and Forrest Tancer, vice president of the SBIC, each personally owned 25 percent of Tar Gard Corp. After brooding, they decided to drop the SBIC deal and obtain their filter money elsewhere. Says Mr. Joffe: "If anything went wrong with the loan, it would have been very unpleasant for us" with the other 21 SBIC stockholders. Differing views about self-dealing are illustrated by Robert M. Nason, president of Arizona Capital Corp., in Tucson. One director of this SBIC insisted he did not want to borrow from it and obtained money elsewhere. But SBA approval has been sought and granted for a $60,000 loan to a company in which another director, F. C. Thum, holds an interest. Mr. Thum is president of this concern, John Porter Manufacturing Co., of Phoenix; the SBA letter of approval noted he owns less than 5 percent of its stock but holds an option which would give him 31 percent equity. SBA officials say they apply three criteria to self-dealing applications. First, there must be noninterested persons in the SBIC with power to block the transaction if they wanted to. Second, terms of the deal must be "fair and reasonable." Third, the arrangement must "serve the purposes of the Small Business Investment Act of 1958." Though this may seem vague, and though officials refuse to elaborate, it has been used to reject a few proposals. Neil Christopher, president of Southern Small Business Investment Co., in New Orleans, says Washington prohibited a $60,000 loan intended for Hammond Homes, a real estate development firm. SBA objected that Southern Small Business Investment Co. was controlled by a mortgage company in which Mr. Christopher and an associate together held 49.5 percent ownership; that the two of them owned all of Hammond Homes; that the projected deal "would constitute a use of the (SBIC) by its owners as a financing medium of their own undertaking." Complains Mr. Christopher: "If the SBA was justified in turning down this loan, it should have turned down a lot of the others it has approved. I think a lot of SBIC's have gotten loans that were the same kind as mine. It might be that some of the others didn't furnish full information." SBA operations How much information the SBA does demand remains obscure. Its officials say they do not normally attempt on-scene investigations before approving selfdeals, though traveling examiners may later look into them during routine checks made every year or two. Washington operates mainly by correspondence. And its letters of approval seem by reporters merely recite back to the self-dealing SBIC the same information the SBIC has provided. Sometimes Washington takes months to make up its mind. But SBA took only 2 days to clear a deal for Chicago Capital Corp.; a director of this SBIC happened to be partner in a law firm serving as legal counsel for a company which obtained a loan, and he also served as a director and secretary of his borrowing company-but he had no financial interest in it. In some cases the Small Business Administration may be getting slightly less than the full story. Gerald Hardwick, president of First West Texas Capital Corp., in Odessa, Tex., pulled out of the files for a visiting reporter a letter from SBA authorizing a loan "in the amount of $62,500" to Rebel Pipe & Supply Co., Inc., partially owned by J. D. Ormand, a director of the SBIC. The loan actually granted was $85,000, however, he declared. He explained that after filing its application this SBIC had increased its capital surplus, which raised its ceiling on the size of any one loan-so he didn't think further approval by SBA was necessary. "If it hadn't been a good loan, I would have voted 'no' myself," commented Mr. Ormand. He declined to disclose earnings of Rebel, a small oilfield equipment concern. According to the SBIC's annual report, however, Rebel showed a profit of $13,960 at the end of its last fiscal year-August 31, 1962-and a loss of $9,533 through February 28 of this year. The SBIC itself operated at a $7,520 loss in the year ended March 31. It has received $470,000 in taxpayer money from the SBA. Many real estate ventures Though SBIC's on the SBA's list of "self-dealers" enter diverse ventures, they appear to find a special magnetism in real estate. And with full approval of the Small Business Administration-although this agency, when operating under a separate direct-loan program to small businesses, proclaims that it will not back “speculation in any kind of real or personal property" because of its “unique responsibilities as a lender of taxpayers' money." "Congress should have been more specific in the type of investments it allows the SBIC's to make. I don't think they should allow real estate loans; there is plenty of venture money available for real estate development." So says Ezra Mintz, portfolio manager for Georgia Capital Corp. of Atlanta. Nevertheless this SBIC, which has drawn $600,000 in Federal funds, made two $60,000 loans last year to a real estate holding company whose president at the time was a vice president of Georgia Capital, he reports. Details are withheld because they are of "a personal nature." In the Boston area, all three of the SBIC's which SBA reports as having received approval for self-dealing share their offices with real estate firms, and their transactions have involved real estate in some form. Alan Zuker, treasurer of Chestnut Hill Capital Corp., says that when this SBIC took a third mortgage on a Boston apartment house owned by Diwal Trust, it granted an interest rate of 10 percent, somewhat lower than for other borrowers. The reason, he reports, is that Chestnut Hill's president, Robert Waldman is, as a stockholder, entitled to a special rate, and he is a trustee of Diwal Trust. Says Mr. Waldman: "There was sufficient equity in the property to merit the loan." Colony Hotel Corp. Julian Cohen, treasurer of Massapoag Investment Corp., in Brookline, Mass., and partner in the real estate firm which shares office quarters, says that this SBIC's deal cleared by SBA did not really involve self-dealing. He states Massapoag granted a $54,000 mortgage for his brother, Bernard Cohen, on the Colony Hotel Corp., in Swampscott. Bernard Berkman is a man of many interests who likewise denies any real self-dealing. He says he sells insurance and owns a liquor store and operates— within one office in Brookline-a real estate firm, Berkman Associates, Inc., and Pilgrim Capital Corp., an SBIC. He is president of both. Phillip Lemelman is clerk (secretary) and a director of the SBIC; his son, Herbert Lemelman, is clerk of Berkman Associates, according to Mr. Berkman; the Lemelmans have joint law offices. Pilgrim loaned $17,500 to Wendell Realty Corp. last year on a Boston guesthouse, subject to a previous bank mortgage, according to Mr. Berkman. Treas urer of Wendell Realty is Phillip Lemelman; he declines to comment on the deal but his son, Herbert, says "my father is a substantial owner of Wendell." Mr. Berkman declares SBA approval was also gained for a $30,000 second mortgage granted last September to Bayside Manor Nursing Home, Inc., of which Herbert Lemelman was an incorporator. Pilgrim also has granted Bayside short-term loans from time to time, Mr. Berkman says. "Pilgrim agreed to buy 50 shares of Bayside stock, but the price has not been determined as yet," adds Mr. Berkman. Bayside's president, Richard Gens, states that Pilgrim has obtained the 50 shares, amounting to half ownership, paying nothing for this stock since it was granted in return for a "favorable" 8-percent interest rate on the loans. "They put in the venture capital and we put in the know-how," comments Mr. Gens. Herbert Lemelman declines to confirm Mr. Berkman's statement that he or his father obtained SBA approval on behalf of Pilgrim for the Bayside and Wendell loans. "It is not a matter of public record," he comments. He insists neither he nor his father engaged in self-dealing. “We are lawyers and professional clerks and we do this all the time; we have no (investment) interest in Bayside or Pilgrim." Mr. Berkman states that he personally owns all of Pilgrim's stock, with $154,000 of his own capital and $150,000 borrowings from SBA. And he too insists none of Pilgrim's transactions constitute self-dealing. Richard Felts, manager of Small Business Investment Corp. of Georgia, says it lent $45,000 last summer to Pleasant Hill Acres, Inc., which wanted to develop a trailer park at the edge of Atlanta. Two of this SBIC's directors owned 20 percent shares in Pleasant Hill. Since the SBIC had previously invested in a trailer sales agency, explains Mr. Felts, "I looked upon the creation of this mobile home park as a potential to sell some of our trailers." He adds: "We're not deliberately going into self-dealing transactions; we'd rather avoid them. It's going to be hard, because each of our 27 directors have diverse business interests around town * ** we don't want to turn down a good deal." When SBA Deputy Administrator Parris officially approved a $60,000 loan to Crossroads Development, Inc., by Small Business Investment Co. of Hawaii, an SBIC in Honolulu, he wrote that "Crossroads is stated to be a real estate devel opment company, with two projects currently underway and plans for continuing series of development projects." He noted, with his approval, that Crossroads was wholly owned by Robert D. Thomas, vice president of the SBIC. Mr. Thomas has invested $5,000 in this SBIC, according to its officials, while the SBA has put in $300,000. [From the Wall Street Journal, July 8, 1963] FLEXIBLE FEDERAL ETHICS Some close scrutiny certainly seems in order when an agency of the Federal Government deliberately fosters conflicts of interest. As this newspaper reported the other day, that's just what the Small Business Administration is doing. This activity involves some of the nation's 600 small business investment corporations, private firms clustered under the supervisory wing of the SBA. When Congress authorized the SBIC's a few years ago, its aim was to provide a new source of capital for little companies. But despite tax advantages and Federal financial help, most SBIC's have found it unprofitable to lend to small firms; many such firms simply aren't good risks and others require costly supervision. In this situation, some of these "small business" lenders are seeking the right to lend to big business; others are folding up and selling out. But still others are trying another tack: They're lending to firms in which their own officials are interested. What's more, this practice in many cases is not merely condoned but encouraged by the SBA. The Washington agency, to cite only one example, gave the go-ahead to a $60,000 loan by the Small Business Investment Co. of Hawaii to Crossroads Development, Inc., a real estate development company. The SBA was not deterred by the fact that the owner of Crossroads and the vice president of the SBIC happen to be one and the same. Speaking of the general practice, which the SBA cheerfully labels "self-dealing," one of the agency's officials argues that it gives the SBIC's desirable "flexibility." Another SBA man adds: "We don't want to bog small SBIC's down with too many regulations." Though self-dealing is perfectly legal-and may even be profitable for the SBIC's some Federal agencies fail to share the SBA's enthusiasm for it. The Securities and Exchange Commission, keeping an eye on SBIC's which have sold stock to the public, refuses to OK such loans; it fears that self-dealing officials could influence lending to their own failing enterprises, or perhaps get a "free ride" for their own investments made profitable by injection of SBIC money. It could be noted that the SBA is a dubious enterprise from many points of view, with its subsidized competition for private banks and its program of reserving Government business for small companies merely because they are small. It becomes even more dubious when it eagerly promotes flexible ethics. (The reply from the administration follows:) EXHIBIT 4 AFFILIATED TRANSACTIONS The committee requested that we submit a reply to the Wall Street Journal's criticism of affiliated transactions. The attached letter to Senator William Proxmire, dated July 9, 1963, reflects the agency's position in connection with the article's treatment of these transactions. The amendment to the Small Business Investment Act of 1958, which was enacted this past year as Public Law 88-273, deals specifically with the regulatory treatment of the subject. SMALL BUSINESS ADMINISTRATION, Hon. WILLIAM PROXMIRE, Washington, D.C. DEAR SENATOR PROXMIRE: This is in reply to your letter of July 2, 1963, requesting our specific comments on the article of July 2, in the Wall Street Journal entitled, "Usual Federal Frown on Conflicts of Interest Absent in SBIC Cases." We appreciate this opportunity to explain our own position since the Wall Street Journal article contains a number of statements that are misleading, incomplete, or only partly true. This is not surprising since, from past experience, we know that the Wall Street Journal can hardly be regarded as an objective observer of small business problems of Main Street. The purpose of this letter, however, is not to answer all of the misleading points of the Journal article, but to answer the points raised by your letter. For convenience, we first will list the four basic points or implied questions set forth in your letter. 1. Does SBA "encourage this highly questionable activity" (i.e., transactions labeled for convenience as "self deals" but which would be better described as transactions involving affiliation of interest between an SBIC and a small business concern in which the SBIC invests)? 2. Are the three criteria used by SBA in reviewing such transactions "so vague as to be virtually meaningless"? 3. Should SBA have refused to "disclose to the press the full and complete story on self-dealing"? 4. Should the "examples given in the article of self-dealing by SBIC's in real estate ventures and speculations" be regarded as "particularly alarming"? At the outset, it should be noted that "self-dealing" is regulated by SBA under section 107.716 of the regulations, which provides as follows: “Section 107.716 Self-dealing limitation. "(a) Self-dealing to the prejudice of SBA or the licensee's shareholders is prohibited. "(b) Without the prior written approval of SBA, a licensee shall not purchase equity securities of, or make a loan to, an officer or a director of the licensee, or any person owning or controlling, directly or indirectly, 10 or more percent of the stock of said licensee, or any close relative of such officer, director, or stock owner or controller, nor shall the licensee purchase equity securities of or make a loan to any company in which such officer or director or such owner or controller of the licensee's stock, or his close relative is an officer or director or owns or controls 10 or more percent of the stock of such company: Provided, further, That without the prior written approval of SBA a licensee shall not make such purchase of such securities or make such loan within 6 months after the termination of such officership or directorship in the licensee, or within 6 months after the termination of such ownership or control of 10 or more percent of the licensee's stock. Nothing herein contained is intended to preclude a licensee from permitting an officer, employee or representative from serving as a director, officer, or in any other capacity in the management of a small business concern for the purpose of protecting its investment in, or loan to, such concern. "(c) Without the prior written approval of SBA, no licensee, nor any officer or director thereof, shall borrow money from a small business concern, or from any officer, director, or owner thereof, which has sold equity securities as defined in section 107.501 to, or has borrowed money from, said licensee." In this connection, it should be noted that SBA's procedure and regulations in this respect have been in effect continuously since 1959. 1. Does SBA "encourage this highly questionable activity"? The article states that SBA officials are "sponsoring" financial transactions that involve various degrees of affiliation between principals of an SBIC and a small business concern. In the first place, SBA does not "sponsor" any investment made by an SBIC. Each SBIC, as a privately owned and operated corporation, has complete authority and sole responsibility to determine which investments it will make, so long as such investments are permissible under the provisions of the Small Business Investment Act and the regulations. In the second place, there is a distinct difference between granting an exception from the prohibition of a regulation and the "sponsoring" of a transaction. The kind of transaction discussed in the article is prohibited, except where prior SBA approval has been obtained. Regarding the comment that "taxpayer money is involved" in these transactions, this program does not provide grants of Federal money but rather provides for Federal loans to SBIC's. Moreover, substantial private investment must be made before Federal funds are available. Even in transactions where there is some element of affiliated interest, the individual investments of the SBIC stockholders are at stake since their investments are subordinated to Federal funds. It should be noted that many of the affiliated transactions approved by this agency do not involve an affiliation created by substantial stock interest by the same person in both the SBIC and small business concern. The affiliation more often is created by a director or officer of the SBIC who is a director or officer of a small business concern. These transactions arise more frequently in the smaller SBIC's that are serving a particular community, where many of the officers and directors are local small businessmen whose businesses need financial assistance. It is only natural that these men would turn to the SBIC with which they are associated. Analysis of the cases mentioned in the Journal will bear out our contention that this is primarily a problem of the smaller SBIC's. To recognize that this problem of small SBIC's exists and to regulate it is hardly the same as saying that we are "sponsoring" this kind of financial transaction. During the 9-month period ended June 30, 1963, of 45 applications for SBA approval of an "affiliated interest" investment or loan, processed to completion, 38 were approved and 7 were denied. Of the 38 approved, only 3 involved companies having statutory capital and paid-in surplus in excess of $1 million. The total investments made by by the 38 companies that were granted approvals was approximately $3 million. During the same 9-month period, the amount of long-term loans and equity capital invested by about 650 licensees was at the rate of about $14 million per month, or approximately $126 million. 2. Are the three criteria used by SBA in reviewing such transactions "so vague as to be virtually meaningless"? On the surface, it would seem desirable to have detailed and very specific tests for reviewing transactions involving affiliated interests. A review, however, of statutes, regulations, and court decisions applicable to other regulated investment companies, banks, financial institutions, and fiduciary duties of corporate officers reveals that the tests used are generally broad in nature. For example, under the Investment Company Act of 1940 (to which many SBIC's are subject), Congress itself used broad standards with respect to financial transations between affiliated persons that might be permissible upon application. This, section 17(b) of the 1940 act provides that the Commission may exempt certain otherwise prohibited financial transactions between affiliated persons if the evidence establishes that "(1) the terms of the proposed transactions * * * are reasonable and fair and do not involve overreaching on the part of any person concerned, (2) the proposed transactions is consistent with the policy of each registered investment company concerned * * *, and (3) the proposed transaction is consistent with the general purposes of this title (the 1940 act)." In addition, section 21(b) of the 1940 act prohibits with one exception so-called upstream loans (that is, loans by an investment company to any person that "controls" or is "under common control" with the investment company). These 1940 act tests are quite similar to the standards that are applied by SBA which are summarized in the Journal and in your letter. 3. Should SBA have refused to "disclose to the press the full and complete story on self-dealing"? The purpose of the SBIC program is to assist small business concerns to obtain long-term funds on reasonable terms. In line with that purpose, we have reduced as much as possible, consistent with the protection of Government funds and of small business firms, the administrative burdens placed on SBIC's which they, in turn, would have to place on their small business clients. Also consistant with SBA's policy, established in 1953 under the Small Business Act, we have treated business data of small business concerns and SBIC's on a confidential basis under the Small Business Investment Act. Furthermore, the Small Business Investment Act does not require SBA to act pursuant to order, after appropriate notice and opportunity for hearing, or to make public disclosure of information filed by SBIC's in this area. In contrast, the SEC is required by section 40 of the Investment Company Act to act by notice and order and by section 45 to make public disclosure of information filed with it, unless the SEC finds that the public disclosure is "neither necessary nor appropriate in the public interest or for the protection of investors." The statutory responsibility of this agency has been to develop a good regulatory balance between protection of Government funds and small business concerns on the one hand and the establishment of a "program to stimulate and supplement the flow of private equity capital and long-term funds which small business concerns need for the sound financing of their business operations and for their growth * * *" (sec. 102 of the Small Business Investment Act). This dual responsibility was pointed out with considerable emphasis to the Journal at the |