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an integral part of our free enterprise system, particularly with reference to the subject of whether or not the small business investment company is really helping small business or whether it has developed into an unnecessary adjunct of this otherwise very fine operation.
As I have said in the past, “let the chips fall where they may" in arriving at this goal while keeping in mind what is best for our citizenry at all times. I feel that we should also consider the economic and efficient operations of our Federal Government—the proper use of our dwindling supplies of dollars coupled with the dwindling individual purchasing power. All of these things come within the function of this Committee on Government Operations and our Subcommittee on Investigations which is charged by the Senate to undertake studies of this kind. I welcome the opportunity, Mr. Chairman, to go into this very interesting aspect of our Federal operation.
Senator HARRIS. Thank you, Senator Mundt, for your emphasis on the long and continuing interest of Congress in the small business of America, a statement with which I certainly agree, and for your delineation of the legislative history of small business measures which will be helpful to the subcommittee in its work.
The subcommittee is pleased to have as our first witness, Mr. Bernard L. Boutin, Administrator of the Small Business Administration, to whom I referred in my earlier statement.
Mr. Boutin, we are pleased to have you here, and you may, if you like, have any of your assistants come forward and sit with you at the table there if that would be helpful. I understand you have a prepared statement and so you may proceed as you desire.
TESTIMONY OF BERNARD L. BOUTIN
(The witness was sworn at a later point in the proceedings.)
Mr. BOUTIN. Thank you very much, Mr. Chairman and members of the committee.
My brief remarks will be directed mainly to the problems in the small businesss investment company program, where we stand today and what my current and future plans are.
The premises on which Congress based this program, in my opinion, are still valid. Small business requires equity capital and long-term loans. The SBIC program is a vehicle to fill this need.
As of September 30, 1965, there were about $462 million in private capital invested in licensed SBIC's—far more than the $274 million in Government funds made available to these companies as of May 31, 1966. The SBIC industry has made over 20,000 investments in small firms for a total of nearly $1 billion since 1958.
As of September 30, 1965, the SBIC's had an outstanding investment in small businesses of over $550 million and, for the first time, showed a combined profit from operations and realized gains. This profit was $4.6 million for the 6-month period for the 637 companies reporting:
In the 21/2-month period that I have been Administrator, I have spent many hours in evaluating this program. I fully realize that every effort must be made to resolve the problems which plague itif it is to fulfill the high hopes that Congress, America's small busi
nesses, and the Small Business Administration, have had for the program from the very beginning.
I have discussed these problems before two other committees of the Congress-the Subcommittee on Small Business of the Committee on Banking and Currency, U.S. Senate, and the Select Committee on Small Business, House of Representatives.
We have also been as helpful as possible to this committee, and we will continue to cooperate, and to cooperate fully. We recognize that we do not have all of the answers to all of the problems. We appreciate the advice and counsel of this committee.
For example, your staff brought the matter of a problem SBIC to our attention. We investigated the case, determined that violations had occurred, and the Government recovered all of its funds. The company will now surrender its license, liquidate, and dissolve.
Frankly, the problems in the program stem from two sources, some companies in the industry and SBA management of the program.
As of June 30, 1966, our best information is that there were 237 companies categorized as “problems"-ranging from financial difficulties due to investment losses, to criminal violations. The Government's investment in these companies amounts to $68.5 million with private capital of $108.9 million. I have not indicated here the Government's estimated possible loss for several reasons. First, our present loss estimates were made about a year ago and are out of date. Secondly, the speed and the methods employed in computing these losses raise serious doubt in my mind about their adequacy and accuracy. When we have full information upon which we may rely, as a result of actions which I have taken, we will be in a position to establish more accurate estimates.
At this juncture, I would like to outline the major problems and indicate what actions have been taken, and those planned.
Previous standards and procedures allowed unqualified licensees to enter the program. A freeze on licensing was instituted on July 7, 1964, and lasted for 90 days. New and higher standards were established October 16, 1964, and codified in our regulations March 19, 1965. During fiscal years 1965 and 1966, only 25 new licenses were issued while 61 licensees left the program.
Under the new procedures, each individual to be associated with an SBIC in any important capacity is thoroughly checked.
We have agreements with the Department of Justice, Securities and Exchange Commission, Internal Revenue, and other supervisory and regulatory agencies, particularly those in the financial field, for this purpose. We make personal calls on people who have done business with the applicants, to determine their record and reputation for ethical dealing. The principals of a proposed SBIC must meet in person with the Deputy Administrator for Investment, to go over in depth their plans for management and operation of the SBIC. When a license is granted, we now require an examination within 6 months or before that time when any Government funds are to be disbursed
to the new company. We are considering adopting even higher standards for new licensees, as well as requiring present licensees to meet the new standards within a reasonable time.
CHANGE OF CONTROL
Under previous procedures, a change in control was often not reported to SBA until after it had occurred. In some cases, this was too late for the proper protection of the Government investment. Consequently, new and tighter controls were instituted February 17, 1966. Prior approval by SBA is now required. The controlling person who sells without approval may in some circumstances be held personally liable if the new control parties are not approved by us. The new principals must now meet the same higher standards, including the same check with regulatory agencies, and a personal meeting with the Deputy Administrator for Investment, as they would if they were applying for a new license.
Operating an SBIC is a difficult and complex undertaking. Unqualified managers quickly encounter difficulties because of lack of background and experience. We will shortly issue lending guidelines to stimulate sound and prudent financial techniques for loans and investments made by all SBIC's. We will insist that the licensees adopt businesslike practices and have qualified full-time management. We will check their adherence to these requirements through our system of examinations.
ACCOUNTING PRACTICES OF SBIC'S
Difficulty has been experienced because of the manner in which SBIC's have handled their accounting records. These relate mainly to retained earnings, dividends, establishment of loss reserves, and repayment or recasting of obligations of small business concerns. We expect that our expanded examinations system, close surveillance and new and revised reporting requirements, which are discussed later, will solve this problem.
INACTIVE OR DORMANT LICENSEES
Some licensees have made little or no effort to make loans to small businesses. We will try to activate these SBIC's. If they fail to respond we will proceed rapidly to remove them from the program. There were 61 such companies as of June 30, 1966, of which 37 are in the process of surrendering their licenses at this time.
CONFLICTS OF INTEREST
Conflict-of-interest transactions, or self-dealing, were covered by an agency regulation as early as December 4, 1958. Following a statutory amendment on February 28, 1964, an implementing regulation in considerably expanded form was adopted by SBA on January 15, 1965. The amendment and the regulation cover not only transactions with people connected with the SBIC itself, but also transactions with people connected with any other SBIC. Thus, cross-dealing as well as self-dealing is now forbidden. However, provision is made for appeal to SBA for approval where the affiliation may be fortuitous and is clearly not to the prejudice of SBA or the SBÍC. All approvals granted by SBA must be published in a local newspaper, and are also summarized in a periodical release to the SBIC industry.
When more than one SBIC is directly or indirectly controlled by the same individuals, abuses such as conflicts of interest or excessive leverage with Government funds may arise. Our regulation prohibits such multiple control without prior agency approval. I think our rule is adequate. We will move aggressively to eliminate any of these abuses and I will do my level best to prevent future occurrences.
INADEQUATE PRIVATE INVESTMENT
We have found cases where the founders of an SBIC used borrowed money for the required private investment. They then repaid the loan by causing the SBIC to finance one of their own companies. In a few cases, this became a complex of SBIC's, where funds were advanced to another company, whose principal than used the money to start another SBIC, and so on.
Regulations forbidding this practice have been clarified and strengthened. Also, in licensing a new company we now require a certification by the principals, disclosing whether they are using borrowed money to buy stock. In case loans are used, we now have minimum net worth requirements for principals which must be met or the license is not granted. Similar requirements govern any proposed purchase of control stock by a new party.
The act and our regulations limit the financing of a small business to not over 20 percent of the SBIC's statutory capital, unless prior approval of SBA is obtained. SBA does occasionally allow overlines of moderate amount when the licensee is in good financial condition and the reason advanced are sufficiently pressing, as, for instance, to protect a previous investment.
REAL ESTATE LOANS
When the program began, there were no restrictions on investments of a real estate nature by SBIC's. However, it became evident that an unduly large proportion of portfolio investments were in this field. In July 1964, SBA ceased licensing SBIC's which specialized in real
New licensing standards, adopted in October 1964, limited real estate financing to one-third of a portfolio. In September 1965, new regulations were adopted which restated and strengthened our rules against speculative real estate financing. Also, all SBIC's not originally licensed as real estate specialists were required to adhere to the one-third limitation, and to bring their portfolios down to that percentage as payoffs occur, if they were in excess when the rule was adopted. We are now studying the possibility of eliminating such financing from the program entirely.
A loan for relending occurs when an SBIC lends money to a company whose business activity involves the investing or relending of that money. An SBIC has been classically prohibited from lending funds other than for the growth, expansion, or modernization of the small business concern. Our regulation which prohibits relending is basically sound. I intend to see that it is rigidly enforced.
INFORMATION LAG AND DEFICIENCY Some SBIC's do not report to SBA on their operations as required. We will move to suspend the licenses of these companies. Reports from other SBIC's were and are not sufficiently complete and accurate for useful program analysis and management.
We have taken action to correct that. A new format for the semiannual report 468 was developed and the first such report is due September 30, 1966. A new report called Program Evaluation Report 684 will give additional detailed information on portfolio companies. The first report was due on May 31, 1966. The revised and new reports will give us better tools for the management of the program. With the action taken to improve examination procedures, which I will discuss shortly, we will now have four annual opportunities for review:
1. A semiannual report on form 468 which need not be audited independently.
2. A yearend report on form 468 which must be audited by an independent accountant.
3. 684 Program Evaluation Report.
EXAMINATION AND INVESTIGATION DEFICIENCIES
Examination of SBIC's authorized by law were not conducted in the past with sufficient frequency or in enough depth. This plus the fact that investigations, also authorized by law, were often delayed, hampered our efforts in bringing cases to a successful conclusion. Both activities were responsible to the Deputy Administrator for Investment.
I have taken the following steps:
A. Effective July 3, I made the Assistant Administrator for Administration directly responsible to me for all audits, inspections, and investigations for all of our programs, including SBIC's.
B. I have directed that an examination of all SBIC's be completed within 120 days.
C. I have directed that each SBIC be thereafter examined at least once each year.
Appropriate resources to accomplish this task will be provided.