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the nature of the game that they would make investments that would grow to be larger, and until their investment impeded their ability to invest in other small business concerns, in other words, where they did not have enough cash available to invest in other small business concerns, that they should be allowed to retain those investments. That was another area.
Then there was another question with respect to stock purchased from underwriters where there was a new issue of a small business investment that came up, it was a highly technical problem with respect to whether it was a firm underwriting or best efforts underwriting. The policy had been that it was a best efforts underwriting, the SBIC would allow the purchase of the stock. If it was a firm underwriting, it would not. There was a fine line of distinction that I felt needed to be clarified.
We introduced what was called a special discretionary portfolio which allowed essentially 20 percent of the assets of the business could be invested on somewhat more liberal terms in the sense that it could be a somewhat shorter term investment or it could be made an insurance company or it could be made a leasing corporation, a few things of that nature which we felt was necessary to give flexibility to the operation.
I might point out this is common to other financial institutions. Insurance companies, for instance, have something comparable to a special discretionary portfolio. I felt it was particularly necessary in the case of these.
I felt that our accounting system for the SBIC's, themselves, not speaking of SBA's accounting system, but I thought it was unduly complex. We required something like 35 schedules and 172 account classifications for a SBIC which might be a one-man operation with very little capital. This required a great deal of accounting help. I thought we could get the necessary information with somewhat fewer schedules and somewhat fewer accounts.
So we made a change of that sort. There was a question with respect to the qualification of retained earnings for additional SBA loans. In other words, if a SBIC made profits, it seemed to me that that profit should become, it should be possible for the SBIC to add that into its capital which would become part of its loan basis.
Senator Munur. Instead of paying its indebtedness to the Government, you mean?
Mr. KELLEY. No. This was in the growth-well, it could make payment to the Government, surely, but this would apply particularly to those smaller SBIC's. There was another means of putting capital into the SBIC. If they realized a profit up to the general borrowing ability and that was a sustainable profit, I felt it should be recognized just as though the SBIC had injected additional cash.
Senator Mundt. Was it part of the goal of the SBA in Washington to get the SBIC's on their feet with their own money so they could operate without Government capital as soon as possible?
Mr. KELLEY. Yes. I would certainly like to have seen more and more of these companies operate without the need of Government capital. Remember, this was an early program. In the early years these companies were still in the process of proving themselves. It
was difficult for them to attract additional private capital in those early years.
That was one of the reasons, as I understand it, that the Congress provided for loans to the SBIC's and also had a termination date on the period on which those loans would be made available. Also, I think one thing in connection with the losses here that we must recognize is that the nature of the loans that SBA made, there are two classes. There is section 302 and section 303.
The section 302 loans are subordinated loans which the statute specifically states shall be subordinated, and these loans hence are not secured, and they are the first loans, they come first in preference above the shareholders.
Apparently it was the thought of Congress that there would be a possibility of some losses taken with that type of loan involved there. What I have said publicly in respect to this is that my regret is not so much that there have been some losses from those who have legitimately been trying to operate a SBIC within the intent of the act, but that some of the losses are caused by the fact that some of the wrong people were allowed to get into the program and operate SBIC's in the first instance.
I think that is the perspective in which we have to think about this.
One of my recommendations made to some of the other committees, too, is that I do not feel that the section 302 loan is a sound loan, as matters have demonstrated it. I believe SBIC loans should be made on the basis of specific portfolio items. In other words, I believe that the SBIC should start up with $500,000 private capital, invest that $500,000 of private funds, then come to the SBA and say: “This is what I have done with my money. Now I would like to borrow from you a certain amount of money against this, and then that the funds be disbursed on a business judgment basis.”
Senator Munds. That kind of proposition has never been put into operation ?
Mr. KELLEY. No, we made a start at it, Senator, but I think it would take legislation to throw it fully into operation because the 302 loans are provided as a matter of statute to be subordinated loans. What we did do was provide—we would not make a 302 loan until we had seen what had been done with at least 40 percent of the statutory capital.
In the case of new SBIC, we would examine that first, and we would also make an examination in any case before a disbursement of 302 funds was made. That still does not overcome the basic problem of whether a 302 loan or that concept is a sound concept. I am inclined to think it should be changed by statute.
Senator MUNDT. Were you in control or Assistant Administrator at the time the SBIC made a loan to the Growth Industry Corp. of $100,000 after it was in a 107-percent deficit position ?
Mr. KELLEY. I don't know when that loan was made, Senator.
Mr. KELLEY. I seo; he has a date actually. He has some rate of disbursements from October 1, 1965, through May 30, 1966. So it must have been within that period.
Senator MUNDT. That is right. The date is on top. How do you justify making a loan of that magnitude to a company which is already 107 percent in arrears?
Mr. KELLEY. The only way I could justify that, and I don't know the circumstances in this particular case, would be that we might have thought that by making the additional loan it would make it possible for the company to recover on some good investments that it had which it would not otherwise recover on; hence, we would not take a loss. I cannot state for a fact that is the case because I don't happen to know the circumstances surrounding this company. It was not brought to my attention.
Senator MUNDT. On December 16, 1965, this disbursement of $111,255 was made to a company that was 7 percent worse off than in bankruptcy.
Mr. KELLEY. There was also one element, too, that I didn't mention. At times the reports that we received in the first instance were subsequently modified and were not completely accurate at the time. That might be that situation, too. I can only conjecture. It may have been a goof.
Senator MUNDT. I don't know as to the accuracy, but the information came from the SBA office.
Mr. KELLEY. I understand. Whether or not the report the company submitted at the time the disbursement was made showed 107 percent, I could not say.
Senator MundT. I believe you were also the Deputy Administrator when we had the Frontiers Capital Corp. difficulty. At the time that Mr. Phelan, James Thomas Phelan, was director of the office of eastern area SBIC operation, were you Deputy Administrator then?
Mr. KELLEY. I believe so, yes.
Senator MUNDT. You probably heard the discussions this afternoon dealing with paragraph 10 of the examination report of November 19, 1965, in which, after finding all kinds of violations, they simply made a recommendation that there be a conference between the violators and SBA. In fact that was not even done because the testimony was that it seemed so futile so that nothing was done for a period of several months.
Mr. KELLEY. That case was not brought to my attention, Senator. I am at somewhat of a loss to explain why there was that much delay involved in that.
Senator MUNDT. If you would not get them as Deputy Administrator, would the Administrator get them? What did they do with the problem cases if they didn't come up to the high levels of SBA?
Mr. KELLEY. Generally speaking, the delegation would be either to the director of eastern operations or to my assistant. My assistant tried to bring most of these cases to my attention that he thought I should know about. I don't happen to recall that this one was.
Senator MUNDT. Your testimony is that this case, known as the Frontiers Capital Corp., bad as it was, and occurring as it did under your administration, was not brought to your personal attention ?
Mr. KELLEY. I will correct my testimony in this respect. It was brought to my attention within the last, I would say, 6 or 8 months.
Senator MUNDT. Why was not some immediate action taken in a case of that kind! It was brought to the attention of SBA by the Comptroller General. The examiner did a very sorry job. Then several months elapsed after it was brought to your attention. Then some delay was had before our committee got into the act.
Mr. KELLEY. I think the problem was that our staff of people conducting investigations was overloaded and we were also looking for a new man to head the investigatory unit. We had had many investigations started in the past that seemed to kind of go around in circles. We wanted to be sure that any investigation we started would result in the type of information that could be used by the Office of General Counsel in bringing a suitable action. There was some delay involved during that period while we were seeking a man to head that operation. Mr. Levine in fact is the man who took over and has done a very fine job since he did take over.
Senator Mundt. You served as Deputy Administrator, I think you said, very briefly under Mr. Boutin. To all intents and purposes you did not have a period of service with him.
Mr. KELLEY. That is right.
Mr. KELLEY. He is the Assistant Secretary of Commerce or an Assistant Secretary of Commerce, Senator.
Senator MUNDT. How about Mr. Ross Davis ?
Mr. KELLEY. Mr. Ross Davis is Economic Development Administrator at the Department of Commerce.
Senator MUNDr. Still associated with Mr. Foley? Mr. KELLEY. That is correct, sir. I might point out, Senator, that Mr. Foley is responsible for giving me a Superior Service Award for the agency, highest award in the agency.
Senator MUNDT. Say that again.
Mr. KELLEY. Mr. Foley gave me the highest award in the agency in 1965, Superior Service Award.
Senator MUNDT. I misunderstood you. I thought you said it was under his administration the agency got a high efficiency award.
Mr. KELLEY. No.
Senator MUNDT. You stated that you would like to have the examinations undertaken to see if the companies were there; this was in your statement. Did you find some places where the companies weren't there?
Mr. KELLEY. I think we need to clarify there, Senator, what company we are talking about. Whether we are talking about the SBIC or the portfolio companies of the SBIC.
Senator Mundt. I took this from your printed statement. I thought you meant the portfolio company.
Mr. KELLEY. I think both instances apply. We had some instances where we could not locate the SBIC. That would be one circumstance. Fortunately a relatively few, but some. Then other instances where
Senator MUNDT. Were those instances where you had Government money involved ?
Mr. KELLEY. Some of them, yes.
Senator MUNDT. You could not find the company. What did you do about those ?
Mr. KELLEY. We then conducted an investigation and where there was not a good explanation, they were referred to the Department of Justice if we felt there was any fraud involved, either criminal or civil. If it was a less severe case, we would bring adminstrative action of some sort.
Senator MUNDT. Did you refer any cases to the Department of Justice?
Mr. KELLEY. Yes.
Senator MUNDT. What action ensued? Were there any convictions?
Mr. KELLEY. This is one of the frustrating aspects of the job, Senator. We referred many cases to the Department of Justice, and they would sit for a long period of time. I did talk to one of the assistant attorneys general with respect to this problem. I did not get too much satisfaction. Then we tried working within the Department at a somewhat lower level to see if we could get the matter straightened out, again without too much success. The Department seemed to be very loaded. It was pointed out to me they had 13,000 cases and our 40 or 50 or 60 were a relatively small portion of that. We tried many different approaches. We sent over some for what we called cross-dealing situations where there was multiple cross-dealing. We thought possibly to the extent there might even be fraud involved there, although the direct cross-deal was not then a violation of our regulations- it now is.
One case I remember involved 18 companies, and it was over there for a year's time, and then it was subsequently sent back as not having a case. In the meantime, we lost all of this time. We were prohibited from dealing with these companies as long as it was at the Department of Justice. In other words, we could not conduct further investigation or negotiate with them in any way.
Then we thought, well, maybe we can work this on money judgments and get a quicker action from the Department that way. So we tried to bring action which was primarily we will say for default in paying interest. We sent over five cases with respect to that sort of thing and they have been over there for 2, over 2 years.
Senator MUNDT. Have you ever gotten a conviction through the activities of the Department of Justice on any of the cases you have sent them?
Mr. KELLEY. To the best of my knowledge, the only cases in which we got convictions were those in which SBA had done 90 percent of the work. There were very few convictions that came out
Senator MUNDT. You mentioned you sent down about 40 to 60 cases altogether, if I understood you right.