(4) The following shortcomings were noted in the procedures followed by certain examiners:

(a) The reasonableness of the basis for the stated value of collateral securing SBIC loans to small businesses was was not ascertained.

(b) Small business companies which had borrowed from SBIC's were selected for visits by examiners apparently on the basis of proximity to SBIC offices. Such visits were generally not made for the purpose of examining records; they were limited to discussions with company personnel.

(c) Requests were not made for financial statements of borrowers when they were not available at the SBIC's for examination.

(d) Use was not made of the audits of SBIC's that had been performed by independent public accountants.

(5) Examinations of SBIC's have been under the supervision of area program coordinators who are also responsible for (a) encouraging the formation of new SBIC's and reviewing their applications for licenses, and (b) evaluating the operations of existing SBIC's. There would appear to be a need to segregate operating functions from the examination function in order to strengthen internal controls and better insure independent examinations.

We would like to emphasize that our views on the effectiveness of SBA examinations are tentative in that we are still obtaining and evaluating information, and certain matters are still being discussed with agency officials and reviewed within our office.

With respect to our review of certain aspects of the SBA's administration of the SBIC program, we believe that the following specific actions by SBA would substantially improve its administration of the SBIC program and would be beneficial to the SBIC industry, to the small business community, and to the Government.

(1) Establish lending criteria for use by the SBIC's in evaluating prospective portfolio investments in small business companies.

(2) Require adherence to such criteria by incorporating them in the SBA regulations, so that violations thereof will provide SBA with a means to take action to minimize losses to the Government.

(3) Issue necessary guidelines to assist SBA personnel in making meaningful evaluations of SBIC's lending practices.

(4) Evaluate the SBIC's operations shortly after they have been licensed to ascertain the soundness of their lending practices and require SBIC's to take necessary corrective action recommended by SBA before additional Government funds are made available.

(5) Make evaluations of the SBIC's operations including examinations of financial activities at SBIC sites at least annually and at such other times as deemed necessary.

(6) Establish surveillance procedures to insure (a) adherence to the lending criteria established by SBA, and (b) that necessary corrective actions recommended by SBA are taken by the SBIC's in a timely manner.

We believe also that the Administrator should take prompt action to evaluate the financial condition of the SBIC's whose impairments of private capital have already exceeded 50 percent to identify the

potential for remedial or recovery actions. The operations of other SBIC's with continuing operating deficits should also be systematically evaluated to determine the best course of action to follow in resolving their financial difficulties.

We note that in testimony before the Subcommittee on Small Business, Committee on Banking and Currency, on July 15 and the Committee on Small Business, House of Representatives, on July 21, 1966, the Administrator of SBA acknowledged the existence of a number of weaknesses in the administration of the SBIC program, and announced a number of significant actions he has taken or is planning to take to improve the agency's surveillance of this program. In commenting on our report, which has been submitted to the subcommittee, the SBA Administrator stated that he has given serious consideration to our recommendations and that steps are being taken, as expeditiously as possible, to correct weaknesses and to prevent future occurrences. As a part of our continuing review of SBA programs, we will consider whether the actions taken by SBA will correct the weaknesses that we have observed in the administration of the SBIC program.

Mr. Chairman, we have been well pleased with the attitude of the new Administrator facing up to some of the problems which we have noted in our report. We feel much encouraged by the attitude that he has taken and has expressed this morning before this committee.

I have attached, Mr. Chairman, brief summaries of the six detailed cases included in our study. These run about 10 pages. I would not suggest that I read them unless the committee desires.

Senator HARRIS. We would like you to insert the case studies. Without objection, all of them will be made a part of the record. (The six case studies follow:)

SCI-TRONICS FUND, INC.

SBA licensed Sci-Tronics Fund, Inc., located in Nashua, New Hampshire, as an SBIC in October 1961. At the time of our review the SBIC had received total financing of about $965,000, consisting of about $635,000 from SBA and about $330,000 from its stockholders. Throughout its history, the SBIC has had a continual deficit, which according to the most recent available SBA records totaled about $213,000 as of September 30, 1965. As of that date, the SBIC had made loans and investments of about $1,065,000 in 20 small business concerns, cash repayments had totaled about $270,000 and the SBIC estimated a loss of $134,000 on its outstanding loans.

In September 1963, the SBIC was capitally impaired because it had a deficit of about $195,000, a 60 percent impairment of private capital. SBA did not make examination until October 1963, even though the SBIC had been licensed for 2 years, and SBA loans totaling about $635,000 had been made to this SBIC. The examination disclosed that the major cause of the deficit was the SBIC's estimated losses on investments in three companies which were either bankrupt or in financial difficulty. SBA, however, took little action to assist this SBIC or to protect the Government's interest.

Subsequently, the ony action taken by SBA between October 1963 and April 1966 were several exchanges of correspondence and one meeting at which it appears that details concerning the financial difficulties were not discussed. One of these exchanges of correspondence involved a questionnaire which was sent to the SBIC in October 1965, after the financial position of the SBIC had seriously deteriorated. The questionnaire included such questions as "How is the SBIC managed?" and "What is the present extent of the impairment?" We believe that answers to such questions should have been ascertained by SBA long before the SBIC experienced serious financial difficulties. Notwithstanding

the incompleteness of the SBIC's evaluations of its portfolio companies which was furnished in response to the questionnaire, SBA estimated a loss of $250,000 of its investment in this SBIC. In February 1966, SBA placed the SBIC on a "Wait" list which signifies that no major action was required at that time. In April 1966, SBA officials informed us that they will request the SBIC to furnish the March 31, 1966, financial statements as soon as possible and if the financial condition of the SBIC had not improved consideration will be given to demanding payment of the SBIC indebtedness to SBA.

NEW HORIZONS CAPITAL CORP.

SBA licensed New Horizons Capital Corporation, located in Syosett, New York, as an SBIC in March 1962. At the time of our review, the SBIC had received total financing of about $463,000, consisting of $300,000 from SBA and about $163,000 from its stockholders. As of September 30, 1965, the deficit had risen to about $275,000 a 169 percent impairment of private capital. At that date, the SBIC had made investments totaling about $700,000 in 13 small business concerns; about $255,000 had been repaid and about $254,000 was estimated to be uncollectible.

In March 1964, the SBIC was capitally impaired because it had accumulated a deficit of about $100,000, a 62 percent impairment of private capital. In October 1964, SBA requested the SBIC either to obtain a cash donation from the stockholders or sell additional stock in order to eliminate the impairment. Neither of the requested actions were complied with. Instead, the SBIC's president advanced a plan whereby he stated that the SBIC would have a good chance of recovery. Under the plan it was contemplated that, among other things, accounting and communications services would be donated, only minimum expenses would be paid, and an annual profit of $1,500 could be realized. Also, a potential gain of $85,000 was possible on two of its investments.

Our review of the proposal disclosed that since the deficit had increased to $168,000, it would have required about 56 years to eliminate the deficit under the plan advanced by the president. SBA did not make any visits to the SBIC or its portfolio companies to determine the soundness of the basis for the statements made by the president, nor did it evaluate the effects of this plan on the deficit. Our review of the plan indicates that the proposals could not have restored the SBIC to a financially sound position and action could have been instituted to protect the Government's investment.

In November 1965, SBA estimated it would lose $100,000 of its $300,000 investment in this SBIC. In March 1966 a receiver was appointed.

TECHNO FUND, INC.

SBA licensed Techno Fund, Inc., in Columbus, Ohio, as an SBIC in April 1960. As of the time of our review, Techno Fund had received total financing of about $8.4 million, consisting of about $3.2 million from SBA ($150,000 has been repaid) and about $5.2 million from its stockholders. As of September 1965, the financial statements of the SBIC showed a deficit of about $4.7 million, or a 91 percent impairment of private capital. As of that date, the SBIC had made loans and investments in 13 small business concerns totaling about $10.7 million; about $2.7 million had been repaid, and $4 million had been written off or considered uncollectible by the SBIC.

The financial statements of the SBIC pertaining to various periods from March 31, 1961, through December 31, 1963, showed a definite deterioration of its financial condition, primarily because of the establishment of estimated losses on outstanding loans and investments. During this period the deficit had risen from about $240,000 to about $1.7 million. In addition, two annual independent accountants' reports submitted by the SBIC during this period pointed out that a majority of the portfolio companies were operating at substanial losses. During this period also, without making an independent evaluation of the SBIC's loan practices or inquiring into the financial stability of the portfolio companies, SBA guaranteed additional funds of $500,000 which were disbursed by a bank and also purchased a debenture of $400,000 from the SBIC.

SBA's only examination of the SBIC was made about 4 years after licensing at which time the deficit exceeded $1.7 million. An SBA official stated that the examination in March 1964:

“* * * disclosed a deplorable situation with respect to the soundness of its investments and/or loan portfolio. Ten of the thirteen borrowing small business companies are in financial difficulty, and only a miracle will prevent a catastrophe. Short of a miracle, this Licensee's ability to repay its obligations to SBA under subsection 303(b) and 302 is so far from assured as to border on the non-existent."

In April 1964, SBA assigned staff personnel to the SBIC to act as liaison, and during the next 6-month period, SBA and SBIC officials met several times to discuss the financial condition of the SBIC. An SBA official concluded that SBIC was in need of additional funds.

The March 31, 1965, financial report of the SBIC disclosed a deficit of about $3.7 million, a 71 percent impairment of private capital, and during the year the SBIC had made additional investments of $477,000 in existing portfolio companies on which it had already estimated losses of over $1.6 million. During the next 6 months SBA held several meetings with SBIC officials and discussed the sale of additional stock and merger possibilities. During the same period the deficit increased about $1 million and the SBIC continued to make investments of $114,000 in portfolio companies in which they already had estimated losses of about $790,000.

In November 1965, SBA initiated action leading to placing the SBIC in receivership, but at the time of our review further action was being held in abeyance by SBA pending the outcome of the proposed merger with another SBIC.

CASCADE CAPITAL CORP.

Cascade Capital Corporation, located in Spokane, Washington, was licensed as an SBIC in April 1961. At the time of our review, Cascade had been financed by about $191,000 in private funds and $380,000 in SBA funds. The SBIC had provided financing of about $540,000 to 11 small business concerns, of which $284,000 had been recorded as a loss or estimated to be uncollectible by the SBIC; about $146,000 had been repaid to the SBIC, and about $110,000 on investments outstanding is expected to be collectible by the SBIC. The SBIC repaid $62,467 to SBA thereby reducing the Government's investment to $317,533.

This SBIC has experienced continual financial deterioration and by September 1962, the deficit had risen to about $97,000, or about 51 percent impairment of private capital. The deficit continued to increase until it reached $363,412 or a 190 percent impairment of private capital on September 30, 1965. Although the deficit continued to increase, SBA's actions were similar to those described in the preceding cases, namely (1) SBA advised the SBIC to obtain additional capital which resulted in a negative response from the stockholders, (2) liaison men were assigned but only after the deficit exceeded $300,000, and (3) SBA concurred in the SBIC's plan to bring itself into a profitable basis without obtaining first-hand information as to the merits of the SBIC's plans.

SBA did not make an examination of the SBIC between April 1962 and April 1965. The SBA examiner reported that during his examination in 1965, he interviewed the vice president and director of the SBIC, who was also a vice president of a bank. The latter stated that the original stockholders were more interested in a fast ride for their money, and looked more to the potential bright future of a company, than they did to the credit side of the applicant or the purpose for which the funds were to be used.

In November 1965, SBA estimated a loss of $262,797 on its outstanding funds of $317,533 in the SBIC. SBA officials informed us that the SBIC will probably be placed in receivership.

GEORGIA CAPITAL CORP.

SBA licensed Georgia Capital Corporation, located in Atlanta, Georgia, as an SBIC in February 1962. At the time of our review, the SBIC had received total financing of $905,000, consisting of $600,000 from SBA and $305,000 from its stockholders. The SBIC has made investments totaling $1,094,623 in 15 small business concerns of which $273,269 was repaid to the SBIC and $110,324 was written off as uncollectible.

SBA made an examination in May 1963, which indicated deficient loan practices by the SBIC. An evaluation at this time of the loan practices for the purpose of assisting the SBIC in their lending operations could have been very helpful, but instead SBA asked the SBIC to keep SBA informed of actions being

taken by the SBIC to prevent a possible impairment of capital. The SBIC replied that the sale of additional stock had been authorized but subsequent financial statements submitted by the SBIC show that no additional stock was sold. The SBIC's deficit increased steadily until it reached $162,698, a 53 percent impairment of private capital in September 1964. A year later the deficit had risen to $274,462, a 90 percent impairment of private capital.

Although the financial condition of the SBIC was deteriorating, an SBA official did not visit the SBIC until October 1965. The SBIC official concluded that something had to be done immediately to put the SBIC in a sound financial position. After the visit a letter was sent to the SBIC requesting current financial statements for each portfolio company and answers to a series of questions. Typical questions were (1) How are you managed? and (2) What do you want us to do to protect our investment? The letter requesting this information set a deadline of December 15, 1965. The deadline was not met, and no follow-up was made by SBA until we requested a copy of the reply in April 1966.

As of November 1965, SBA estimated a loss of $40,000 on its $600,000 financing in this SBIC. SBA officials do not know the basis for the estimate, and the employee responsible for the estimate has left the agency.

SBA officials informed us in May 1966 that no further action is contemplated until after receipt of the financial statements which are due from the SBIC by June 30, 1966.

AMERICAN BUSINESS CAPITAL CORP.

SBA licensed American Business Capital Corporation located in Los Angeles, California, as an SBIC in September 1960. Pacific Capital Fund located in the same city, was licensed as an SBIC in January 1962. Pacific Capital Fund was merged into American Business Capital Corporation in March 1963. At the time of our review the surviving SBIC had received total financing of $1,142,500, consisting of $717,500 from SBA and $425,000 from its stockholders. The SBIC made loans and investments in 21 small business concerns totaling over $1.2 million of which $419,000 was repaid and about $384,000 was recorded as estimated losses.

The financial statements of the SBIC in March 1963 showed a deficit of about $226,000, a 53 percent impairment of private capital but SBA did not visit the SBIC or its portfolio companies to evaluate investment practices. Instead, SBA requested the SBIC to obtain additional private capital to cure the impairment. Similar requests were made several times by SBA from 1963 to 1965; however, no additional private capital was obtained.

By March 31, 1964, the deficit had increased to about $391,000, an impairment of private capital of 92 percent. In April 1964, SBA informed the SBIC that it was assigning personnel to act as financial liaison between SBA and the SBIC. However, the files do not indicate any visits by the liaison men.

In March 1965, after the SBIC had been financially impaired for about 2 years, SBA made its first examination. As a result of the examination, SBA sent a letter to the SBIC in which it requested the latter to introduce additional capital to cure the impairment but made no comments concerning its lending practices or the status of its portfolio. The SBIC's financial statements as of March 31, 1965, showed that the deficit was about $608,000, an increase of over $200,000 within a year. In June 1965, officials of SBA and the SBIC met to review the latter's financial problems, but SBA's solution was that the SBIC obtain additional funds from stockholders. In November 1965, SBA estimated that it would lose about $396,000 of its investment in this SBIC.

Although the SBIC had been capitally impaired since March 1963, SBA did not commence administrative action leading to the suspension of the SBIC's license until January 1966. In May 1966, SBA issued the order suspending the license. The suspension order requires the SBIC to cure its impairment, or submit a plan to cure its impairment within 6 months of the suspension date.

Senator HARRIS. Would you present the first case study?

Mr. STAATS. If agreeable, I will read the first one and perhaps Mr. Neuwirth and Mr. Medico, who have been most directly involved in the case studies, might summarize some of the other points brought out in the other studies.

Senator HARRIS. Very well.

Mr. STAATS. The first of these is the Sci-Tronics Fund, Inc.