AMERICAN BAR ASSOCIATION Section of Business Law Spring Meeting Seattle, WA April 1-4, 2004

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1 AMERICAN BAR ASSOCIATION Section of Business Law Spring Meeting Seattle, WA April 1-4, 2004 What You Should Know About SBICs: How to Form and Operate Them Thursday, April 1, :30 a.m. to 12:30 p.m. Panelists: Christopher Lane Davis, McCarter & English, LLP Alan B. Roth, Wildman, Harrold, Allen & Dixon Michael B. Staebler, Pepper Hamilton LLP Moderator: Lee R. Petillon, Petillon & Hiraide LLP Program Outline HANDOUT MATERIALS TABLE OF CONTENTS Small Business Investment Companies, by Lee R. Petillon Leverage, by Alan B. Roth Basic Requirements, by Michael B. Staebler The Community Reinvestment Act Regulations: An Opportunity for Banks and SBICs, by Christopher Lane Davis Licensing Criteria and Process, by Michael B. Staebler Investment Guidelines/Requirements, by Alan B. Roth Conflict Between Market Terms and SBIC Terms, by Alan B. Roth National Association of Small Business Investment Companies, by Michael B. Staebler Is the SBIC Program Right for You?, by the Small Business Administration, Investment Division Biography of Christopher Lane Davis Biography of Lee R. Petillon Biography of Alan B. Roth Biography of Michael B. Staebler

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3 AMERICAN BAR ASSOCIATION Section of Business Law Spring Meeting Seattle, WA April 1-4, 2004 What You Should Know About SBICs: How to Form and Operate Them Thursday, April 1, :30 a.m. to 12:30 p.m. Panelists: Christopher Lane Davis, McCarter & English, LLP Alan B. Roth, Wildman, Harrold, Allen & Dixon Michael B. Staebler, Pepper Hamilton LLP Moderator: Lee R. Petillon, Petillon & Hiraide LLP Topic Introduction of Panelists History and Overview of the SBIC Program Basic Requirements o Capital Requirements Debenture SBICs Participating SBICs Management/Ownership Diversity Requirements Leverage o Debenture SBICs o Participating Security SBICs o Five Year Commitments o Just in Time Call Downs o Interest on Leverage Debenture SBICs Participating Security SBICs o SBA Profit Participation Participating Security SBICs Community Reinvestment Act of 1977 Licensing Process o Management Qualifications Debenture vs. Participating Security SBICs o Management Assessment Questionnaire o Meeting in Washington; issuance of go forth letter o License Application o Time Schedule

4 Investment Guidelines/Restrictions o Size Standards o Term of Loans o Interest/Cost of Money o Control of Portfolio Companies o Conflicts of Interest o Companies Ineligible for Financing o Overline Limitations o Redemption Restrictions Conflict Between Market Terms and SBIC Terms Operating Issues o Annual Examination o Impairment of Capital o Valuation of Portfolio National Association of Small Business Investment Companies (NASBIC) Future of the Program Question and Answers

5 LEE R. PETILLON* MARK T. HIRAIDE* *A PROFESSIONAL CORPORATION LAW OFFICES OF PETILLON & HIRAIDE LLP A LIMITED LIABILITY PARTNERSHIP OF PROFESSIONAL CORPORATIONS DEL AMO FINANCIAL CENTER HAWTHORNE BOULEVARD, SUITE 1260 TORRANCE, CALIFORNIA TELEPHONE (310) FACSIMILE (310) lpetillon@corplawp-h.com mhiraide@corplawp-h.com February, 2004 SMALL BUSINESS INVESTMENT COMPANIES Summary of the SBIC Program If a proposed venture capital fund applies for a Small Business Investment Company ( SBIC ) license, it will be subject to regulation by the Small Business Administration (the SBA ) under the Small Business Investment Act of 1958, as amended (the SBIA ). The objective of the SBIC program is to stimulate and supplement the flow of private equity capital and long-term loan funds available to small businesses. SBA regulations define a Small Business Concern as a concern with a net worth of up to $18 million and an average annual after-tax net income of up to $6 million for the two years preceding the SBIC investment. However, at least 20% of the fund s investments must be invested in "Smaller Concerns, defined as those having a net worth less than $6 million and average annual after tax net income less than $2 million for the two previous years. An alternative measure of size are the industry standards based on the number of employees or gross receipts set forth in the North American Industry Classification System for the particular industry of the subject concern Amendments. In order to correct structural flaws in the SBIC program and to improve the program s effectiveness in promoting the availability of private equity capital for small businesses, Congress enacted The Small Business Equity Enhancement Act of 1992 (the 1992 Amendments ), which amends the SBIA. Pursuant to the 1992 Amendments, the SBA has created a new SBIC program involving participating securities, for which final regulations were issued and become effective April 23, 1994, and which operates in addition to the original debenture SBIC program Amendments. In 2000, Congress enacted the Small Business Investment Corrections Act of The bill made three significant changes to the SBIA: It allows SBIC s to take controlling interest in the companies they invest in during the period of investment. As a result of the statutory change permitting SBIC s to exert control over their portfolio companies, provided that management retains at least around 20% of the total equity of the company, an SBIC can now be a buyout fund, provided that there is 1

6 a plan to finance the growth of the company so that the SBIC is not merely a holding company for operating subsidiaries. The minimum term for an SBIC investment was reduced from five years to one year. The SBA is authorized to bill SBIC s a surcharge of up to 1% per year in order to reduce the subsidy rate (the rate of subsidy of losses incurred by the SBA in the SBIC program) to zero, so that the program will be selfsustaining. SBA Leverage. Under the new SBIC Program, the SBA can finance SBICs by purchasing nonvoting Participating Securities that are similar to preferred stock rather than debt. Participating Securities mature in 10 years, but no prepayments are required until and unless profit distributions are made to the private investors. One benefit of this structure is that use of such leverage will not generate unrelated business taxable income (UBTI), which in the past has discouraged pension funds and other institutional investors from investing in debentures of SBICs. Two dollars of Government leverage for Participating Security SBICs will match each $1 of private capital. This leverage can boost the financial return to Limited Partners substantially above that which would be achievable without such leverage. A Participating Security SBIC must have private capital of at least $10 million 1 ; however, only $2.5 million of the private capital needs to be paid in prior to issuance of the SBIC license. When at least half of this $2.5 million is invested, the SBIC is eligible to call down the 2:1 leverage. The SBA continues to license debenture SBIC s with a term of 10 years, principal payable at maturity. The maximum leverage here is 3:1, but the SBA will initially grant only two tiers of leverage, and the SBIC has to demonstrate its need for the third tier of leverage which is determined by the following table, as adjusted for increases in the Consumer Price Index: Leverageable Capital (LC) Maximum Leverage (000) (000) $18, % of LC >$18,900 but <$37,800 $56,700 +[2 x (LC - $18,900)] >$37,800 but <$56,700 $94,500 + (LC - $37,800) >$56,700 $113,400 Minimum private capital is $5 million 1. A debenture SBIC does not have to pay the Government any share of its profits, so the only cost of money is the interest, which is equal to the 10-year treasury note rate (currently about 4.15%), plus basis points 1 Private capital can include funds invested by state or local government entities up to 1/3 of total private capital. 2

7 or currently about 5.95% to 6.65%, payable semi-annually. The minimum term for loans to small business concerns is one year. Just In Time Financing. Under recent Congressional Amendments, the SBA leverage can be reserved shortly after licensing by purchasing a five year commitment for a standby fee of 1% of the total amount of leverage reserved. When each tranche of leverage is called down, an additional 2 ½ % fee is paid on the amount of the call down. Once committed, just in time financing arrangements allow a call down to be made within a few days after the request to the SBA. The dividend on the Participating Securities, called the Prioritized Payment, is presently equal to approximately basis points above the rate on 10-year Treasury notes (currently about 4.15%) at the time the securities are issued, accruing on the amount of outstanding leverage, and is compounded annually. The present Prioritized Payment rate would therefore be about 5.95% to 6.65%. Prioritized Payments will be deferred and accrued, and will be payable when and as the SBIC s cumulative profits exceed the cumulative Prioritized Payments due. The SBA also receives a participation in the SBIC s profits, called the Profit Participation Rate, on all portfolio assets outstanding while there is outstanding leverage, even after all leverage has been repaid. Thereafter, the SBA will not share profits on any new investments until new leverage is taken down. The SBIC s Profit Participation Rate depends on the 10-year Treasury note rate and the ratio of SBA leverage pursuant to a formula. If the leverage ratio is 2:1, and the 10-year Treasury Note interest rate is 4.15%, SBA s profit share would be approximately 6.2%, and ranges from 3.38% to 15%, depending on the ratio of Participating Securities to net private capital and the then prevailing 10-year Treasury note rate. Profit is determined after all expenses, including Prioritized Payments and management fees. The following are principal provisions of the SBIA reflecting the 1992 and 2000 Amendments and SBA regulations which affect SBICs: Principal Provisions The manager of a participating securities SBIC may receive management fees for the first five years of the fund of up to 2.5% per annum of the total committed capital of the fund, including an assumed two tiers of leverage and adding back any distributions. Thereafter, the 2.5% is applied to the Combined Capital (private capital plus outstanding leverage). An SBIC may make loans to and/or purchase the equity securities only of a Small Business (a firm with a net worth of $18 million or less and average net income after Federal income taxes for the preceding two years of $6 million or less). An SBIC with outstanding Participating Securities must lend to or invest in Smaller Enterprises (net worth of $6 million or less and average net income after taxes for the preceding two years of $2 million or less) to the extent of at least 10% in the first year, 20% 3

8 thereafter of all Financing (all outstanding loans and investments). An SBIC utilizing Participating Securities must make Equity Capital Investments 2 in an amount at least equal to the amount of its outstanding Participating Securities. An SBIC may not provide capital to any concern whose principal business is financing others or investing in real estate. Loans to a small concern must mature in not less than one year (changed from 5 years by the 2000 Amendments) and not more than 20 years, may not require amortization during the first year, and must permit prepayment with reasonable prepayment penalties. The annual cash cost to the small concern of loans and debt securities from an SBIC (excluding capital appreciation) generally may not exceed 11 percentage points for a loan and 6 percentage points for a debt security, plus the current interest rate being charged on SBA-guaranteed 10-year Debentures (currently 4.875%), plus SBA s annual charge (currently 1.454% for Participating Securities SBICs and 0.855% for Debenture SBICs), or a total of 6.3% for Participating Securities SBICs and 5.73% for Debenture SBICs. The alternative cost of money maximum is 19% for loans; 14% for debt securities (debt with conversion or option rights to equity securities). An SBIC generally may not invest more than 20% of its private capital in a single concern without SBA approval. The initial maximum will increase by 20% of the fund s realized and undistributed net income. An SBIC generally may control a Small Business Concern, either directly or in concert with its affiliates or other SBICs, provided such control is divested within seven years. (Affiliates of an SBIC include its General Partner and holders of 10% or greater ownership interests.) Participating Securities may be used to maximum leverage up to 200% of private capital. The aggregate amount of outstanding leverage for SBICs utilizing Participating Securities may not exceed currently $116 million (indexed to changes in the CPI). To maintain its license, an SBIC generally must have invested at least 25% of its idle funds at year-end during the preceding 18 months, until its idle funds at year-end total less than 25% of its assets. 2 Equity Capital Investments include: common or preferred stock, options, warrants and subordinated debentures if the minimum term of the debentures is one year, interest is contingent upon sufficient earnings, there are no amortization provisions and no redemption within one year. 4

9 An SBIC may not redeem or reduce its private capital more than 2% annually without prior approval of the SBA, and must make distributions of retained earnings within each fiscal year. The SBA s prior approval is required for any transfer of a 10% or greater ownership interest or which would result in a 10% or greater ownership interest by any person or affiliated group, or any proposed change of control of the SBIC s management and policies, including a change of General Partner, and possibly including a change in the membership of the Board of Advisors. The SBA may prohibit a person, including a General Partner, from participating in the affairs of an SBIC if (a) he is charged, indicted, or convicted in connection with a felony, or (b) it finds that he has violated the SBIA or regulations under the SBIA or breached his fiduciary duty. The SBA is required to conduct an independent audit of each SBIC each year, in addition to the audit that will be conducted by the fund s independent certified public accountants. Investment Potential With 2:1 leverage, as SBIC could generate the following returns to the limited partners: Gross Portfolio Return Impact of SBA Leverage on Investor Returns Return to Investors w/o SBIC Leverage* Return to Investors w/sbic Leverage* % Yield Improvement 10.0% 4.4% 0.0% NA 15.0% 8.4% 12.7% 51.2% 20.0% 12.5% 19.5% 56.2% 25.0% 16.7% 27.3% 63.5% 30.0% 20.9% 35.2% 68.4% 40.0% 29.4% 49.6% 68.7% *Compound Annual Return, net of management expenses and 20% carried interest. Assumes 4-year investment period and 4-year holding period and 15% uninvested capital. Also assumes 2x leverage on private capital in the form of SBIC Participating Securities with 7.75% Prioritized Payments and 9% Profit Participation Rate and 2.5% Management Fee. Source: National Association of Small Business Investment Companies 5

10 LEVERAGE Alan B. Roth Wildman, Harrold, Allen & Dixon LLP 225 West Wacker Drive Suite 2600 Chicago, IL I. LEVERAGE SBA FUNDING A. Called Leverage i. Fiscal Year $3.0 Billion Debenture Leverage; $4.0 Billion Participating Security Leverage B. SBA raises money by pooling Trust Certificates and selling them with SBA s guaranty to purchasers of 10 year, fixed rate government guaranteed securities. Interest payable semiannually by SBA. Small pool of purchasers. Costs to SBA most recently were basis points over interest rate on Treasury Bonds with 10 year maturities ( Treasury Bond Rate ). SBA imposes an annual fee (88 bps for Debentures; bps for PS) and makes the money available to SBICs. C. Debentures i. 10 year, unsecured, non-recourse loans ii. iii. iv. Interest only payable semi-annually; between basis points over Treasury Bond Rate (including SBA fee) Prepayable pre-payment penalty. No penalty after 5 years Distributions 1. Cumulative profits may distributed at any time Page 1

11 2. Capital may not be reduced by more than 2% per year without SBA approval recycle capital a) Year 5 SBA plan required - Wind-up Plan approved by SBA which assures repayment of SBA leverage v. Unrelated Business Income Issues D. Participating Securities a) Potential addition to pending tax legislation i. SBA is a preferred limited partner upon issuance of participating securities 1. Considered equity security a) ok for UBTI purposes ii. iii. iv. 10 year maturity Liquidation preference Distributions to SBA-Preferred Return ("Prioritized Payment") 1. Contingent upon and payable only from cumulative realized earnings of entire SBIC-Aggregate portfolio 2. Compounds annually 3. Usually basis points over Treasury Bond Rate (including SBA fee) v. SBA entitled to share of profits ( Profit Participation Payment ) % (based on 2 variables: Treasury Bond Rate and Leverage Ratio) 10 Year Treasury Bond Rate Ratio of Participating Securities to Private Capital 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0% % 2.81% 3.38% 3.94% 4.50% 5.06% 5.63% % 5.63% 6.75% 7.88% 9.00% 10.13% 11.25% % 6.57% 7.88% 9.19% 10.50% 11.81% 13.13% % 7.5% 9.00% 10.50% 12.00% 13.50% 15.00%

12 vi. Distributions of Capital ( Returns of Capital ) made in proportion to Leverage Ratio (Private Partners capital is adjusted to reflect capital impairment, i.e., losses and net unrealized depreciation ) 1. Ratio of outstanding leverage to private capital contributed 2. Two tiers of leverage ratio of one to one vii. All distributions only out of "READ" Retained Earnings Available For Distribution 1. First-all accumulated Prioritized Payments are paid 2. Second- Tax Distribution a) Profits (after Prioritized Payments) multiplied by combined Federal and State applicable tax rate (Federal rate adjusted to reflect deduction of State tax rate) b) SBA receives its Profit Participation Rate share 3. Third-Depends on Leverage Ratio a) If Leverage Ratio greater than 1:1, SBA gets 1/2 of cash I) Profit Participation Payment II) Prepayment of Participating Security b) If Leverage ratio is 1:1 or less, SBA gets Profit Participation Payment c) Legislative Proposal to Change viii. ix. No recharacterization of Distributions. Once distributed as Prioritized Payment or Profit Payment, distribution will not later be recharacterized as a Return of Capital No ability to return capital solely to SBA (unless investors agree ) E. Leverage commitments/mechanics i. Can reserve a commitment for up to 2X regulatory capital for Participating Securities and up to 3X regulatory capital for Debentures

13 1. Upon licensing 2. 2 times per year 3. 1% Commitment Fee payable in 30 days ii. iii. iv. Draw down Leverage by submitting draw requests on as little as 1 day s notice Pay 2% User Fee and 50 basis points in underwriters fees Funds are made available on an interim basis by Federal Home Loan Bank of Chicago v. Every 6 months interim funding are pooled and rates permanently re-set vi. vii. 1% annual fee Legislative changes F. Libor Based Variable Rate Financing i. SBA and NASBIC are working on Libor based, floating rate financing. 1. Create lower costs with a cap G. Benefits of Leverage Gross Portfolio Return Return To Investors w/o SBIC Leverage Return To Investors w/sbic Leverage % Yield Improvement 10.0% 4.4% 0.0% NA 15.0% 8.4% 12.7% 51.2% 20.0% 12.5% 19.5% 56.2% 25.0% 16.7% 27.3% 63.5% 30.0% 20.9% 35.2% 68.4% 40.0% 29.4% 49.6% 68.7% *Compound Annual Return, net of management expenses and 20% carried interest. Assumes 4-year investment period and 4-year holding period and 15% uninvested capital. Also assumes 2x leverage on

14 private capital in the form of SBIC Participating Securities with 7.75% Prioritized Payments and 9% Profit Participation Rate and 2.5% Management Fee. Source: National Association of Small Business Investment Companies

15 BASIC REQUIREMENTS Michael B. Staebler April 1, 2004 I. STRATEGIC DECISION TO BECOME AN SBIC A. Fundamental Questions How large a fund do I want? $15 million to $180 million Is my investment strategy consistent with SBA Regulations? a. b. c. d. e. f. g portfolio companies US companies small businesses permitted industries investing in companies not the stock market profit motive not economic development building business not financial engineering 3. Do my investors want to invest in an SBIC? B. C. Qualifications of Management Team the Mirror Test Is Dealing with the Government Worth It!

16 II. THE BASICS A. B. C. D. SBIC Privately Owned and Operated; Formed Under State Law Licensed and Regulated by SBA Investment Decisions Privately Made Reasons for Formation: 1. Use of Leverage up to twice amount of Private Capital ceiling $113.4M (COL indexed) 2. Banks a. b. c. Community Reinvestment Act Credit (CRA) Own 5% of voting securities Capital charge regulations and lending affiliation rules under Gramm-Leach-Bliley III. STRUCTURING THE SBIC A. B. C. SBICs using Debentures or Unleveraged Limited Partnership, LLC or Corporation -- $5M minimum capital SBICs using Participating Securities Limited Partnership - $10M minimum capital Plain Vanilla Structure SBIC Limited Partnership General Partner a. b. c. LLC or LP (corporation or LLC as general partner) Makes decisions for SBIC 20% Carried Interest (1) Net of SBA s share (a few exceptions) -2-

17 (2) Return of capital to LPs vs. sharing profits from beginning (a) (b) (c) (d) Deal by deal. Allocation of expenses. Portfolio valuation important Clawbacks Serious issues because of use of SBIC Leverage. (3) Preferred Returns to Limited Partners (6-8%) with GP catch up (4) Vesting d. e. f. Single purpose entity Subject to SBA examination along with SBIC Principals ( General Partners ) also contribute 1% of private capital 3. Investment Advisor/Manager ( Management Company ) a. b. c. d. Not examined by SBA May conduct other activities Pays day-to-day operating expenses Receives Management Fee SBA Tech Note #7, Dec 2000 (1) (2) (3) (4) 5 years 2.5% of 3x unreduced Regulatory Capital After 5 years 2.5% of Combined Capital (actual Regulatory Capital plus Outstanding Leverage) Plus $125,000 if base amount less than $20M Payable quarterly in advance -3-

18 (5) (6) (7) Excess Management Fee excess over 2.5% of Combined Capital (plus $125,000 if Combined Capital less than $20M) is ignored in computing Prioritized Payments and SBA s Profit Participation Payments SBA s attitude toward maximum fee Private investors attitudes D. Governance 1. Directors, managers, officers and significant owners (10%) subject to prior SBA approval. a. b. Form 415A or Management Assessment Questionnaire ( MAQ ) Fingerprint cards Need to maintain qualified management Transfers which change control not permitted without SBA prior approval. a. Transferor s liability contract E. Drop-Down Fund Structure Parent Fund invests portion of capital in SBIC Class A Limited Partner Investors become Class B Limited Partners to guaranty payment of Parent Fund commitment Distributions (net of amounts paid to SBA) are distributed to Parent Partnership General Partner of SBIC is a new, separate entity, which makes decisions for the SBIC but has no economic interest (Delaware limited partnership law) Reason for formation -4-

19 a. b. c. Investments made prior to filing formal License Application Investments which do not conform with SBA regulations (foreign, not small, overline, otherwise ineligible) Raise more funds than needed for Leverage 6. Converting existing private equity fund a. Amend Partnership or LLC Agreement (1) (2) (3) (4) (5) (6) Term Management Fee Allocation of Organizational Expenses Permit investment in the SBIC Class A Class B structure Restrictions on transfers by investors b. Supplement Subscription Agreement (1) SBA requirements status as Institutional Investor c. d. Supplement Private Placement Memorandum Letter explaining rationale investor meetings F. Investors 1. Institutional Investors a. Entities --$10M net worth or other qualifications -5-

20 b. Individuals (1) (2) $10M net worth (exclusive of equity in residence), or $2M net worth and investment not exceed 10% of net worth Domestic or foreign Diversity of Management and Ownership a. b. No investor may own over 70% 30% must be owned by investors unrelated to management 4. Identification of all investors. a. Investors owning 10% must be approved by SBA and identify their 10% owners Fingerprint requirements and Personal History Questionnaire 33% owners Transferor s Liability Contract Control Persons (Principals; 50% owners; and 10% owners that participate in investment decisions) personal liability if they participate in a change of control without SBA s consent IV. FUNDRAISING A. Private Placement Memorandum Accredited Investors limited disclosure required Description of SBIC Program a. b. Benefits of Leverage Regulatory Requirements c. Risks -6-

21 3. Principal terms SBA requirements a. b. c. d. e. f. g. Term of Partnership Indemnification Defaulting Investor Penalties No Fault Divorce - may be prohibited Key Main Provisions special scrutiny Special management fee provisions Distributions to subsequent investors. B. Likely investors Banks CRA Strategic investors conflicts of interest Wealthy individuals -- Institutional Investors a. IRAs b. Family partnerships 4. Tax exempt investors a. Debentures unrelated business income tax 5. Major institutions uneven acceptance of SBICs Error! Unknown document property name. -7-

22 The Community Reinvestment Act Regulations: An Opportunity for Banks and SBICs By Christopher Lane Davis August 1, 2003 Abstract Banks subject to the Community Reinvestment Act regulations need to make qualified investments to meet the performance standards under the regulation s investment test. Investment in an SBIC is an advantageous way for a bank to meet this need, and can provide a bank investor with significant economic as well as regulatory benefits. This paper discusses the current CRA regulations and focuses on the significance of the investment test for banks and SBICs. The attached Appendix to this paper provides a list of Internet web sites that have basic resource materials for the CRA regulations and SBIC program. The endnotes to this paper provide more detailed technical information and citations to legal materials. Introduction Since July 1, 1997, the joint rule under the Community Reinvestment Act (the CRA ) 1 has strongly encouraged large banks 2 to have a program of ongoing qualified investment activity in their communities and regions in order to meet their obligations under CRA. The CRA regulations present banks with a continuing need to make investments that qualify for CRA purposes, are permissible under bank regulation, and provide a return consistent with the safe and sound operations of the bank. 3 Investment in an SBIC gives a bank the opportunity to accomplish all three of these objectives. An investment in an SBIC operating in a bank s community or region is specifically identified in the Interagency Interpretive Questions and Answers Regarding Community Reinvestment for the joint rule 4 as a type of investment which will be presumed by the regulatory agencies to be a qualified investment for CRA purposes. 5 Likewise, Federal law explicitly permits banks and federally chartered savings associations to invest in and own SBICs. 6 Finally, the banking industry has substantial experience with both independent and affiliated SBICs. 7 The data on investment results of existing bank-affiliated SBICs demonstrate that as an industry, SBICs have provided returns on invested capital consistent with (or in many cases higher than) the return on the capital employed by their bank investors in their principal lines of business. 8 Christopher Lane Davis is Special Counsel to McCarter & English in New York City. He is a member of the bar of the State of New York and specializes in corporate finance, focusing on matters relating to domestic and international venture capital and private equity investment. 1 Copyright C.L. Davis All Rights Reserved Permission to reproduce and distribute, in whole or in part, is granted to the U.S. Government

23 The Community Reinvestment Act The CRA. In 1977, Congress enacted the Community Reinvestment Act to encourage banks to help meet the credit needs of the local communities in which they operate. 9 To implement the CRA, each of the four federal bank regulatory agencies (the Office of the Comptroller of the Currency, the Federal Reserve Board, the Federal Deposit Insurance Corporation, and the Office of Thrift Supervision) promulgated regulations. 10 The CRA Regulations. The CRA regulations establish the framework and criteria that each agency uses to evaluate a bank s performance in meeting the credit needs of its local community under the CRA. Banks are examined on a regular basis by their regulating agencies to assess how well the bank s activity has met the credit needs of its local community in the areas of lending, service and investment as measured by the regulatory standards established in the CRA regulations. 11 The agencies numerically grade each bank s performance in each of the three areas specified by the joint rule, and the combined grades for all three areas determine a bank s overall CRA performance rating. 12 The agency evaluation of a bank's CRA performance is a public document, and is required to include the agency s assessment of the bank s performance in each area and the overall CRA rating. 13 Regulatory Compliance. The CRA does not permit the bank regulatory agencies to require banks to achieve any specified CRA performance rating. 14 Banks are strongly motivated to achieve high ratings, however, because the agencies are expressly authorized by the CRA to take a bank s CRA performance into account when reviewing an application by the bank for approval of an activity relating to deposit-taking facilities (e.g., acquisitions, new branches, and the like). 15 Historically, the bank regulatory agencies have made it clear that the quality of a bank s CRA performance can have a significant impact, both positive and negative, on obtaining regulatory approvals desired by the bank, making CRA performance important to the overall operations of the bank. 16 Other Effects. A bank s CRA rating can also have effects beyond the CRA regulations, for example Federal Housing Finance Board regulations restrict long terms advances by Federal Home Loan Banks to a member bank unless the member bank has at least a Satisfactory CRA rating. 17 For many banks, an Outstanding CRA rating is also an important aspect of the bank s corporate image of quality, community involvement and industry leadership, and has a significance that extends beyond the bank s relationship with its regulating agency. The CRA Regulations The Joint Rule. Beginning in 1993, all four federal regulatory agencies began a collective effort to develop new joint CRA regulations. 18 This effort culminated in the promulgation of a joint rule by all four agencies on May 4, That joint rule replaced the previous CRA regulations in their entirety. The provisions of the joint rule were phased in over a 2 Copyright C.L. Davis All Rights Reserved Permission to reproduce and distribute, in whole or in part, is granted to the U.S. Government

24 two-year period, from July 1, 1995, to July 1, 1997, when all provisions of the joint rule went into effect. 20 Ongoing Interpretation and Application of the CRA Regulations. Since the promulgation of the joint rule, the agencies have continued to develop their regulatory policy on CRA performance through the publication of Interagency Questions and Answers Regarding Community Reinvestment that interpret the regulations through responses to specific frequently asked questions. 21 The agencies have also provided guidance on specific questions relating to the application of the CRA regulations through issuance of Interpretive Letters. 22 In addition, the increasing number of publicly available bank CRA Performance Evaluations sheds some light on how the standards for CRA performance are being applied by examiners in the field. 23 Scope. The joint rule applies to substantially all the banks operating in the U.S. 24 There are limited exceptions for special purpose banks (such as banker s banks and banks that provide only cash management controlled disbursement services, correspondent banking services, trust company services, or clearing agent services) and for certain types of uninsured banks. 25 There are also special provisions for small banks. 26 The rules specifically apply, however, to limited purpose banks, wholesale banks and insured Federal or state branches of foreign banks. 27 The Credit Needs of the Community. The joint rule generally provides that each agency will base a bank s CRA rating on an evaluation of the bank s performance record in meeting the credit needs of its community. 28 The concept of a community s credit needs used in the joint rule explicitly incorporates the concept of community development. 29 Community development under the regulations is an active concept that requires a bank to take affirmative action to address the needs of its community. This contrasts with the prior CRA regulations which listed as the first two criteria for evaluating a bank s CRA performance the activities conducted by the bank to ascertain the credit needs of the community and the bank s activities to make the community aware of the credit services that the bank had to offer. 30 The Definition of a Bank s Community. The joint rule requires a bank to specify the geographic area that it considers to be the community in which the bank operates. 31 This defined community is referred to as the assessment area. 32 In general, a bank s assessment area is defined in terms of the consolidated metropolitan statistical areas or other political subdivisions within which the bank s headquarters, branches and deposit-taking ATM machines are located, as well as any contiguous surrounding areas in which the bank originated or purchased a substantial portion of its loans. 33 In addition to a bank s local community (defined by its assessment area), a bank can define a larger statewide or regional area within which it operates. This larger region must include the bank s assessment area or areas, must be contiguous, and must be defined in terms of political units (such as states, counties or cities). 34 The Performance Context. A bank s definition of its community, both local and regional, is important because the tests and standards under the joint rule are applied to a bank in the context of the specific conditions that exist in the bank s assessment area. 35 The joint rule identifies a number of categories of information that are relevant, including: demographic data, information about lending, investment and service opportunities, the bank s product offerings, 3 Copyright C.L. Davis All Rights Reserved Permission to reproduce and distribute, in whole or in part, is granted to the U.S. Government

25 the bank s institutional capacity and financial condition, the economic climate, past performance and public comments. 36 The joint rule does not provide a specific process for defining a bank s performance context. A bank may, but is not required to, prepare or present information on its performance context to examiners. 37 Similarly, the regulations do not require the agencies to collect any particular information or go through specified procedures to determine a bank s performance context. The guidance in the 2001 Interagency Questions and Answers assumes, however, that the agencies will provide examiners with information on the community and that the examiners will develop additional relevant information through independent investigation. 38 Evaluating a Bank s CRA Performance. A bank s overall CRA performance is rated as Outstanding, Satisfactory, Needs to Improve, or Substantial Noncompliance. 39 To determine a bank s overall CRA rating, the agencies rate the bank on the basis of its performance in each of three performance categories: lending, service, and investment. 40 In determining the CRA rating, a bank s performance in each of the three areas is scored separately. 41 In this regard, the joint rule specifically provides that activities considered for purposes of evaluating performance under the lending and service tests may not be considered when evaluating performance under the investment test. 42 Performance in each category is rated numerically, but the three tests are not all of equal weight. The overall CRA rating is determined by a matrix, which takes both the individual test scores and the bank s combined score on all three tests into account in determining the bank's overall CRA rating. 43 Subject to some exceptions, the matrix gives the lending test a 50% weight and each of the service and investment tests a 25% weight in determining the overall CRA rating. Investment and CRA Performance Ratings. The requirement that activities evaluated under the lending or service tests cannot be considered when evaluating performance under the investment test requires a bank to focus specifically on its investment activity, as distinct from lending and other banking activities. This emphasis is reinforced by the scoring methodology used under the joint rule. Scoring under the joint rule is intentionally structured so that satisfactory performance in all three performance tests is important to the overall rating. The performance scoring system in the joint rule is discussed in the preface to the joint final rule in the adopting release, which describes the specific intention of the agencies to require that even if a bank had the maximum score in both lending and one of the other two areas, at least a low satisfactory performance rating in the third area would be necessary for the bank to receive an overall CRA rating of Outstanding. 44 The effect of investment performance test ratings on overall bank CRA ratings can be seen by reviewing the publicly available CRA Performance Evaluations on the agency s Internet web sites. 45 The Investment Test Effective Date for the Investment Test. Since July 1, 1997, a bank s investment activity has been one of the three types of activity that is evaluated by the regulating agencies to determine a bank s CRA rating. The joint rule requires the regulating agencies to evaluate a bank s record of helping meet the credit needs of its assessment area through qualified investments that benefit its assessment area or a broader statewide or regional area that includes the bank s assessment area(s) Copyright C.L. Davis All Rights Reserved Permission to reproduce and distribute, in whole or in part, is granted to the U.S. Government

26 Criteria for Evaluating Investments. The joint rule provides four specific criteria to be used in evaluating a bank's CRA investment performance: (1) the dollar amount of qualified investments, (2) the innovativeness or complexity of the investments, (3) the responsiveness of the investments to credit and community development needs, and (4) the degree to which such investments are not routinely made by private investors. 47 While the dollar amount of an investment is a quantitative matter, the other three criteria require a qualitative evaluation of an investment. The 2001 Interagency Questions and Answers discusses how examiners should combine the quantitative and qualitative criteria, and indicate that the quantitative evaluation of the amount of a bank s investments determines a base rating, and the evaluation of the qualitative aspects of the investments determines whether there is a basis for a higher rating than would be justified solely by the amount of the bank s investments. 48 Qualified Investments. For purposes of evaluating a bank s performance under the investment test, the joint rule defines the characteristics of investments which can be considered. These investments are referred to as qualified investments. 49 The joint rule defines qualified investments as lawful investments that have as their primary purpose community development. Both primary purpose and community development are used as terms of art in the definition of qualified investment. The Definition of Community Development. The definition of community development in the joint rule 50 specifically identifies four activities: (1) affordable housing and community services for low- and moderate-income people (2) community services to low- and moderate income people, (3) activities that promote economic development by financing businesses or farms that meet the size eligibility standards of the Small Business Administration s Development Company or Small Business Investment Company programs 51 and (4) activities which revitalize or stabilize low- and moderate-income communities. 52 The activities listed as items (1), (2) and (4) reflect traditional concepts of community development. The explicit inclusion of financing businesses and farms in item (3) as a community development activity is a significant change from the much vaguer language regarding community development in the old regulations. 53 The Definition of Primary Purpose. The term primary purpose is critical to determining whether an investment will be a qualifying investment. The term, however, is not defined in the regulation and has been the subject of considerable uncertainty. The 2001 Interagency Questions and Answers adopted a new question and answer specifically to clarify the term. 54 An investment has as its primary purpose community development when it is designed for the express purpose of accomplishing one of the four activities in the definition of community development. An investment is viewed as being designed for the express purpose of accomplishing a community development activity if it meets one of two tests. The first test is whether a majority of the dollars of the investment are identifiable to one or more of the four community development activities. If the first test is not met, an investment may still qualify if (1) the express, bona fide intent of the investment is to achieve a community development purpose, (2) the investment is specifically structured to achieve the community development purpose, and (3) the investment actually accomplishes or is reasonably certain to accomplish its community development purpose. 5 Copyright C.L. Davis All Rights Reserved Permission to reproduce and distribute, in whole or in part, is granted to the U.S. Government

27 Investments in Businesses Qualify under CRA. The joint rule expressly recognizes investments (distinct from loans) by banks in businesses and farms as a qualified CRA activity. 55 Although the language of the joint rule does not distinguish between financing businesses and farms and the other types of activity listed in the definition of community development, the bank regulatory agencies have interpreted the regulation to require both as size and a purpose test for investments in business, so that even if a business meets the size standards set forth in the definition of community development, an investment in a business or farm must additionally meet one of the other criteria listed in the definition in order to be considered a qualified investment. 56 SBICs as Qualified Investments SBICs are Permitted Nonbank Investments for Banks. As discussed above, bank and savings association ownership of SBICs is specifically authorized by statute. 57 Equally important, securities owned by an SBIC in nonbank businesses are not attributed to a bank that owns an interest in the SBIC. This non-attribution is the case whether the SBIC is a wholly owned subsidiary of the bank or the bank is a minority owner of an independent SBIC. As a result, SBICs avoid a common problem for banks considering community development activity through investments in nonbank businesses. SBICs are Qualified Investments. SBICs have a unique favorable treatment as qualified investments under the CRA regulations and agency interpretations. The adopting release for the final joint rule specifically identifies investment in an SBIC as an example of a qualified investment for CRA purposes. 58 The status of SBICs as qualified investments is clarified further in the 2001 Interagency Questions and Answers, which state that bank examiners will presume that an investment in an SBIC promotes economic development and meets the standard for a qualified investment. 59 In addition, the release for the joint rule clearly contemplates that it is the investment by the bank in the SBIC itself that is considered for CRA purposes, not the underlying portfolio investments subsequently made by the SBIC. 60 SBICs Comparative Advantage as Qualified Investments. The presumption of economic development purpose given to SBICs creates an important distinction between an SBIC and most other types of investments (including non-sbic investment funds) for a potential bank investor. A bank s investment in an SBIC will be presumed by examiners to be a qualified investment without further evaluation. In the case of non-sbic investment funds, however, examiners will specifically evaluate whether the primary purpose of the fund is to engage in one or more of the community development activities specifically enumerated in the regulations. 61 Independent and Bank-Affiliated SBICs. Investments in independent SBICs and affiliated SBICs are both considered qualified investments under the joint rule. The joint rule specifically permits a bank to receive credit for a qualified investment made by an affiliate (including a bank holding company parent), so long as no other bank is also claiming CRA credit for that investment. 62 The provisions of the joint rule which allow a bank to receive CRA credit for investments by affiliates allow a bank to take advantage of a broader range of investment opportunities than it could participate in directly. 63 This flexibility provides a bank that wishes 6 Copyright C.L. Davis All Rights Reserved Permission to reproduce and distribute, in whole or in part, is granted to the U.S. Government

28 to use the SBIC program as a means of addressing its CRA obligations with a wide range of alternatives in structuring and managing a qualified investment program. Local, State, and Regional Investment. The investment test under the joint rule specifically permits consideration of qualified investments made outside the bank s assessment area in a broader surrounding region that includes the assessment area. 64 In the case of wholesale and limited purpose banks (such as credit card banks), the regulations permit a bank to consider qualified investments on a nationwide basis. 65 Permitting a regional investment focus makes it easier for a bank to determine in advance whether a prospective SBIC will be an appropriate qualified investment. As a result, allowing an SBIC that has a regional (and for some banks, national) focus to be considered a qualified investment makes SBICs much more attractive and practical investments for CRA oriented bank investors. 66 The Importance of the Regional Investment Focus. Recognizing regionally focused SBICs as qualified investments is an important step in aligning the CRA regulations with the way SBICs actually need to operate in order to be economically viable investment operations. 67 A broad geographic territory is important for the successful operation of most SBICs, since few individual assessment areas can provide sufficient deal flow to permit an SBIC to create a diversified portfolio of private investments. 68 In addition, because SBICs (particularly independent SBICs) are typically formed as blind pools with a limited investment period (normally 2 to 4 years) it is rarely possible to predict whether a specific locality or community will generate potential investment opportunities for a particular SBIC. Evaluating a Specific Investment for CRA Purposes. A question frequently asked by both SBIC managers and bankers is whether a bank will receive CRA credit for a particular investment in an SBIC. The first issue is whether the SBIC is a qualified investment as defined in the joint rule. For an SBIC, the answer to this question will normally be yes, because an investment in an SBIC is presumed under the joint rule to be a qualified investment. 69 The second issue is whether the SBIC is relevant to the bank s CRA performance. In the first instance, the answer to this question depends on whether the SBIC operates in the bank s region. 70 This is a factual question and the answer will depend on the SBIC s business plan (does the SBIC explicitly intend to seek investments and/or invest in the bank s region) and the SBIC s actual performance. Weighing Qualified Investments. All qualified investments do not receive equal weight (equal CRA credit ) in the evaluation of a bank s CRA performance. To the extent information is available, examiners will assess the needs and opportunities for qualified investments in a bank s performance context. 71 Examiners evaluate qualified investments using the criteria described in the joint rule: taking into account both the amount of the investment 72 and any other qualitative factors. 73 Finally, since almost all SBICs operate on a regional basis (as opposed to operating exclusively in a bank s assessment area), examiners will evaluate the degree to which the SBIC s investment activity is likely to (or does) benefit the bank s assessment area. 74 While the 2001 Interagency Questions and Answers are clear that an investment need not directly benefit a bank s assessment area, it seems equally clear that the more likely it is that the investment will produce a benefit to the assessment area, the greater the weight that investment will receive. 7 Copyright C.L. Davis All Rights Reserved Permission to reproduce and distribute, in whole or in part, is granted to the U.S. Government