On May 2, the U.S. Small Business Administration (SBA) published a Notice, delaying for an additional 90 days the effective date of a recent Final Rule that modifies SBA’s regulations on the ability of a small business investment company (SBIC) to finance passive businesses. (See our previous Client Alert for a summary of this Final Rule).

The Final Rule was scheduled to take effect on January 27. However, on January 26, SBA pushed the effective date to March 21 and invited additional public comment on the Final Rule. SBA further delayed the effective date of the Final Rule to May 20, but, unlike the initial delay, SBA did not reopen the comment period.

SBA has now again delayed the effective date of the Final Rule to August 18 and has requested comment regarding whether SBA should remove the provision benefitting SBICs with investors that are taxed as regulated investment companies. Comments are due no later than June 1.

The initial delay and reopening of the public comment period was the result of a January 20 memorandum from the White House titled “Regulatory Freeze Pending Review,” which calls for agencies to temporarily postpone the effective date of any pending rules and to invite new public comment. The initial delay was a fairly standard regulatory action taken when there is a change in presidential administrations from one political party to another. When SBA published the second delay, it stated that it would use the additional period to consider further the Final Rule’s impact on the SBIC program and its participants and to make necessary determinations regarding the effects of the Final Rule on the examination and liquidation functions of the SBA’s Office of Investment and Innovation.

In the May 2 Notice, SBA stated that it was considering removing the provision of the Final Rule that would allow an SBIC to use a blocker entity to protect any of the SBIC’s investors that have elected to be taxed as a regulated investment company (RIC) from receiving (or being deemed to receive) gross income that does not qualify under section 851(b)(2) of the Internal Revenue Code. This provision in the Final Rule was specifically designed to allow SBICs that are owned by business development companies (BDCs) to invest in the equity interests of portfolio companies taxed as partnerships through a blocker entity to preserve the BDC’s RIC status and avoid the adverse tax consequences that would arise if the BDC lost that status.

SBA noted that there are currently 31 SBICs with BDC investors holding greater than 23 percent of SBA’s guaranteed leverage and its belief that, if the Final Rule became effective, many SBICs owned by BDCs would structure a number of their investments through blocker entities. SBA expressed concern that, because BDC-owned SBICs represent a large percentage of SBA’s guaranteed leverage portfolio, the SBIC program could be exposed to an unacceptable level of risk if these SBICs structured a significant number of investments through blocker entities, unless SBA increased significantly its examination and monitoring resources. Therefore, SBA is considering revising the Final Rule to remove this provision.

We note that SBICs are presently permitted, with SBA prior written approval, to use a blocker corporation to protect any of the SBIC’s investors from incurring “unrelated business taxable income” (UBTI) and that the Final Rule extended the permitted use of blocker entities to protect any of the SBIC’s investors from incurring “effectively connected income” (ECI). In the May 2 Notice, SBA expressed its expectation that the number of blocker entities used to protect against UBTI and ECI would be relatively low when compared with the anticipated use of blocker entities by BDC-owned SBICs to preserve the BDC’s RIC status. Thus, it seems that UBTI and ECI exceptions will be preserved once the Final Rule becomes effective.

The Final Rule’s modifications to the passive business SBIC program regulations, along with two technical changes unrelated to those regulations, will not go into effect until August 18. However, the delay in implementing those technical changes does not impact their effect under the law. One change reflects SBA’s current oversight practices allowing for a reduction of the minimum $5 million regulatory capital and $2.5 million leveragable capital requirements for SBICs if the reductions are performed in accordance with an SBA-approved wind-up plan. The other change reflects congressional legislation that had an immediate effect on the increase in the maximum amount of SBA leverage available to SBICs under common control from $225 million to $350 million.

A more detailed description of the SBIC Program is available in the Pepper Hamilton publication “Description of the Small Business Investment Company Debenture Program.”