribution as permitted under program accounting rules. The amount
that may be capitalized for this purpose is limited to profits
generated since the licensee's fiscal year end immediately preceding
the publication of this Notice.
Other terms required in connection with the use of debt financing
of the repurchase are included in ``Other critical terms of the
repurchase transactions'' below.
Further Discussion of the Repurchase Program
The Repurchase Program is intended to strengthen the SSBIC Program
and enable it to provide additional financing to small businesses. It
is not intended to transfer value from SBA to the owners of SSBICs
without consideration. The proposed terms of the Repurchase Program
assure these intentions are fulfilled.
It should be noted that the 3% preferred stock to be repurchased
under the Repurchase Program has no provision for a ``put'' by SBA or
mandatory redemption by the SSBIC. Further, the SSBIC is not required
to pay accrued dividends to SBA; however, distributions to other
shareholders may not be made until any such dividends have been paid.
The repurchase price to be paid for the preferred stock is based on
actual market indicators, and is intended to represent a reasonable
substitute for fair market value, since these securities are not
publicly traded. For an SSBIC which does not intend to liquidate or
transfer ownership in the foreseeable future, the difference between
par value and the repurchase price is an unrealized loss already
sustained by SBA. In this case, the sale itself does not create the
loss.
An SSBIC which intends to liquidate or transfer ownership would be
required, in the absence of the Repurchase Program, to pay its accrued
dividends and repurchase its 3% preferred at par before any liquidating
distributions could be made to its other shareholders. Nevertheless,
there is often insufficient value in the licensee under such
circumstances for SBA to recover the full amount due.
To avoid the opportunity for a windfall through repurchase at a
price below par value and/or the forgiveness of accrued dividends, the
Repurchase Program requires that as consideration for the repurchase,
the SSBIC agree to remain active for a five year period. If the SSBIC
liquidates or becomes inactive prior to the end of this period, it is
required to pay a declining proportion of the difference between the
par value and the repurchase price of the shares. This is consistent
with the purpose of the Program: To encourage SSBICs to continue
investing or lending funds to small businesses.
Similarly, the terms of forgiveness of accrued dividends are
designed to further the purpose of the Program without providing a
windfall to the SSBIC, its owners or management.
In the case of an SSBIC in financial distress, with no reasonable
prospect of paying its accrued dividends, SBA is not surrendering value
when it forgives such dividends. At the same time, the SSBIC program
benefits from such forgiveness because it strengthens the financial
condition of the SSBIC and increases the licensee's opportunities to
secure additional financing or to be acquired by owners who would
commit to remain active in the program.
A non-distressed SSBIC can gain the benefit of the dividend
forgiveness only by agreeing to remain active in the program for five
years, and to pay the dividends on a declining scale during that period
(or during the term of any repurchase debt, if longer) as a
precondition to any distributions to its other shareholders. This
should encourage these SSBICs to defer distributions, and therefore
have greater resources available for investments or loans to small
businesses. Should the SSBIC become inactive, SBA will have the right
to demand payment of the accrued dividends as of the end of the fiscal
year for which the licensee became inactive.
In the event of a change of ownership of an SSBIC, the potential
forgiveness of accrued dividends would be a factor in determining the
purchase price to the new owner. To avoid the possibility that the
benefit of such forgiveness might therefore benefit buyer or seller,
without increasing the financial strength of the SSBIC, the terms of
the repurchase provide that in this case the remaining balance of
dividends accrued as of the date of the ownership change (which may
have been reduced by the terms of the preferred repurchase, if
completed earlier) must be paid, either at the time of sale, or later,
but before any distributions are made by the new owner.
It should also be noted that SSBICs with regulatory violations that
would not be cured by repurchasing their stock at a discount will be
ineligible to participate in the Repurchase Program.
Other Critical Terms of the Repurchase Transactions
SBA has determined that it is necessary to include the following
provisions in the agreements to repurchase 3% preferred stock:
1. To evidence the agreement of the SSBIC to remain active as a
consideration for the opportunity to repurchase, an SSBIC repurchasing
its preferred stock at a discount will be required to grant SBA a
preferential limited ownership interest (the ``liquidating interest'')
in a newly created capital account. As soon as the repurchase is
completed, this account will be credited by the SSBIC in an amount
equal to the discount at which the stock was repurchased. The value of
SBA's liquidating interest in the account will decline on a straight
line basis over time (generally five years or the duration of any
repurchase financing, whichever is longer). In the event of a change of
ownership of the licensee, SBA's liquidating interest continues in
effect on the same terms as would have applied had the change of
ownership not taken place.
The balance in the new capital account may be included in the
licensee's private capital only for purposes of calculating the
licensee's ``overline'' limitation and its capital impairment
percentage.
In order to make the SBA liquidating interest a matter of public
record, the SSBIC will be required to evidence it by an amendment to
its Articles of Incorporation.
2. An SSBIC that finances its repurchase through SBA or a third
party lender will be expected to agree that, during the term of the
financing, or until private capital in the amount of the repurchase
price is raised (whichever is earlier), it will not:
a. Make any distribution in favor of any non-SBA shareholder or
associate (as defined in 13 CFR 107.3) of the licensee, except with the
prior approval of SBA. This is to protect the value of SBA's
liquidating interest.
b. Prepay the financing without SBA's approval. This is intended to
conserve the cash resources of the SSBIC, avoid the use of its idle
funds for the repurchase, and avoid the transfer of cash resources from
the SSBIC to SBA.
c. Apply for new leverage from SBA. This is meant to encourage the
SSBIC to raise new capital for the repurchase. Refundings of existing
leverage would not be restricted by this provision.
d. Grant a security interest in its assets to any party other than
SBA. This is to protect the value of SBA's liquidating interest.
Application Procedure
After considering any comments received concerning this Notice, SBA
will distribute a Policy and Procedure Release to all SSBICs announcing
the commencement of the Repurchase Program and explaining the
application procedures. All licensees with outstanding 3% preferred
stock will then have one year to apply to repurchase their stock from
SBA. No applications will be accepted after that date.
SBA intends to consider applications and process repurchases in the
order in which the applications are received, subject to any special
needs of severely distressed licensees. SBA anticipates that all
repurchases will be completed within three years from the effective
date of the final rule.
Authority: Title III of the Small Business Investment Act, 15
U.S.C. 681 et seq.; 15 U.S.C. 687(c); 15 U.S.C. 683; 15 U.S.C. 687d;
15 U.S.C. 687g; 15 U.S.C. 687b; 15 U.S.C. 687m, as amended by Pub.
L. 102-366.
Dated: March 24, 1994.
Erskine B. Bowles,
Administrator.
[FR Doc. 94-7847 Filed 3-31-94; 8:45 am]
BILLING CODE 8025-01-M