TESTIMONY OF ELMER B. STAATS, RALPH RAMSEY, ARTHUR SCHOENHAUT, MAX NEUWIRTH, AND FRANK MEDICO

Senator HARRIS. Would you identify yourself for the record, please, and your associates?

Mr. STAATS. On my immediate left is Mr. Ralph Ramsey, of our General Counsel's Office. He has been concerned with this problem. To my right is Mr. Arthur Schoenhaut, Deputy Director of our Civil Accounting and Auditing Division.

Next is Mr. Max Neuwirth, Assistant Director, and Mr. Frank Medico, Assistant Director, in that order.

Mr. Chairman, I have a prepared statement.

With your permission I will read it and be happy to attempt to answer any questions that you have.

Senator HARRIS. Very well.

Mr. STAATS. We appear before this subcommittee today at the request of the chairman to apprise you of the results of our review of certain aspects of the small business investment company (SBIC) program administered by the Small Business Administration (SBA). Our review was directed principally toward (1) the effectiveness of actions taken by SBA with respect to SBIC's in financial difficulty; and (2) the effectiveness of SBA's system of management control over the SBIC program. Also, we are currently reviewing the effectiveness of SBA examinations of SBIC's and we believe our preliminary findings on this review will be of interest to the subcommittee.

I might stress that this particular part of our report is still in the preliminary stage, but we felt it would be helpful to the committee to have the progress report and our findings to date.

Before proceeding we would like to briefly present some general background information about the small business investment company program. The purpose of the program is to improve and stimulate the national economy, in general, and the small business segment thereof in particular, by stimulating and supplementing 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.

The Small Business Investment Act of 1958 provides for the establishment of SBIC's, subject to the approval of SBA, for the purpose of providing equity capital and making long-term loans to small business concerns. To assist in the formation and growth of SBIC's, SBA is authorized to provide funds to such companies within certain limits. SBA is also authorized to prescribe regulations governing the operations of SBIC's and to carry out the provisions of the act. SBA's major duties and responsibilities with respect to the SBIC's include: (a) Approving articles of incorporation;

(b) Issuing licenses;

(c) Making loans and investments; and

(d) Performing examinations and investigations to determine compliance with legal and regulatory requirements.

The Small Business Investment Division of SBA, established by the 1958 act, is responsible for carrying out the SBIC program. The division is headed by a Deputy Administrator who is appointed by the

Administrator of SBA. The program is administered through the division headquarters in Washington and through eight area offices in the field. As of June 30, 1966, there were 98 employees at headquarters and 30 employees in the field directly involved in the SBIC

program.

SBA financial records do not provide accurate, complete, and current information on the status of its loans and investments in SBIC's or the financial condition of these companies. For example, financial records show that funds are due from companies which in some instances had been out of existence for 1 or 2 years, and there are substantial unreconciled differences between summary control account balances and the totals of amounts of individual loans and investments. We are currently looking into the causes of these accounting problems, and have offered to assist SBA in developing an accounting system that will meet the prescribed principles and standards of our Office and provide management with the type of information it needs to help administer all of the SBA programs.

The best information available from SBA indicates that SBA had provided SBIC's with funds totaling about $290 million from inception of the program through April 30, 1966; repayments and other credits totaled about $27 million, leaving a balance of about $263 million due SBA from 699 SBIC's. These funds of about $263 million consisted of $150 million of debentures purchased from the SBIC's under section 302 of the act, and $113 million in operating loans made under section 303 of the act.

The most recent compilation by SBA of financial statements received from 637 of the 708 SBIC's licensed as of September 30, 1965, shows that the SBIC's were being financed with about $435 million of private capital. As of that date, the reporting SBIC's had loans and investments outstanding totaling about $558 million.

Many of the SBIC's have been experiencing finanical and other difficulties and are considered as problem cases by SBA. The number of these cases have been increasing. Problem cases are those SBIC's designated by SBA as requiring special attention because of such reasons as litigation, significant deficits resulting from operations, and investigations in process by SBA. These are listed in detail, Mr. Chairman, in our report.

Between October 1964, which is the time the first problem case list was compiled by SBA, and April 1966, the number of SBIC's classified by SBA as problem cases increased from 129 with about $35 million in SBA funds, to 232 SBIC's with about $67 million in SBA funds-this 232 I believe Mr. Boutin testified this morning had risen to 237, as of June 7-the number of SBIC's decreased from 722 to 699 during this same period, though I believe the current figure is 686.

We noted that as of September 30, 1965, which is the date of the latest information available, there were 637 reporting SBIC's of which 351 had deficits. Of these, 149 SBIC's had deficits exceeding $50,000. The latest information compiled by SBA shows that between March. 1964 and September 1965, the number of SBIC's with deficits of at least 30 percent of private capital increased from 82 to 122 and the SBA funds in such SBIC's increased from about $24 million to about $43 million.

SBA has followed the practice of considering SBIC's as capitally impaired when accumulated deficits exceed 50 percent of the private capital invested. There have been significant increases in the number of such SBIC's. Between March 1964, which is the date that such information was first compiled by SBA, and September 1965 impairment cases increased from 30 SBIC's with about $7 million of SBA funds to 62 SBIC's with over $22 million of SBA funds. Thus, within a year and a half the number of SBIC's with capital impairments more than doubled and the SBA funds involved more than tripled.

During this same period, the number of other SBIC's with deficits ranging from 30 to 50 percent of private capital increased also from 52 SBIC's with about $17 million of SBA funds to 60 SBIC's with almost $21 million of SBA funds. If the financial condition of these 60 SBIC's continues to deteriorate, it is reasonable to assume that the impairment problem will increase.

The agency estimated as of April 30, 1966, that it expects to incur losses of about $18 million on funds totaling about $37 million invested in 103 SBIC's. We have doubt as to the reasonableness of this loss estimate, since it generally was not determined on the basis of an evaluation of the SBIC's loan portfolios. Also, the estimate has not been substantially revised by SBA since November 1965, although a number of SBIC's have been added or deleted from the lists of prob lem cases since that time.

Because of the increasing trend in the number of SBIC's having financial difficulties, we examined into certain aspects of SBA's policies and practices with respect to such SBIC's and selected 6 of the 62 SBIC's with capital impairments at September 1965. The six SBIC's we selected are of varying sizes, including a large publicly held company and are located in various sections of the country. These 6 SBIC's had about $5.6 million or about one-fourth of the total SBA funds invested in the 62 SBIC's. Details concerning these six cases are included in the report submitted to the chairman of the subcommittee on August 1, 1966. Selected highlights of these cases are included in an attachment to this statement. We believe that SBA could improve its administration of the SBIC program by (1) establishing lending criteria for use by the SBIC industry and, (2) strengthening its management control system. In testimony before two other interested committees of the Congress, the SBA Administrator indicated general concurrence with the need for these improvements. He so restated in his testimony this morning, Mr. Chairman. Our views with respect to each of these matters follow.

SBA had not issued criteria to guide SBIC's in making sound value loans and investments in small business concerns to carry out the requirements of the Small Business Investment Act of 1958 that longterm loans to small business concerns shall be of such sound value, or so secured, as reasonably to assure repayment. In contrast, criteria have been established for direct business loans made under the Small Business Act concerning the sound value and security of its loans. Although the Small Business Investment Act provides for furnishing equity capital to small business concerns, it does not contain a sound value provision. We believe that when Government funds are in

volved, criteria should be established by SBA for guidance of the SBIC's in making sound equity investments.

The need for criteria is also indicated by the lending practices followed by the SBIC's included in our review. For example, as of September 30, 1965, one SBIC had made loans and investments to 11 small business companies totaling about $540,000, of which it anticipated it would lose about $284,000 or 53 percent of the funds advanced to these concerns. An SBA examiner reported that one of the SBIC officials informed him that credit standing of potential borrowers had not been a factor in making investments; applicants were not properly screened as to past performance; a thorough analysis was not made as to whether the money to be loaned could do the job properly or if the amount so loaned was sufficient; and there was no followup to see where the money was going or to see that it was actually being used for the purpose purported in the loan application. Similar practices were noted with respect to other SBIC's included in our review. As of September 30, 1965, the six SBIC's included in our review made loans and investments totaling over $15 million in 93 small business concerns, of which over $5 million, or one-third of the funds advanced to these concerns is not expected by the SBIC's to be repaid.

Officials of two SBIC's informed us that issuance of lending criteria by SBA would be feasible and of benefit to the industry as a whole. They stated that such criteria would assist managers with limited investment background and would guide others in making appropriate inquiries before approving loans to small business concerns. These two SBIC's followed a practice of making studies of the business condition of the loan applicant and the financial potential of the business before making loans. In addition, a recent study of bank-affiliated SBIC's sponsored by the American Bankers Association disclosed that the larger SBIC's frequently require information similar to that required by the two SBIC's referred to above.

We believe that lending criteria for use by the SBIC industry should include such items as customer surveys, competition, market trends, plant management, earnings, proposed financing and qualifications of key personnel. To provide SBIC's with flexibility in applying these criteria, they should be designed to provide a reasonable basis for evaluating applications for loans of varying sizes. It is our view that such criteria should contribute to the growth and progress of this program by assisting SBIC's in making sound investments and loans. In addition, the criteria would provide SBA personnel with a reasonable basis for appraising the loan practices and operations of SBIC's which should improve the administration of the program and provide a means for protecting the Government's interest.

Our findings with respect to SBA's management control system are summarized below.

(1) SBA did not make effective and timely evaluations of the operations of SBIC's during their early years to determine whether their lending policies and practices would further the objective of the SBIC

program.

(2) SBA generally did not express concern about the deficit positions of SBIC's until the deficits exceeded 50 percent of the privatecapital invested. After the deficits exceeded this regulatory limit,

SBA's efforts were directed primarily toward reducing the deficits under such limit. SBA as a rule did not determine the causes for SBIC's continuing financial deterioration so that appropriate action could be taken. SBA's recommended solutions generally consisted of a request that the SBIC's obtain cash donations or additional capital from stockholders, or concurrence in actions planned by SBIC's which had little effect in improving their financial condition.

(3) SBA placed heavy reliance on correspondence with SBIC's, rather than on making on-site visits to evaluate the loan practices of the SBIC's and to ascertain the causes and extent of their financial problems. Generally, replies received from the SBIC's were not responsive, but SBA did not obtain supplementary or clarifying data. Therefore, effective evaluations and appropriate decision could not be made of the SBIC's operations.

(4) As previously indicated, SBA financial records do not now provide management with accurate, complete, and current data on the status of its loans and investments in SBIC's or the financial condition of these companies.

The actions taken by SBA on the six cases we reviewed resulted in little improvement in the financial condition of the SBIC's from the time they were considered financially impaired. For example, at the time of initial impairment, one of the SBIC's had a deficit of about $226,000, and within 212 years the deficit had risen to about $616,000. In another case the deficit at the time of initial impairment was about $98,000, and within 3 years the deficit had risen to $363,000. We currently have underway a review of the effectiveness of SBA examinations of SBIC's. A report on the results of this review will not be completed until later this year. However, our preliminary findings indicate that in many instances the examinations did not disclose existing problems that were significant and should have been brought to management's attention. The apparent weaknesses in SBA examinations we observed at 24 SBIC's, that were under the cognizance of four of eight SBA area offices, may be categorized as follows:

(1) SBA had not provided its examiners with specific criteria to be followed in evaluating management actions, acceptable collateral, credit standing, past earnings, and estimates of future prospects for successful operation and repayment of loans and investments made to SBIC's. In contrast, detailed instructions have been promulgated to assist SBA personnel in evaluating such factors under SBA's direct business loan program.

(2) There were instances where sufficient data was not available for adequate examination at SBIC's in support of financing decisions and the management of loans and investments. SBA had not set forth specific requirements as to the documentary evidence that SBIC's should have available for examination.

(3) In some instances where evidence did exist indicating possible violations of SBA regulations or transactions that might adversely affect the financial condition of SBIC's, the examiners generally did not note or sufficiently develop and document such matters nor disclose them in their reports as matters for consideration by SBA management.