Roy Andersen
When the Dodd-Frank Act was enacted in 2010, it placed severe restrictions on a variety of business practices across the banking industry. The law’s so-called “Volcker Rule” reserved its strictest limitations for the business of trading in securities. A bank’s ability to deal in securities has always been limited under the Glass-Steagall Act (the demise of which has been greatly exaggerated), so the Volcker Rule essentially doubles down on the regulations. The rule has even made it more difficult for banks to affiliate with funds that invest in securities.
However, one area that received a reprieve under the Volcker Rule, and that many banks are beginning to discover, involves funds sponsored under the aegis of the U.S. Small Business Administration (SBA). Banking regulators and the SBA both permit banking organizations to sponsor and establish “Small Business Investment Companies” (SBICs) to invest in the securities of small businesses without restriction under the Volcker Rule. Licensed by the SBA, an SBIC is a privately owned and operated company that makes long-term investments in American small businesses.
The SBA reports that 43 banks have formed their own SBICs as of Sept. 30, 2015.
The Dodd-Frank Act expressly permitted banks to invest in SBICs and retain any existing investments in such entities. Further, bank-owned SBIC’s “covered funds” are not subject to Dodd-Frank’s restrictions on affiliations. There are limits, however, on how much banks may invest in SBICs and how much control a bank can exert over an SBIC through its own voting shares.
How Can Banks Invest In SBICs?
The Small Business Investment Company Act of 1958 permits national banks to own stock in SBICs, while the Bank Holding Company Act of 1956 effectively permits bank holding companies to make these investments. The Federal Reserve also allows a bank holding company to invest up to 5 percent of its banking organization’s capital and surplus in SBIC stock. Since 1978, the Federal Reserve has permitted bank holding companies to own up to 100 percent of a SBIC’s voting stock.
What Are SBICs Permitted To Do?
SBICs may invest primarily in qualifying “small business concerns,” defined as enterprises – including affiliates – that do not have a net worth in excess of $19.5 million and whose average net income did not exceed $6.5 million over the previous two years. Alternatively, an enterprise may qualify as a small business concern if it is not dominant in its field of operation and it meets certain employment size standards or receipts standards set forth in SBA regulations.
SBICs are subject to restrictions on the type and extent of certain qualified investments. For example, any investment that would trigger a presumption of control over a small business requires prior written approval from the SBA. Control is presumed to exist whenever an SBIC owns and controls 50 percent of a company’s voting securities in a company that has fewer than 50 shareholders.
Notably, SBICs are not permitted to deal with their own “associates,” who may include their shareholders, control persons or officers, directors or employees. Other restrictions apply to real estate or real estate-related activities and investments in financial or leasing companies, passive businesses and companies predominantly located in foreign countries.
The Path To Forming An SBIC
To become a federally licensed SBIC, a corporation or limited partnership must apply to the SBA and pay an application fee of $10,000. The minimum capitalization from the private sector is $5 million, which may be higher in certain markets.
Applicants must provide a business plan including a five-year projection of income and expenses. Details relating to the proposed management are required as the SBA must approve the SBIC’s investment advisor or manager before issuing a license. Information on all affiliations and relevant corporate documents must also be submitted to the SBA during the application process.
Not unlike other oversight, the company’s officers and directors are subject to comprehensive background checks, including fingerprinting. Each prospective officer is required to submit a personal statement and business qualifications. At least one officer with a minimum of five years of successful experience in business investing must be designated as manager. The majority of the board of directors and the officers must be U.S. citizens or lawful permanent residents.
The careful use of the Volcker Rule in this manner is one of the more intriguing developments in our industry. Many banks, while not publicly detailing their plans pending SBA approval, are exploring partnerships. TD Bank for one has gone on record as being supportive of well-managed SBIC funds. There is clearly opportunity in this area that banks should not overlook.
Roy C. Andersen, of counsel with Boston-based Sullivan & Worcester LLP, specializes in bank regulatory and compliance matters for the firm’s corporate practice. He is based in the firm’s New York office and can be reached at randersen@sandw.com.
