dealer firm and buy the stock. Then the bids and asks are usually published in the sheets" *** (hearing, Subcommittee on Banking and Currency, 85th Cong., 1st sess., May 20-29, 1957, pp. 63–69).

Following Mr. Armstrong's testimony, C. Canby Balderston, Vice Chairman of the Board of Governors of the Federal Reserve System, was questioned by the committee on the same point:

"Senator BENNETT. Yesterday, when Mr. Armstrong was testifying, he suggested two amendments, one of which interests me in view of your endorsement of S. 1168. This particular amendment would put into operation the provisions of the present Securities Exchange Act affecting insider trading, but it would suspend them for a period of 2 years to give the SEC a change to weigh its effect on this situation.

"On these over-the-counter securities there is no ready-made market, is there, on the existing exchange? I know from personal experience that, as a matter of practical fact, in many of these local companies-and most of them are localthere is a local broker either on the board or interested in the company, who more or less undertakes to make a market, and who is willing to buy and sell the security, sometimes out of his own inventory, just in order to keep some kind of a market going on the security.

"The SEC testified that their scanty investigation had revealed that that was beneficial to the security holders and might be destroyed by an immediate enforcement of the rules against insider trading, and they wanted a chance to have the reports that would be required by the bill available after 2 years for study so that they could determine, on the basis of actual reports, the effect of this provision.

"That is a long statement. Do you think the Board would have any objection to that particular amendment?

"Mr. BALDERSTON. Well, Senator Bennett, I cannot speak for the Board as a whole, but I would be happy to speak for myself. It is my feeling that it would be well not to apply that provision immediately, and perhaps not even at the end of the 2-year study which was suggested by Mr. Armstrong. I share rather strongly the view that you have presented, that our small-and-medium-sized companies have difficulty in maintaining access to the capital markets; that when they ask a broker to go on the board of such a company they are seeking not only advice with respect to future financing, they are seeking also his help in making a market for their stock which otherwise might not exist.

"In fact, it is conceivable to me that such a broker might not be willing to help with a new issue unless he had taken a substantial position in the stock of the company in question. If he were to back a new issue without having taken that substantial position, the issue might prove a failure with unfortunate results, both to the broker and to the company. Consequently, my feeling at the moment would be that informed students of the subject might be able to agree right now, before the making of the study suggested by Mr. Armstrong. I would have no objection, certainly, to the study proposed, except that it involves some expense."

The SBIC's which have had public offerings to date have, until recently, had a reasonably favorable market acceptance. Because of the newness of the industry, this market acceptance has been and must be considered a fragile thing. In a number of instances a fair market price was only maintained because of markets afforded by underwriters of the stocks. Since none of the SBIC's has been in operation long enough to have any real history, the entire program is being watched closely for favorable or unfavorable developments. While the publicly held SBIC's have been remarkably successful in attracting outstanding business leaders in their various communities to serve on their board of directors, the management of each of these companies had obviously had no direct previous experience in the field. In short, the entire SBIC program is clearly on trial. Continued public acceptance and confidence in this program is essential if the SBIC's which have not yet tapped the public money market are to become economically feasible operations.

Basic to public acceptance of this new investment medium is an orderly, over-the-counter market in the stock of these companies. Since the stock of SBIC's presently held by the public has been outstanding for a relatively short time, the bulk of it less than a year, a much larger proportion of this stock is subject to trading than the more "seasoned" stock of the average over-thecounter company. In addition, as new SBIC offerings come out, a marked tendency has been observed for purchasers of earlier issues to sell a portion

of the earlier issue, replacing it with shares of the new issue, thus diversifying their SBIC holdings among several companies.

A further factor making SBIC stock subject to more than usual fluctuations in price is the fact that Congress has afforded SBIC stockholders an ordinary loss deduction on their shares, rather than the capital loss deduction applicable to other securities. Thus, the vulnerability of SBIC stock to "tax loss selling" is considerably greater than that of the average company.

For the foregoing reasons, having a responsible investment banking house making an orderly market in the SBIC stock is substantially more important than is the case with the usual unlisted company.

Unless the representative of the investment banking firm is exempted from the application of section 30 (f) of the 1940 act with respect to normal trading in making the over-the-counter market in the stock of the SBIC, he has no choice other than to resign from the board or avoid making a market in the stock of the SBIC. If the investment banker resigns from the board, the SBIC will suffer the loss of professional counsel in its deliberations. Having an investment banker act as an adviser to the board without the responsibilities and fiduciary duties of a director is obviously no substitute for his being a member of the board. On the other hand, if the investment banker remains on the board and his firm ceases to trade in the stock of the SBIC, its stockholders will cease to have the protection of an orderly market in its stock maintained by an investment banking firm identified with the SBIC and realizing a responsibility for the issue. In this connection it should be pointed out that rule 16(b-2) under the 1934 act exempts trading by an investment banking firm during the course of a distribution of a public offering. At the conclusion of the distribution, this exemption is no longer available. However, since practically all companies subject to section 16 are companies with securities listed on the national securities exchange, the problem of maintaining an orderly market in the stock is then in the hands of the specialist at the exchange. This specialist is required by the exchange to maintain an orderly market, buying as principal when sell orders exceed buy orders and selling when buy orders exceed sell orders.

Unfortunately, the small handful of companies subject to section 16 that are not listed on an exchange do not have the benefit of such services. Since the sponsoring investment banker can no longer make the market, if any market is made it will be made by a firm which does not have the responsibility to the company or to its shareholders that the sponsoring investment banking firm has. Accordingly, such market as another firm may make will be motivated solely by a profit motive and will tend to accentuate the variations in market price. The recent price fluctuations of SBIC's stock reflect this type of market. While the sponsoring firm feels a responsibility in that its name will be linked with the company involved, it also has the prospect of being the sponsoring underwriter on subsequent public offerings of the company. Neither factor is present with the independent firm which might otherwise fill the gap in making a market in the stock of the company.

Referring now to the language of section 10 (c) of H.R. 6672 as introduced, we respectfully submit that it fails for technical reasons to meet the full problem posed by section 30 (f) of the 1940 act. We believe section 10 (c) is deficient in three important respects:

1. The section as written is too broad in that it would make the requested exemption available not only to persons engaged in the business of buying and selling securities, but also to any other person who happened to be an officer, director, or 10-percent stockholder in a publicly owned SBIC. Our sole purpose in requesting the exemption is to protect only those officers, directors, or 10-percent shareholders of publicly owned SBIC's who are partners or officers in an investment banking firm maintaining a market for the securities of the small business investment company with which they are affiliated;

2. The formula for measuring profit as set forth in section 10 (c) of H.R. 6672 is, in our opinion, defective; and

3. Section 10 (c) as proposed fails to take into account existing liabilities to publicly owned companies under section 16(b) of the 1934 act.

In our March 28 memorandum to the Commission, we proposed language which we feel would achieve the solution necessary to the present problem. I now respectfully submit a draft of amended language for section 10 (c) of H.R. 6672. This same draft has been submitted to the House committee.

Thank you very much.

NATIONAL ASSOCIATION OF SMALL BUSINESS INVESTMENT COMPANIES, Washington, D.C., March 28, 1961. Re section 30 (f), Investment Company Act of 1940; request for limited exemption for small business investment companies. SECURITIES AND EXCHANGE COMMISSION, Washington, D.C.

GENTLEMEN: Representatives of this association met with Mr. Philip A. Loomis, Jr., Director, Division of Trade and Exchanges, and Mr. Abraham A. Raizen, Assistant Director, Division of Corporate Regulation, and other members of the Commission's staff on March 9, 1961, to discuss informally the matter of a limited exemption for small business investment companies under section 30 (f) of the Investment Company Act of 1940.

I now forward herewith 25 copies of a memorandum on this subject prepared in accordance with the suggestions of the staff.

This association regards this problem as critical and therefore would appreciate your early consideration of the enclosed request for limited exemption. Please feel free to call on the undersigned in the event you require additional information or assistance of any kind.

Sincerely yours,

CHARLES M. NOONE, General Counsel.

MEMORANDUM

To: Securities and Exchange Commission, Washington, D.C. From: National Association of Small Business Investment Companies, Washington, D.C.

On March 9, 1961, representatives of the National Association of Small Business Investment Companies (NASBIC), accompanied by Walter B. Stults, staff director of the Select Committee on Small Business of the U.S. Senate, met with members of your staff to discuss informally a most serious problem which had just been discovered with respect to the small business investment company program under the Small Business Investment Act of 1958 (SBIA). At the conclusion of the meeting with your staff it was suggested that a written presentation of this problem be submitted to the Commission. This memorandum is in response to that suggestion.

I. SUMMARY OF PROBLEM

In brief, the problem arises from the fact that publicly held small business investment companies (SBIC's) technically come within the definition of an "investment company" contained in the Investment Company Act of 1940 (1940 act). Accordingly, publicly held SBIC's have registered as investment companies under the 1940 act. By the operation of section 30(f) of that act, officers, directors, and 10-percent stockholders of these SBIC's are subject to the same duties and liabilities as those imposed by section 16 of the Securities Exchange Act of 1934 (1934 act).

Section 16 of the 1934 act provides, among other things, that the profits resulting from purchases and sales within a 6-month period by a director, officer or 10-percent stockholder of the company must be returned to the company. Some courts have held that the actual profit incurred in any such transactions is not the measure of recovery, but that the theoretical profit which might have been realized if the lowest purchase prices were matched with the highest sale prices can be recovered. Under these circumstances, a substantial liability to the company might arise even though the person involved had realized an actual loss on the transactions. In addition, these courts have held that the portion of any partnership profit attributable to a partner who is an officer, director or 10-percent stockholder is also subject to recovery. As a result, if an SBIC has on its board of directors a partner of an investment banking firm, this partner might be liable to the SBIC for his share of the theoretical profits that might have accrued from the normal trading activities of his partnership in maintaining a market for the stock of the SBIC.

Under such an application of section 16, a representative of an investment banking firm cannot serve on the board of directors of an SBIC if his firm has assumed the responsibility of making an orderly over-the-counter market in the stock of the SBIC. For the reasons hereafter set forth, it is believed that the continuance of this situation may have the effect of precluding new

SBIC's from obtaining capital through public offerings and will subject the thousands of stockholders of existing publicly held SBIC's to disorderly fluctuations in the market for their stock. The result may well be to stop further growth of the SBIC program just as it has reached the threshold of accomplishing the congressional design.

As hereafter set forth, the Commission has repeatedly advised congressional committees considering legislation which would make over-the-counter companies subject to 1934 act provisions, that it was opposed to the application of section 16(b) to over-the-counter trading, pointing out that a significant portion of such trading does not involve short-swing speculation but relates to the maintenance of adequate and liquid markets. The Commission also advised that the loss of such liquid markets would have an adverse effect on shareholders of such companies. For the reasons hereinafter set forth, it would appear that administrative exemption by the Commission rather than statutory exemption is the preferable course of action.

Accordingly, you are respectfully requested to adopt by rule a limited exemption from section 30 (f) of the 1940 act applicable to trading in SBIC stock in the normal course of business by registered dealers.

II. DESCRIPTION OF SMALL BUSINESS INVESTMENT COMPANY PROGRAM

With the enactment of the Small Business Investment Act of 1958, Congress created the possibility of an entirely new source of equity capital for the small business segment of the economy. It was the expressed congressional intent that this program would cause vast amounts of private capital to become available for the first time to small business concerns. While Government money was available in limited amounts, private capital was clearly essential to the accomplishment of the congressional purpose. The statement of policy in the first section of the SBIA reads in part as follows:

"It is declared to be the policy of the Congress and the purpose of this Act to improve and stimulate the national economy in general and the small business segment thereof in particular by establishing a program to stimulate and supplement the flow of private equity capital and long-term loan funds which small business concerns need for the sound financing of their business operations and for their growth, expansion, and modernization, and which are not available in adequate supply."

In its report to Congress on the operations of the SBIC program in April 1960, the Senate Select Committee on Small Business found much to be done to improve the program, but commented:

"Nonetheless, the SBIC program has already proved the soundness of its basic design. Capital is beginning to flow, in modest but increasing amounts, to fill the equity gap. Able, aggressive management of high integrity has been attracted to the program. With the vital improvements outlined below, your committee believes the SBIC program * * * has every promise of attracting enough capital to go far toward filling the gap. But there is an enormous distance yet to go from a very small beginning. The equity needs of small business as a whole are in the billions of dollars-not in the tens of millions" (at p. 2).

In the latter part of 1960 liberalizing legislation was adopted making the SBIC a more attractive investment for the risks involved. Concurrently, a sharp upswing in the number of publicly held SBICS occurred. As of the end of 1960, a total of 171 SBICs were licensed, having a total capital and surplus of approximately $161,900,000, of which $143,400,000 had been raised by public or private offerings and the remainder subscribed by the Small Business Administration (SBA).

While Congress has established a $300,000 capitalization (including the possibility of $150,000 in SBA funds) as the minimum-sized SBIC, experience of the industry has demonstrated that for economic and effective operation an SBIC must have a capital of $1 million or more. This generally requires a public offering of stock by the SBIC. While a minority of the licensed SBICs have had public offerings, it now appears that most of the remaining companies must raise additional capital if their operations are to be successful. Accordingly, it can be anticipated that in time most licensed SBICs will be subject to the 1940 Act as publicly held companies. Unless this comes to pass, the SBIC program will, in the view if this association, fail to accomplish the goal which Congress has established for the program.

The SBICs which have had public offerings to date have, in general, had a reasonably favorable market acceptance. Because of the newness of the industry, this market acceptance has been and must be considered a fragile thing. In a number of instances a fair market price was only maintained because of markets afforded by underwriters of the stocks. Since none of the SBIC's has been in operation long enough to have any real history, the entire program is being watched closely for favorable or unfavorable developments. While the publicly held SBICS have been remarkably successful in attracting outstanding business leaders in their various communities to serve on thier board of directors, the management of each of these companies has obviously had no direct previous experience in the field. In short, the entire SBIC program is clearly on trial. Continued public acceptance and confidence in this program is essential if the SBICs which have not yet tapped the public money market are to become economically feasible operations.

Basic to public acceptance of this new investment medium is an orderly overthe-counter market in the stock of these companies. Since the stock of SBICS presently held by the public has been outstanding for a relatively short time, the bulk of it less than a year, a much larger proportion of this stock is subject to trading than the more "seasoned" stock of the average over-the-counter company. In addition, as new SBIC offerings come out, a market tendency has been observed for purchasers of earlier issues to sell a portion of the earlier issue, replacing it with shares of the new issue, thus diversifying their SBIC holdings among several companies.

A further factor making SBIC stock subject to more than usual fluctuations in price is the fact that Congress has afforded SBIC stockholders an ordinary loss deduction on their shares, rather than the capital loss deduction applicable to other securities. Thus the vulnerability of SBIC stock to year-end "tax loss selling" is considerably greater than that of the average company.

For the foregoing reasons, having a responsible investment banking house making an orderly market in the SBIC stock is substantially more important than is the case with the usual unlisted company.

III. DESCRIPTION OF PROBLEM UNDER 30 (F) OF 1940 ACT

This association first became aware of the problem to the SBIC program under section 30 (f) of the 1940 act shortly before the conference with members of your staff on March 9, 1961. It is our considered judgment that this problem, unless remedied, will seriously impair the possibility of further public offerings by SBICS. Due to the applicability of this provision, a sponsoring investment banking firm must either refrain from having a representative on the board of directors of the SBIC or must refuse to make an orderly market for the stock of the SBIC. It is our position that neither alternative is in the public interest, in the interest of investors, or in the interest of the SBIC program generally.

The typical history of the formation of a publicly held SBIC is that a group of interested individuals are approached with respect to their willingness to serve on the board of directors or as executive officers of a company to be licensed as an SBIC. These individuals either include or they must approach an investment banking firm with a view to having that firm organize an underwriting syndicate to sell the stock of the SBIC. At this point the proposed SBIC obviously has no operating history whatsoever and the individuals involved have no specific experience in this entire new field, The investment banker is asked to sponsor the stock of a completely untested company in an entirely new industry. The reluctance of investment banking firms to underwrite such issues in this unchartered field is clearly one of the reasons for the slow start of the SBIC program. The risks presented were recognized by the Commission in requiring that the prospectuses relating to offerings of SBICS state that the securities are offered as a speculation. In most prospectuses the Commission has required lengthy statements pointing out the risks inherent in such operations, the absence of any experience of management in the field, and the mortality rate which should be expected with respect to investments in small business concerns. It has also been required that prospectuses state that because of the inherent risks, such securities are primarily suitable for persons in higher income tax brackets.

In the context of such a speculative situation it is not surprising that the great majority of publicly held SBIC's have a representative of the sponsoring investment banking firm on its board of directors. Our records indicate that