United States: A Bank's Guide To SBA Fintech Investing; Compliance With The Volcker Rule

Last Updated: April 20 2018
Article by Gerald A. Francese and Felicia Xu

In second quarter 2017, global investments in fintech companies reached $8.4 billion across 293 deals.1 The rise of fintech continues to dramatically change the landscape of the financial sector, as financial institutions recognize the need to reduce operating costs and provide customers with easier access to services. In response to the disruptive nature of fintech, 30 percent of large financial institutions have invested in artificial intelligence and 77 percent are expected to adopt blockchain as part of an in-production system by 2020.2 However, as the number of financial institutions interested in the fintech industry continues to grow, they are faced with regulatory barriers to invest in these businesses.

The Volcker Rule prohibits financial institutions from engaging in "proprietary trading," acquiring or retaining any equity, partnership or other ownership interest in a hedge fund or private equity fund and sponsoring a hedge fund or private equity fund. As a result, financial institutions that seek a stake in the fintech industry must either develop their own technologies in-house, invest in individual fintech companies or find other regulatory authorities to make a permissible investment. The options are especially challenging for smaller financial institutions that are not financial holding companies or do not have the resources to independently develop new technology.

One alternative is that financial institutions can invest in fintech companies without acquiring ownership in a hedge fund or private equity fund by forming or investing in a Small Business Investment Company (SBIC). Investment in an SBIC is exempt from the Volcker Rule. This article provides an overview of the SBIC program and discusses some benefits to financial institutions to invest in fintech via an SBIC program.

The SBIC Program

The SBIC program is designed to assist small businesses in securing long-term capital for growth. Qualified investors, including financial institutions, may apply to the Small Business Administration (SBA) for a license to provide access to low-cost, government-guaranteed capital (SBA leverage) to make investments in U.S. small businesses.3 Launched in 1958, the SBIC program has deployed more than $84 billion of capital, made more than 174,000 investments in small businesses, and licensed more than 2,100 funds.4

Investment Criteria

Small Business. SBICs may only invest in "small businesses." A portfolio company qualifies as a small business by having, with its affiliates, (i) tangible net worth of less than or equal to $19.5 million and (ii) an average net income of less than or equal to $6.5 million after federal income taxes (excluding any carry-over losses) over the previous two years, at the time of investment.5

A business may also be deemed "small" under the SBA's North American Industry Classification System codes.6

Smaller Business. Twenty-five percent of an SBIC's capital must be invested in "smaller businesses," defined as a business that, together with its affiliates, has (i) tangible net worth of less than or equal to $6 million and (ii) an average net income of less than or equal to $2 million after federal income taxes (excluding any carry-over losses) over the previous two years, at the time of investment.7

Form of Investment. SBICs can provide financing to small businesses in the form of equity securities,8 loans,9 debt securities,10 and guarantees.11 Additionally, SBICs may purchase securities of a small business through or from an underwriter.12 Loans may be secured and amortizable but generally must have a minimum one-year term and maximum twenty-year term.13

Investment Size. A financial institution's total investments in SBICs may not exceed five percent of its capital and surplus.14 Further, an SBIC may not invest an amount greater than 10 percent of its total capital (private and SBA leverage), and 30 percent of its private capital, in any single portfolio company.15

Other Investment Restrictions

  • An SBIC may not invest in businesses with more than 49 percent of their employees located outside the United States.16
  • An SBIC may not invest in other SBICs.17
  • An SBIC may not invest in industry sectors deemed contrary to the public interest nor may they invest in: (i) re-lenders or re-investors, (ii) passive businesses, (iii) real estate businesses, (iv) project finance, (v) farm land purchases, (vi) associated suppliers or (vii) financing licensees.18
  • An SBIC can control its portfolio companies for up to seven years19 and may qualify for an extension upon pre-approval by the SBA.20

The Volcker Rule

As discussed above, the Volcker Rule, a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, generally prohibits banking entities21 from engaging in proprietary trading and investing in hedge funds or private equity funds.22 However, the final Volcker Rule implementing regulations excludes portfolio companies controlled by a SBIC from the definition of banking entity.23 Thus, SBICs are not subject to the Volcker Rule's prohibition on sponsoring or investing in covered funds.

Additional Incentives

Investment Performance

In addition to using its own private capital, SBICs can issue debentures up to three times the amount of their private capital.24 Such capital is provided at a significantly lower cost than traditional limited partner equity investments. Furthermore, the concentration of a large portion of funding from one source reduces fund managers' fundraising burden and administrative and reporting requirements.25

CRA Consideration

Financial institution investments in SBICs may meet the definition of qualified investments under the Community Reinvestment Act (CRA).26 Financial institutions qualify for CRA consideration under the investment test for investments in SBICs when the investment benefits its assessment area. In addition, financial institutions may receive CRA consideration under the community development test when investments in SBICs benefit a broader statewide or regional area that includes its assessment area.27 In essence, CRA credits provide an additional source of private funds to SBICs that they would not otherwise receive.

Gramm-Leach-Bliley Act (GLB Act)

Financial institutions are also exempt from certain regulations that govern regulatory capital treatment for certain equity investments held by banks, bank holding companies and financial holding companies under the GLB Act. Under the regulations:

  • An eight percent Tier 1 capital deduction applies on covered investments that in the aggregate are less than 15 percent of an organization's Tier 1 capital;
  • A 12 percent deduction applies to investments aggregating 15 to 24.99 percent of Tier 1 capital; and
  • A 25 percent deduction applies to investments aggregating 25 percent and above of Tier 1 capital.28

SBIC investments are exempt from the above regulations so long as their value is less than 15 percent of Tier 1 capital.29

In addition, ownership of a 15 percent equity interest in a portfolio company by a bank-affiliated SBIC will not give rise to a presumption that the portfolio company is an Affiliate under Sections 23(a) and (b) of the GLB Act.30

SBIC Advisers Relief Act

The SBIC Advisers Relief Act amends provisions of the Investment Advisers Act of 1940 (Advisers Act) that relate to an exemption from investment adviser registration for advisers to SBIC funds and state regulatory authority with respect to such SBIC fund advisers. Under the SBIC Advisers Relief Act:

  • Advisers whose only clients are SBICs will not be required to register at the federal or state level;
  • SBICs will be considered to qualify as a "venture capital fund" for purposes of the VC fund adviser exemption (note this is applicable only to the federal exemption); and
  • The "private fund adviser exemption" is expanded to include advisers with non-SBIC private funds that have gross assets of less than $150 million.


1 KPMG Pulse of Fintech Q2-2017.

2 PwC Global FinTech Report 2017.


4 SBIC Overview: U.S. Small Business Administration Office of Investment and Innovation

5 13 C.F.R. § 121.301(c). The size standards were adjusted for inflation in 2014, according to the interim final rule in 79 Fed. Reg. 113 (June 12, 2014).

6   13 C.F.R. § 121.201.

7 13 C.F.R. § 107.710.

8 Pursuant to 13 C.F.R. § 107.800(b), "equity securities" are defined as stock of any class in a corporation, stock options, warrants, limited partnership interests in a limited partnership, membership interests in a limited liability company, or joint venture interests.

9 Pursuant to 13 C.F.R. § 107.810, a "loan" is defined as a transaction evidenced by a debt instrument with no provision for the SBIC to acquire equity securities.

10 Pursuant to 13 C.F.R. § 107.815, "debt securities" are defined as instruments evidencing a loan with an option or any other right to acquire equity securities in a small business or its affiliates, or a loan which by its terms is convertible into an equity position, or a loan with a right to receive royalties that are excluded from the cost of money pursuant to §107.855(g)(12).

11 107.50

12 107.825

13 §4.3 Permitted loans and investments

14 15 U.S.C. § 682(b).

15 Program Overview, U.S. SMALL BUSINESS ADMINISTRATION (April 7, 2017, 11:00 AM), https://www.sba.gov/sbic/general-information/program-overview.

16 Id.


18 Id.

19 The Small Business Investment Company (SBIC) Program

20 Pursuant to 13 C.F.R. § 107.50, "control" is defined as the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a corporation, limited partnership or other concern, whether through the ownership of voting securities, by contract, or otherwise.

21 Pursuant to 12 C.F.R. § 44.2, a banking entity means (i) any insured depository institution; (ii) any company that controls an insured depository institution; (iii) any company that is treated as a bank holding company for purposes of section 8 of the International Banking Act of 1978 (12 U.S.C. 3106); and any affiliate or subsidiary of any entity described above.

22 12 C.F.R. § 44.10(a)(1).

23 12 C.F.R. § 44.10(c)(11).

24 Typically, SBICs can only issue debentures up to two times private capital.

25 https://www.sbiclaw.com/faqs/

26 Id.

27 12 C.F.R. § 25.23 & 12 C.F.R. § 25.26(c).

28 FEDERAL RESERVE SYSTEM. 12 CFR Parts 208 and 225. [Regulations H and Y; Docket No. R–1055] Dec. 10, 2001

29 Id.

30 http://www.jdsupra.com/legalnews/description-of-the- small-business-71461/

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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