cu.e"-™/ 97 * A UNITED STATES DEPARTMENT OF COMMERCE PUBLICATION 8 *^' G¥ . U.S. DEPARTMENT OF COMMERCE Economic Development Administration THE Local Economic d evelopment Corporation LEGAL AND FINANCIAL GUIDELINES COMPILED BY THE PRACTISING LAW INSTITUTE under the direction of THE U.S. DEPA^TWSfNjf OF COMMERCE ECONOMIC DEVEU2f|lVlT£NT ADMINISTRATION OFFICE OF MINOSm BUSINESS ENTERPRISE Digitized by the Internet Archive in 2012 with funding from LYRASIS Members and Sloan Foundation http://archive.org/details/localeconomicdevOOprac THE|_ E D C OCAL CONOMIC EVELOPMENT ORPORATION LEGAL AND FINANCIAL GUIDELINES 1970 Sf 4TES Of * Compiled by the Practising Law Institute Under Direction of U.S. Department of Commerce Maurice H. Stans, Secretary Rocco C. Siciliano, Under Secretary Robert A. Podesta, Assistant Secretary for Economic Development Abraham S. Venable, Director Office of Minority Business Enterprise For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, D.C., 20402. Price $2.00. FOREWORD In our rural communities and central cities, some citizens still live in poverty, almost untouched by currents of economic growth. In order to plan and manage the financial well-being so needed there, the people in a distressed area should define its problems, measure its resources, and recognize its opportunities. And to accomplish these things, the citizens must coordinate their development program through broad community involvement. A cross-section of the neighborhood should participate in decision-making. For all these purposes, experience has taught that a local economic develop- ment group, when supported by its citizens, can help bring new opportunity and a better life for all. It is therefore to be expected that efforts to build and strengthen minority business enterprise specifically should often be made by means of the local economic development corporation. LEDC's (also referred to as LDCs) are local in formation and control; are able to mobilize local talent and energy; and can channel financial resources into community business venture and ownership. This legal and financial source book reflects today's interest in the LEDC as an almost indispensable tool for economic growth in the small, poor community. So it is our hope that this book will meet the need for a widely available reference work on organizing and running local economic development corporations. Robert A. Podesta, Assistant Secretary for Economic Development. in ACKNOWLEDGEMENTS To improve the economic health of poor communities through the creation and expansion of local business enterprise, the Economic Development Admin- istration works closely with community representatives. From these contacts there was discerned the need among these community representatives to know more about forming and running local economic development corporations. This entails legal and financial knowledge often beyond the means of the communities involved. To fill this knowledge gap EDA's Office of Technical Assistance, engaged the Practising Law Institute, New York, under the direction of Dean E. Donald Shapiro, to compile a source book for the guidance of community developers which would draw upon the experience and talents of authorities in legal and financial fields. Marilyn W. Levy, Esq., of PLI, planned the scope of the book, selected the topics, and selected and enlisted the cooperation of some 39 con- tributors, composed of many of the leading law practitioners. Her contribution was most signficant; not only did she formulate the coverage of the book, but she also was deeply involved in shaping the actual subject matter prepared by the author-contributors. Mrs. Levy's assistant in this undertaking was Thacher W. White, Esq., also of PLI. Receiving the original collection of manuscripts from PLI, EDA asked Wil- liam T. Coleman, Jr., Esq., of the Philadelphia law firm of Dilworth, Paxson, Kalish, Levy & Coleman to comment on and give an overview of the manual. Mr. Coleman's extensive comments and insights were extremely valuable, and we wish here to give special tribute to his formidable and enriching effort. The comments of Mr. Coleman guided the subsequent professional editing job performed for EDA by CCM Editorial Services, Arlington, Virginia, an arm of Crowell Collier and Macmillan, Inc. Mr. Peter A. Smith of CCM reworked the compilation, placing the sections in sequence and largely eliminating the inevitable duplication and overlap. We are most grateful for his effort which resulted in a cohesiveness and structure in the final document beyond our original expectations for such a compilation. Finally, Professor Irving Ferman, with the assistance of his students at Howard University School of Law, was engaged to supply additional annotations, citations, and bibliographical references. We are happy to acknowledge the initial contributions as follows: Name and affiliation Initial Section contributed Mr. Arthur I. Blaustein, Economic Develop- LEDC and Other Sources of Technical and ment Coordinator, National Housing and Managerial Assistance and Manpower Development Law Project, University of Training California, Berkeley, California Arthur M. Borden, Esq., Borden & Ball, New Acquisition of Existing Firms York, N.Y. Gilman S. Burke, Esq., Burke & Burke, New Church Groups as a Source of Funds York, N.Y. Richard E. Clark, Esq., Formerly with Davis, Commercial Banks as a Source of Short- Polk & Wardwell, New York, N.Y. Term and Medium-Term Loans (part) Name and affiliation Initial Section contributed Louis A. Craco, John Oitzinger, Marilyn E. Meadors, and Bernard L. Greer, Jr., Esqs., Willkie Farr r employ significant numbers of minority or poverty groups rom urban areas, and to other enterprises of an employ- nent-creating nature located in rural poverty areas. It also expects to make loans or equity-type financial assistance ivailable to individual members of poverty and minority ;roups who need such assistance to start or improve their )wn businesses or acquire existing ones, but who are unable o obtain required financing from conventional sources. It vill not, however, invest in a large, financially strong, cor- >orate enterprise. In addition, where it is in furtherance of its goals, it will nvest in or otherwise support other exempt organizations inducting rehabilitation and training programs. Investments vill be made in churches administering community develop- nent programs, small business investment companies, -EDCs or development banks formed specifically for the purpose of assisting poverty and minority group individuals. and organizations established to provide credit for poverty area rural cooperative organizations. The organization does not expect to have material control over the operation of the businesses it aids, but it will endeavor to prevent by contract the disposal of any business aided by it in a manner which would frustrate its purposes. (2) Employment and Job Assistance. In the related field of employment, an organization providing employment counsel- ling and placement services for the elderly person of limited means has been ruled to qualify as a charity. 23 Similarly, the IRS has ruled as a charity an organization which seeks to eliminate discrimination in employment by discussions and lectures, by bringing to the attention of employers in- formation about availability of personnel, by counseling workers to improve their qualifications, and by arranging interviews for qualified applicants with employers. 24 An organization formed by labor and management conducting an apprentice-training program (not limited to disadvantaged persons) qualifies as a Section 501(c)(3) organization (as an educational organization). 2 "' On the other hand, an organiza- tion designed simply to provide employment for students by selling wood and metal products made by them and not primarily to provide training was held not to qualify as a charity. 2 ''' (3) Housing. There has been a series of published rulings on housing assistance. An organization created to provide instruction and guidance to low-income families in need of adequate housing and interested in building their own homes by conducting training concerning homebuilding, coordinat- ing joint construction activities, buying housing sites for resale at cost, and aiding in obtaining construction loans has been ruled to be exempt. 27 Similarly, an organization which conducts a model demonstration housing program for low-income families has been ruled a tax-exempt charity. 28 This organization, financed in part by a Federal grant, did research on costs of rehabilitation and purchased rehabili- tated houses which were sold or leased to low-income families on a nonprofit basis. Another recognized charitable goal has been assistance to low and lower-middle income families in obtaining improved housing by investing in housing ventures for such groups. 2 " In addition, various organizations designed to combat racial discrimination in housing or to promote integration in housing have been ruled to be exempt.' 5 " In addition to education of the public and members of minority groups, such organizations provide financial assistance to persons purchasing homes in inte- grated neighborhoods, purchase homes for sale or lease on an open-occupancy basis, and make investments in housing ventures not limited to low and lower-middle income groups but having integration as a major goal. 31 (4) Other. Although the rulings discussed above cover the main areas of concern to an LEDC, they should not be considered as exclusive. For example, a legal aid society i»Treas. Regulations 1.501(c) (3)-l (c) (1 ). 20Treas. Regulations 1.501 (c) (3)-1 (c) (2). siTreas. Regs., 1.501(c) (3)-l(c) (3). '-- Letter dated January 2, 1969, issued by Lawrence B. Jerome, Chief, Exempt Organizations Branch to Cooperative Assistance Fund. 23 Rev. Rul. 66-257; 1966-2 Cum. Bull. 212. This ruling is distinguished from Rev. Rul. 57-297, 1957 2 Cum. Bull. 307, which held an organization engaged in combating prejudices against the hiring of older workers not to be exempt where the organization members for whom employment was sought were expected to con- tribute to the organization. M Rev. Rul. 68-70, 1968-1 Cum. Bull. 248. -■"' Rev. Rul. 67-72, 1967-1 Cum. Bull. 125. 2« Rev. Rul. 69-177, 1969-1 Cum. Bull. 150. -'" Rev. Rul. 67-138, 1967-1 Cum. Bull. 129. -'* Rev. Rul. 68-17, 1968-1 Cum. Bull. 247. '-■> Letter cited in footnote 22. 30 Rev. Rul. 68^138, 1968-2 Cum. Bull. 209; Rev. Rul. 68-655, 1968-2 Cum. Bull. 213. 31 Letter cited in footnote 22. 19 formed for the purpose of providing free legal services to the indigent has been ruled to be an exempt 501(c)(3) organi- zation. 32 Providing other needed services such as a day-care center, 33 assistance in obtaining credit, 34 assistance concern- ing financial management to low-income persons, 3 "' and assistance in marketing handicrafts of needy persons 36 have also been ruled to be charitable activities. As indicated in the discussion of employment and housing, combating dis- crimination is a permissible goal. On the other hand, the practice or promotion of racial discrimination or segrega- tion is questionable at best and probably prohibited. Private schools are required to pursue racially nondiscriminatory policies to remain exempt. 37 It is likely that this requirement of nondiscrimination will apply to other activities as well and possibly to discrimination in favor of as well as against minority groups. PROHIBITED ACTIVITIES 5-6. To retain its tax-exempt status a charitable organization must not become an "action" organization, nor can it engage in certain kinds of transactions as determined by the Internal Revenue Code. "Action" Organizations 5-7. A tax-exempt charitable organization cannot be an "action" organization, that is, one that engages to a sub- stantial degree in political activity. Because of the nature of an LEDC this limitation may sometimes be a trouble- some one. The Regulations relating to "action" organiza- tions provide: "'Action' organizations, (i) An organization is not op- erated exclusively for one or more exempt purposes if it is an 'action' organization as defined in subdivisions (ii), (iii), or (iv) of this subparagraph. "(ii) An organization is an 'action' organization if a substantial part of its activities is attempting to influence legislation by propaganda or otherwise. For this purpose, an organization will be regarded as attempting to influence legislation if the organization — "(a) Contacts, or urges the public to contact, members of a legislative body for the purpose of proposing, support- ing, or opposing legislation; or "(b) Advocates the adoption or rejection of legislation. "The term 'legislation,' as used in this subdivision, in- cludes action by the Congress, by any State legislature, by any local council or similar governing body, or by the public in a referendum, initiative, constitutional amendment, or similar procedure. An organization will not fail to meet the operational test merely because it advocates, as an insub- stantial part of its activities, the adoption or rejection of legislation. "(iii) An organization is an 'action' organization if it participates or intervenes, directly or indirectly, in any poltical campaign on behalf of or in opposition to any candidate for public office. The term 'candidate for public office' means an individual who offers himself, or is pro- posed by others, as a contestant for an elective public office, whether such office be national, State or local. Activities which constitute participation or intervention in a political campaign on behalf of or in opposition to a candidate include, but are not limited to, the publication or distribu- tion of written or printed statements or the making of oral statements on behalf of or in opposition to such a candidate. "(iv) An organization is an 'action' organization if it has the following two characteristics: (a) Its main or primary objective or objectives (as distinguished from its incidental or secondary objectives) may be attained only by legislation or a defeat of proposed legislation; and (b) it advocates, or campaigns for, the attainment of such main or primary objective or objectives as distinguished from engaging in nonpartisan analysis, study, or research and making the results thereof available to the public. In determining whether an organization has such characteristics, all the surrounding facts and circumstances, including the articles and all activities of the organization, are to be considered. "(v) An 'action' organization, described in subdivisions (ii) or (iv) of this subparagraph, though it cannot qualify under section 501(c)(3), may nevertheless qualify as a social welfare organization under section 501(c)(4) if it meets the requirements set out in paragraph (a) of 1.501(c)(4)-!." 38 As can be seen, there are two types of prohibited action — lobbying activity and participating or intervening in a political campaign. A 501(c)(3) tax-exempt entity is ab- solutely forbidden to participate in a political campaign to any extent and is prohibited from engaging in any substantial lobbying activity. It does not matter whether the lobbying is for "good" or "bad" legislation. Any sub- stantial lobbying activity may be sufficient to result in loss of exemption, even though public rather than private good is sought. 31 ' However, a certain amount of political activity in the area of voter registration and conducting of political forums is permitted. 40 As indicated in the Regulations, certain organizations which cannot qualify because of political activity can qualify nevertheless as social welfare organizations. As will be discussed at greater length in Section 5-12, it may be desirable for the sponsors of an LEDC also to have a separate noncharitable organization which qualifies as a social welfare organization. "Public" Charities and Private Foundations 5-8. The so-called Tax Reform Act of 1969 made substan- tial changes in the laws governing tax-exempt charities. To a large extent these changes involve making a distinction between tax-exempt charities that are classified as private foundations and other charities conveniently (although somewhat inaccurately) denominated "public" charities. Since substantial restrictions were placed on contributions to private foundations and on operators of private founda- tions, although some of these are somewhat relaxed in the case of private foundations which qualify for a special category of private operating foundations, it is important that an LEDC not merely qualify as a tax-exempt organiza- tion but that it also qualify as a "public" charity or at least as a private operating foundation. 41 At the time it applies for its exemption, a new organization must declare if it claims to be a "public" charity or a private operating 32 Rev. Rul. 69-161, 1969-1 Cum. Bull. 149. 33 Rev. Rul. 68-166, 1968-1 Cum. Bull. 255. 34 Rev. Rul. 68-117, 1968-1 Cum. Bull. 251. 35 Rev. Rul. 69-141, 1969-2 Cum. Bull. 114. 88 Rev. Rul. 68-167, 1968-1 Cum. Bull. 255. 37 IRS news releases, July 10 and 19, 1970, reprinted in 70-7 CCH Stand. Fed. Tax Rep., pars. 6790 and 6814. 3«Treas. Regulations Sec. 1.501 (c) (3)-l(c) (3). 80 But see Seasongood v. Commissioner, F2d907 (6th Cir. 1955); Dulles v. Johnson, 273, F2d 362 (2d Cir. 1960). 4" See Treasury Department Release K-87, May 11, 1969, reprinted in 69-7 CCH Stand. Fed. Tax Rep., par. 6728. More stringent restrictions are placed on political activities of private foundations. See Section 5-9. An interesting discussion of political activities of colleges and universities which was approved by the Commissioner of Internal Revenue is found in Guidelines on Questions Relating to Tax Exemption and Political Activities Statement of American Council on Education reprinted in 1907-7 CCH Stand. Fed. Tax Rep. par. 6743. Many of the guidelines could apply to LEDCs. 4t The advantage of classification as a "public" charity or a private operating foundation in seeking funds are discussed in Section 22-2. The restrictions placed on private foundations are discussed in Section 5-9. 20 foundation. 42 This is a new requirement and, obviously, was not reflected in the exemption application shown in Ap- pendix 5-B. Existing organizations also must declare if they claim to be "public" charities or private operating foundations. 43 Although there are several categories of "public" charities, including churches, schools, and hospitals, two categories appear to be of principal interest to the LEDC. The first of these is somewhat loosely known as a publicly supported organization. The Regulations give two alternative tests for qualification as a publicly supported organization, a mechanical test and a facts-and-circumstances test. 44 The mechanical test requires that the organization have received at least one-third of its support for the preceding four years from the general public or govern- mental sources. Obviously, this test is not available to new organizations. In determining whether contributions have come from the general public, contributions from any one person can be counted only to the extent that they do not exceed 1% of the organization's support, but there is no similar limit on governmental support. 45 Accordingly, a fairly broad range of support is necessary to meet this test. For purposes of the test, support includes all types of support such as contributions, investment income, and un- related business income but does not include funds derived from conduct of charitable activities. 46 The facts-and-circumstances test allows organizations which do not meet the mechanical test but which still have a substantial public source of support or public interest, in- cluding new organizations, to qualify as publicly supported. 47 The Regulations indicate that the organization may qualify if it receives substantial support from a representative number of persons in the community or area in which it operates; if it makes broad-based public appeals; if, in the case of newly created organizations, its proposed structure and method of operation require such support; if it will receive support from such organizations as a United Fund; or if it has a substantial number of members who pay annual membership dues. 48 The Regulations further indicate that, although primary weight is given to the source of support, other relevant factors will also be considered, including whether the organization has a governing body composed of public officials, or selected by officials, or of citizens broadly representative of the interests and views of the public; whether the organization makes public financial reports; and whether it holds open to the public its facilities such as a museum or a symphony orchestra. 49 The second category of "public" charities that may apply to LEDCs is really another way of measuring public support. The principal difference is that for purposes of this second category, support includes amounts received from the conduct of charitable activities. The requirement is that the organization be one which normally receives more than one-third of its support in each year from any combination of (i) contributions and membership fees and (ii) receipts from admissions, sales of merchandise, per- formance of services and so forth from activities which are not unrelated business income excluding amounts received from any one person or in excess of the greater of $5,000 or 1 percent of the organization's support. Only amounts received from persons other than officers, directors or sub- stantial contributors, (that is, certain contributors of over $5,000) can be counted. The organization may not receive more than one-third of its support from investment income. If the LEDC fails to qualify as a public charity under one of the tests described above it may still be a private operating foundation. A private operating foundation is a private foundation which makes distributions for the active conduct of its charitable activities equal to substantially all of its income and which meets one of the following three tests: (1) at least half of its assets are devoted to the active conduct of its charitable activities; (2) it normally spends specified percentages (4 percent in most cases) of the value of its assets for the active conduct of its charitable activities; or (3) substantially all of its support other than investment income is normally received from the general public or five or more exempt organizations with no one such organization providing more than 25 percent of the support and less than half of its support is from investment income. 00 Prohibited Transactions 5-9. The Internal Revenue Code provides a list of pro- hibited transactions for tax-exempt organizations. The list includes not only those that qualify as charitable organiza- tions but also other tax-exempt entities including social welfare organizations. These provisions are primarily limitations on so-called self-dealing, that is, dealing between a tax-exempt organization or its substantial contributors or founders and are not likely to be a problem for most LEDCs, but they must be borne in mind in cases in which they may arise. The organization may not do any of the following with a substantial contributor, a founder, or certain related persons: ( 1 ) Lend any of its property without the receipt of adequate security and a reasonable rate of interest. This requires that some security be received, no matter how good a credit risk the borrower may be. (2) Pay any compensation in excess of a reasonable allowance for personal services actually rendered. (3) Make any part of its services available on a preferential basis. (4) Make any substantial purchases of property for more than adequate consideration. (5) Sell any substantial part of its property for less than adequate consideration. (6) Engage in any other transaction which results in a substantial diversion of its property. 51 Although these prohibitions relate to dealings with con- tributors, any such dealing with any person should be avoided. As noted above, a 501(c)(3) organization cannot have any of its income inure to a private individual. 52 Engaging in transactions of the type described in (2)-(6) above could be evidence that the organization is being operated not for charitable purposes but for the benefit of private individuals. If this were true, the organization would lose its tax-exempt status. Of course, to the extent that making payments to poor individuals or providing other financial assistance is a part of the charitable activity of the organization, there is no objection to doing so. If an LEDC loses its tax-exempt status because it is engaged in a "prohibited" transaction, the loss of exemption is confined to the years following notification by the Commissioner that he has discovered the transaction. 53 Contributors to the organization will lose deduction for 4- Code Section 509(e). 43 Form 4653 has been provided for this purpose and can be filed at any time but does not have to be filed until after final regulations are promulgated or one year after organization, whichever is later. See Temp. Treas. Regs. Section 13.9. -w Treas. Regs. 1.170-2(b) (5) (iii) (a). « Treas. Regs. 1.170-2(b) (5) (iii) (b). 4<> Treas. Regs. 1.170-2(b) (5) (ii). *7 Treas. Regs. l.170-2(b) (5) (iii) (c) (/) . 4«Treas. Regs. 1.170-2(b) (5) (iii ) (c) (3). 49 Treas. Regs. 1.170-2(b) (5) (iii) (c) (4). ■ r '»Code Section 4942 (j). • r >iCode Sec. 503(c). •""Treas. Regulations Sec. 1.501 (c) (3)-l (c) (2). 53 Section 503(a)(2); Treas. Regulations Section 1.503(a)-! (b). 21 contributions for those future taxable years. 54 In other words, as a general rule loss of exemption and charitable deductions is not retroactive where a prohibited transaction is the reason for exemption loss. If it is determined that the organization entered into the prohibited transaction "with the purpose of diverting corpus or income of the organization from its exempt purposes, and such trans- action involved a substantial part of the corpus or income of the organization," then the denial of exemption will be retroactive to the year of the prohibited transaction (rather than prospectively to the year following notification) and will be applicable for all years subsequent thereto. 55 For donors the loss of the charitable deduction in such a "subsequent diversion of corpus" situation may also be retroactive — the extent of retroactivity depending on whether they were involved in the diversion. For donors not involved deduction loss commences for the year following consum- mation of the transaction, while for involved donors (and, if individuals, for members of their families) deduction loss commences in the year of their involvement. 50 If an LEDC should lose its exemption for failure to comply with the general requirement that it be operated exclusively for a purpose sanctioned by the statute, the exemption will probably be lost retroactively to the year of violation. 57 Contributions to the organization by participants in the transactions resulting in loss of exemption would probably be retroactive, while innocent contributors would probably be permitted deductions for contributions to the foundation until the time the revocation of its exemption is published in the cumulative list, 58 but there is no statutory bar to retroactive denial of deductions to them as well. An organization whose exempt status is lost because of a prohibited transaction can apply for renewal of its exempt status but only in the year following the loss of exemption. The status can be restored only in the year following the application, resulting in a minimum of a two-year loss of exemption. 50 There is no published procedure for reestab- lishing exemption to an organization whose status is lost because of failure to meet the operational test, but clearly such status cannot be established until the improper activi- ties have ceased. In the case of private foundations, including private operating foundations, a broad additional list of restrictions has been imposed. The first of these restrictions is an expansion and tightening up of the general prohibitions on so-called self-dealing outlined above. The special limitations prohibit the specified transactions even if they are on a basis that is advantageous to the organization. The trans- actions prohibited are transactions between the organization and disqualified persons, which includes officers, directors, and substantial contributors, that is, certain contributors of more than $5,000, involving: ( 1 ) Any sale, exchange or leasing of property includ- ing a transfer of mortgaged property; (2) Any lending of money except a loan to the organization without interest; (3) Any furnishing of goods or services except the furnishing of goods or services by a disqualified person to the foundation without charge or a furnishing of goods or services by the foundation to a disqualified person on the same terms as such goods or services are available to the general public; (4) Any payment of compensation other than pay- ment by the foundation of reasonable compensation for services necessary to carry out its exempt purpose; (5) Any transfer of the income or the assets of the foundation to a disqualified person; and (6) Certain payments to government officials. r,n In addition, private foundations (other than private op- erating foundations) are required to distribute their income and certain percentages of their assets either for the active conduct of charitable activities or to public charities or private operating foundations. 01 Private foundations are also prohibited from holding more than approximately a 20 percent interest in a business 02 and from making any investment which would jeopardize the carrying out of its exempt purposes 03 that is, any speculative investment. 04 Certain types of investment which may be made by an LEDC are permitted, including such things as low interest or interest-free loans to needy students, high-risk invest- ments in low-income housing and loans to small business where commercial sources of funds are unavailable, but the investment must be primarily for charitable purposes and not have as one of its significant purposes that of deriving a profit from the organization. 05 A private foundation is also prohibited from (to any degree) carrying on prop- aganda or attempting to influence legislation (while a public charity is prohibited from doing so to a substantial degree), trying to influence the outcome of any specific public election or carrying on any voter registration drive (with a limited exception to drives carried on in five or more States). 00 Moreover, grants to individuals for travel, study, or similar purposes are restricted and grants to other private foundations require special administrative control. 07 The principal sanction for violation of these special re- strictions is a series of taxes on the foundation, its officers, and directors, which can run as high as double the amount involved in the improper transaction as well as loss-exempt status for flagrant abuse. 08 Finally, private foundations are subject to a 4 percent tax on their investment income. 09 OTHER TAX ASPECTS 5-10. Even though an LEDC has been determined to be tax-exempt, it nevertheless may be obligated to file an annual information return. In addition, the organization is taxable on what is considered to be unrelated business income. Form 990A (Annual Report) 5—11. An annual information return is required unless the LEDC is supported in whole or in part by government funds or has received more than 50 percent of its support from the general public, as distinguished from a few individuals. 70 Copies of Form 990A and the instructions for the form are available from the office of the District Direc- tor of Internal Revenue. For certain small organizations with receipts and assets under $10,000 a simplified version is provided. It should be noted that the long form is in two parts containing almost identical information and that one part is a matter of public record. Form 990A long or •">+ Sections 503(e); Treas. Regulations Section 1.503(e)-l(b). ■'■' Section 503(a)(2): Treas. Regulations Section 1.503(a)-l(b). 50 Code Section 503(e); Treas. Regulations Section 1.503(e)— 1. • r '" Rev. Proc. 69-3, Sec. 8.01, 1969-1 Cum. Bull. 389. " H Introduction, Cumulative List, Organizations described in Section 170 (c) of the Internal Revenue Code of 1954, Publication 78 (Rev. 12 68). p. III. ■"■"Code Section 503(d); Treas. Regulations Section 1.503(d); Rev. Proc. 69-3, 1969-1 Cum. Bull. 389. ""Code Section 4971. "i Code Section 4942. "- Code Section 4943. <•••'< Code Section 4944. 04 Sen. Rep. No. 91-552, 91st Cong. 1st Sess. p. 45. ""'Code Sections 4943 (4) (a); 4944(c); Sen. Rep. No. 91-552, 91st Cong. 1st Sess. pp. 44, 46. ""Code Sections 4945(d)(1), (2), (e). (f). ""Code Sections 4945(d)(3), (4), (g), (h). "*Code Sections 4941 -4945. BO Code Sections 4941. ""Code Section 6033(a); Regulations Section 1.503(d); Rev. Proc. 69-3, Sec. 503, 1969-1 Cum. Bull. 389. 22 short form is filed on or before the 15th day of the fifth month after the end of the organization's fiscal year. This means that it is filed on May 15 for organizations on a calendar year basis. In addition, the officers and directors of a private foundation, including a private operating foundation, are required to file a separate information return, which must be made available for public inspection at the foundation's office, and they must publish a notice in a newspaper that it is available for inspection. 71 Unrelated Business Income 5-12. Although generally a charitable organization is tax- exempt on all of its income, it was considered unfair for a tax-exempt organization to be able to run a commercial enterprise without paying tax. Accordingly, a 501(c)(3) organization (other than a church) is taxable on what is considered to be unrelated business income. 72 There are two key elements in determining whether in- come is taxable. The income must be business income, and it must be unrelated to the exempt purposes of the entity. Only business income is taxable; in general, dividends, interest, gains on sale of stocks and securities, and rents are considered not to be business income. 73 Results of operations of any kind of commercial establishment are considered business income 74 with certain specific excep- tions. 75 What is considered a related business is a more difficult question. 7 ' 1 Sale of products produced in a program for training the handicapped is considered related business income. 77 On the other hand, any operation designed pri- marily to provide employment even though in a sense related to the purposes of the organization would probably be classified as an unrelated business. 78 It should be noted that in the private rulings cited in footnotes 22 and 31, the Internal Revenue Service expressly reserved on the issue whether any of the activities of the organization would be considered an unrelated business. On the other hand, providing housing referral services promoting open housing for a fee is considered to result in related business income for an organization combating housing discrimination. 79 The basic consequence of an organization's having un- related business income is that the income is taxable in the same way as if it were earned by a non-tax-exempt charity. In view of this, in most cases it would be just as well or better for such profitmaking operations to be carried on by a separate corporation or other organization, thus separating these nonexempt activities. Among other things such separa- tion helps prevent a possible contention that the organization is operated primarily for the profitmaking activity rather than for purposes considered proper for a Section 501 (c) (3) entity. If an organization is considered operated primarily for profit, it can lose its exempt status. 80 Unrelated business income is reported on Form 990-T which may be obtained from the office of the District Director of Internal Revenue. SOCIAL WELFARE ORGANIZATIONS 5-13. As previously noted, a 501(c)(3) organization has severe limitations imposed on its political activities. These limitations are not imposed to the same extent on a social welfare organization qualifying under Section 501(c)(4) of the Code. However, individuals and corporations cannot obtain deductions for contributions to a social welfare organization as charitable contributions and accordingly can deduct such contributions only as business expenses, if that can be justified. Many organizations that have some activities that can qualify as charitable and some that cannot use a dual or- ganizational structure. For example, the NAACP is not a charitable organization but the NAACP Legal Defense and Educational Fund (a completely separate organization) is. As indicated in the Regulations, organizations that are not charitable because they are action organizations may be social welfare organizations. BIBLIOGRAPHY 5-14. Highlights of 1969 Changes in the Tax Law, Internal Revenue Serv- ice publication 553. "Community Development Corporations," 83 Harv. L. Rev. 1558, 1611. May 1970. "Tax Exemption for Organizations Investing in Black Businesses," 78 Yale L. J. 1212. 1969. "Summary of Tax Reform Act of 1969," 25 Business Lawyer 973. April 1970. Provides a sketch of the new law. "Summary of Tax Reform Act of 1969," 4 J. Beverly Hills B.A. 20, March 1970. "Private Foundation and the Tax Reform Act of 1969," 48 Taxes, May 1970. "Foundation Misuse After Tax Reform Act." 48 Taxes, May 1970. "Summary of Tax Reform Act as It Affects Foundations," 40 Foundation News, May-June 1970, p. 87, 89. How To Apply for Exemption for an Organization. Internal Revenue Service Publication 557, October 1969. "Code Section 605b, 6104(d). ~- Code Sections 511-14. 73 See Code Section 512(b); but see Code Section 514. ~* Regulations Section 1.513-1 (b). ""'Code Section 513(a). 715 See generally Regulations Section 1.5 13—1 (d) . 77 Regulations Sec. 1.513-l(d) (4) (ii) ; Rev. Rul. 68-581, 1968-2 Cum. Bull. 250. 7 « Compare Rev. Rul. 69-177, 1969-1 Cum. Bull. 150. ''•' Rev. Rul. 68-225, 1968-1 Cum. Bull. 283. 80 Regulations Sec. 1.501(0(3-1) (e)(1). See Scripture Press Foundation v. United States, 285 F2d 800 (Ct. CI. 1961) Cf. Sec. 502. 23 Section 6 PRESERVING ARMS-LENGTH RELATIONSHIP BETWEEN NONPROFIT AND PROFITMAKING ENTITIES RESTRICTIONS 6-1. In addition to State law regarding self-dealing by cor- porate officials 1 the reporting requirements for tax-exempt organizations established under the Internal Revenue Code represents another restriction on personal enrichment by officials of such organizations. 2 Financial dealings between nonprofit and profitmaking entities should be clearly spelled out, taking into account safeguards such as collateral arrangements and repayment terms. It is possible that individuals who are driving forces be- hind community development programs would serve on the boards of both tax-exempt and taxable entities. To the ex- tent possible it is best to discourage this dual role, but it may be inevitable. Such directors are under a legal duty to act zealously to safeguard the interests of each corporation, as their dealings are potentially subject to the most careful scrutiny. In any situation where the recipient of financial assistance from the LEDC is not exempt under Section 501(c)(3), detailed records should be kept to show the name and ad- dress of each recipient; the amount distributed to each; the purpose for which the distribution was made; the manner in which the recipient was selected; and the relationship, if any, between the recipient and members, officers, or trustees of the 501(c)(3) organization. Adequate records should also be kept regarding the shareholders, officers, and em- ployees of the recipient organization to reaffirm that the purposes for which exemption was granted are being ac- complished. GUIDELINES FOR AVOIDING POTENTIAL CONFLICTS OF INTEREST 6-2. Certain guidelines for dealings with locally sponsored businesses which indicate areas of potential conflict of inter- est for any LEDC have been spelled out in a recent grant by the Office of Economic Opportunity (OEO) to a Local Economic Development Company. These conditions may serve as possible guidelines for other community organiza- tions in dealing with profitmaking entities: (1) Except as provided in paragraph (3) below, the LEDC may not obligate or expend any project funds (i) for the purchase or rental of goods, space, or services; or (ii) to provide direct financial assistance through investment, grants, loans, or loan guarantees if any of the following persons has a "substantial interest" in the purchase, rental, investment, or other transactions described in (2): (a) A voting member of the board of directors of LEDC. (b) The executive director of LEDC. (c) Any other employee of LEDC if his responsi- bilities include the lease, sale, or procurement of goods, space, and services, or the making of a final decision as to the placing of an investment, grant, loan, or loan guaranty conducted in whole or in part with project funds. (d) Anyone who is a member of the immediate family of an individual described in (a), (b), or (c). The following shall be considered members of an "immediate family": Wife Father-in-Law Mother-in-Law Brother-in-Law Sister-in-Law Son-in-Law Daughter-in-Law 'substantial interest" includes the fol- Husband Father Mother Brother Sister Son Daughter (2) The term lowing: (a) Any direct or indirect financial interest in the specific sale or rental transaction, including a commission or fee, a share of the proceeds, the prospect of promotion, a profit, or any other form of financial reward. (b) Any of the following interests in the business which is supplying the goods, space, or services to the grantee; is buying or leasing the goods, space, or services from the grantee; is the recipient of financial assistance through purchase of stock, grants, loans, or loan guaranties; or is a business in which the grantee or delegate agency is otherwise investing: — Ownership — Partnership interest or other beneficial interest of 5 percent or more — Ownership of 5 percent or more of the stock — Employment as an executive officer — Membership on the board of directors or other governing board (3) The limitations described in (1) and (2) shall not apply to: (a) Purchases or rentals of goods, space, and serv- ices from the same supplier or sales or lease of goods, space, and services to the same customer at a total cost of less than $200 within any 12-month period. (b) Purchases or rentals of goods or services if then is no other supplier within the community served by the program or within a radius of 50 miles, whichever is the larger area. (c) Purchases or rentals of goods, space, or service: from the lowest bidder in accordance with rules for adver tised competitive bidding under seal. i Generally, the rules regarding the accountability of officers an directors of nonprofit corporations arc similar to those applied in the case of business corporations. See Pasley. "Nonprofit Corporations Accountability of Directors and Officers," 21 Business Lawy 621 (1966). - Sec Section 5. 24 (d) Purchases or rentals of standardized goods at (g) Grants, loans, loan guaranties, or other forms the lowest price offered after all local suppliers in the com- of financial assistance to nonprofit subsidiaries of the grantee, munity have been contacted for quotations. (h) Purchases or rentals of goods, space, or services (e) Purchases or rentals of services, goods, or space under contracts which were entered into prior to the effec- from public or private nonprofit organizations at cost or at tive date of this memorandum. However, grantees are ex- general rates previously established by those organizations. pected to remedy situations that involve conflicts of interest (f) Sales or lease of services, goods, or space to as soon as possible, public or private nonprofit organizations. 25 Section 7 ORGANIZING AN LEDC AS A NONPROFIT MEMBERSHIP CORPORATION SHAPING OF CORPORATE PAPERS 7-1. In any jurisdiction. State statutes must be checked to determine specific provisions and procedures for forming a nonprofit membership corporation, or alternatively, for in- corporating under the District of Columbia Non-Profit Cor- poration Act and qualifying in the local jurisdiction. The following sections discuss the shaping of such corporate papers to implement the activities listed in Section 2. Ap- pendixes 7-A to 7-E illustrate some State statutes and some other approaches to organizing a nonprofit corporation. Ap- pendix 5-A shows the certificate of incorporation of a New York membership corporation which has been ruled to be a tax-exempt organization. Articles of Incorporation 7-2. The articles of incorporation of a nonprofit member- ship corporation contain certain essential provisions. These provisions are itemized in outline form below. Key points for decision follow each item in the outline. (1) Heading. Articles of Incorporation [or Charter] of [name of LEDC]. The undersigned, acting as incorporators of a corporation under [ Non-Profit Corporation Act], adopt the fol- lowing articles of incorporation for such corporation. (2) Name. First: the name of the corporation is [ ]. (3) Duration. Second: the duration of the corporation shall be [perpetual]. (4) Objects, Purposes, and Powers. Third: the purposes for which the corporation is formed are [see Section 7-3 below]. (5) Fourth: provisions for the regulation of the internal affairs of the corporation including provisions for distribu- tion of assets on dissolution or final liquidation, are: [Pro- visions for regulation of internal affairs of corporation, dis- tribution of assets, and provisions relating to members, their qualifications and rights, may be inserted here. See Sections 7-4 to 7-11 below for discussion of these aspects.] (6) Office of Corporation; Registered Agency. Fifth: the address of the initial registered office of the corporation is [ ], and the name of its initial registered agent at such address is [ ]. (7) Directors. Sixth: the number of directors constituting the initial board of directors of the corporation is [ ], and the names and addresses of the persons who are to serve as the initial directors are: Name A ddress Name A ddress Dated [ ] [ 1 [ ] I ], 19[ ]. [ 1 Incorporator By-Laws 7-3. Initial by-laws are usually adopted by the incorpora- tors, and thereafter amended or repealed by the members, except to the extent that the power to amend is vested in the board of directors. In many instances, provisions dis- cussed in Sections 7—4 to. 7-7 may be placed alternatively in the certificate of incorporation or in the by-laws, if this is not inconsistent with the governing statute or the certificate itself. Wherever possible the articles of incorporation should provide for complete flexibility; restrictions, if desired, should be in the by-laws. Since basic by-law provisions are readily available in form books and from corporation services, they are not repro- duced here. (1) Purposes. Assuming a membership corporation is to be formed to engage in the activities described in Section 2-2, its articles of incorporation (or charter) must provide that its purposes include performing such activities. The purposes clause in the articles of an LEDC (which would perform all of the activities listed in Section 2-2) might state: "The purposes for which the corporation is formed are to operate exclusively for charitable, scientific, and edu- cational purposes by seeking to assist those persons within the community 1 who are attempting to develop businesses or community projects which the corporation deems bene- ficial to the community because they provide necessary busi- ness services to the community, tend to See 15 USC 684 (d) and 685(b). 2i For purposes of the Regulations under the Small Business Invest- ment Act, an "associate" of an SBIC (licensee) means: "(a) An officer, director, general manager, or investment adviser of such Licensee, or any person or firm regularly serving such Licensee in the capacity of attorney at law; or "(b) Any person which owns or controls, directly or indirectly, 10 or more percent of any class of stock of such Licensee; or "(c) Any officer, director, partner, general manager, employer, or employees of any person described in paragraphs (a) and (b) of this section; or "(d) Any person which directly or indirectly controls, or is con- trolled by, or is under common control with a Licensee or any person described in paragraphs (a) and (b) of this section; or "(e) Any close relative of any person described in paragraphs (a) and (b) of this section; or "(f) Any concern in which (1) any person described in paragraphs (a) through (e) of this section is an officer or director or (2) any such person (or group of two or more such persons acting in concert) owns or controls, directly or indirectly, 10 or more percent equity interest (exclusive of any interest attributable solely to ownership of equity interests in the Licensee; and "(g) For the purposes of this definition, any person which has held any of the positions or relationships described in paragraphs (a) through (f) of this section within 6 months prior to the date of financing provided by the Licensee, or which holds any such position or relationship within 6 months after the date of such financing shall 37 financed, 22 the device of bringing in co-vestors is a permis- sible way for an SBIC to arrange for a larger financing to a small business concern than the SBIC itself might other- wise be able to provide because of capital limitations or policy reasons. An SBIC may also buy a participation in a long-term loan made to a small business concern by others, but the SBIC's participation may not exceed 90 percent of the unpaid balance of the loan at the time of participa- tion. 23 The borrower must otherwise be eligible for direct financing by the SBIC. SBICs evidently may not buy a participation of any sort in an equity-type investment made to a small business concern by someone else, 24 although an SBIC is permitted to make an outright purchase of equity in a small business concern from someone other than the issuer in certain circumstances. 23 Within the limits of the Small Business Investment Act 2 '' and Regulations thereunder, the type and terms of financing provided by an SBIC will be the result of negotiations be- tween the SBIC and the small business concern being financed, taking into consideration the needs of such concern and the investment policies of the SBIC. Since SBICs are for the most part growth-oriented investment companies, SBIC managers tend to think in terms of providing equity or venture capital rather than straight loans. The incentive for SBICs to provide venture capital is increased to some extent by virtue of the increased availability of Federal funds to SBICs who have at least 65 percent of their private capital in "venture capital" financings, as previously discussed herein. 27 Obviously, in dealing with disadvantaged small businesses, where the risks of failure may be greater and the potential for superior growth lower, 2S the SBIC manager may suggest a financial package bearing a higher interest rate and involving security in one form or another, but without equity features. The maxim of most SBIC managers, however, is flexibility, and an SBIC will usually tailor its financing to the needs and prospects of the business being financed. Given that the type and terms of financing may be the result of negotiation between the parties within limits imposed by the Small Business Investment Act and Regula- tions thereunder, the entrepreneur seeking financing from an SBIC should have some idea what types of investments may or may not be made by an SBIC and what restrictions apply to such investments. Size of Small Businesses 10-6. SBICs cannot finance businesses which exceed SBA size standards for SBIC financing. 20 Generally, SBA standards require that the business to be financed not have assets in excess of $5 million, net worth in excess of $2.5 million, or average net income in excess of $250,000 (after Federal income taxes and computed without benefit of loss carryovers) for the 2 years immediately preceding the proposed SBIC investment. A small business concern which does not meet these criteria may stili be eligible for SBIC financing if it satisfies other criteria set forth in the Regulations applicable to the industry in which the concern is primarily engaged. 3 " Basically, these latter criteria establish limitations on gross revenues over certain periods and on the number of employees of the business proposed to be financed. Except in determining the industry in which the business is primarily engaged, the size of a business is to be determined with reference to the assets, net worth, average net income, gross revenues, and number of employees, as the case may be, of the small business and its "affiliates,"'" which are lumped together for purposes of the Regulations. Resolution of the affiliation problem is not always easy. If counsel for an SBIC has any doubt as to the eligibility of a small business concern proposed to be financed by the SBIC, he should seek a determination by SBA on the question. As a condition to financing, he should also require from SBA a valid and effective certificate evidencing its determination that the concern proposed to be financed, taken together with its affiliates, meets applicable size standards and other criteria set forth in the Regulations. Counsel to an SBIC should obtain the information needed to resolve the questions posed by the Regulations in this and other areas at an early stage in the proposed financing. Much effort and expense will be saved by weeding out ineligible businesses before substantial time is spent drafting documents. In that regard, a questionnaire to be completed by the concern seeking SBIC funds should be devised which would point up problem areas under the Regulations. Questions designed to elicit information needed to prepare papers in the transaction should also be included. 32 Long-Term Loans 10-7. An SBIC can make loans to any type of small busi- ness, whether it be a corporation, partnership, sole proprietorship, or other form of business enterprise. 33 Such loans may be secured or unsecured 34 but may not be for a term exceeding 20 years 33 or require amortization during the first 5 years at a rate exceeding an accumulated average of 20 percent of principal per year 30 or provide for interest at a rate in excess of the maximum allowable under applicable State law or 15 percent per annum, whichever is be deemed to have such position or relationship as of the date of Licensee's financing." (SBA Regs., 13 CFR 107.3. Definition of Associate of a Licensee: Recently proposed amendments to the Regulations make it clear that a MESB1C and an SBIC owning stock therein, as well as the associates of each, are associates of each other for the purposes of the Regulations. See proposed amendment to Regulation 107.3, 35 Fed. Reg. 8673 (1970)." -'- Except where necessary to protect its investment and for temporary periods, neither an SBIC nor an SBIC and its associates, nor two or more SBICs, may assume control over a small business concern, whether through management, agreements, voting trusts, majority representation on the board of directors, or otherwise. (SBA Regs., 13 CFR 107.901(a) and (c). Temporary control over a small business may be assumed only pursuant to a plan calling for divestiture of control within a reasonable period not to exceed 7 years (and receiving the prior approval of SBA) or as a result of an enforcement action, following which divestiture will take place in accordance with a plan approved by SBA. (SBA Regs., 13 CFR 107.901(d) and (g).) For other provisions relating to presumption of control and divestiture plans, see SBA Regs., 13 CFR 107.901(b), (e), (f), (h), and (i). 23 See 15 USC 685(b). 2+ Compare 15 USC 684(d) and 15 USC 685(b). 25 SBA Regs., 13 CFR 107.502, 107.504(b)(3), and 107.807. 2 U.S. Code 1964, Title 11, sees. 72, 107. U.S. Code 1964, Title 15, sec. 80a-l to 80a-52. See Section 28. '■'n Preemptive rights: Cary, op. cit. pp. 1143-1149, 19 Am. Jur. 2d Corporations, sees. 276-281, 299-300; 637, 662-704 (1965). '•'i Cumulative Voting: Cary, op. cit. p. 224, at 276-288; 19 Am. Jur. 2d Corporations sec. 662-668 (1965). ^See 15 USC 681 (a). ™ For example, the power to make and alter the by-laws, to fix the amount of working capital and determine what dividends shall be declared, to mortgage the property of the corporation, to provide for an executive committee, to determine when and under what conditions the books of the corporation shall be available to stockholders for inspection, and to sell or exchange all or substantially all of the corporation's assets. The addresses of officers and directors will be needed to complete the SBA License Application. See Item 8 of the Licensed Application in Appendix 10-C. Unless the written consent of SBA is obtained, persons found guilty of certain criminal offenses or civilly liable for damages in certain civil actions are barred from becoming officers, directors, or employees of SBlCs or otherwise participating in the management of an SBIC. 15 U.S.C. 687f(c). '■"'■ See footnote 95. 43 to discuss with his client the advisability of taking advantage of any such statutory provisions and of increasing or de- creasing the quorum requirements at stockholders' and directors' meetings. (o) Transfer and Voting Requirements: If the SBIC is to be closely held by a few stockholders and there is a desire to prevent the stock from passing to outsiders and to assure continuity of management, counsel should con- sider available methods of achieving those results. Restric- tions on the transfer of shares usually may be imposed in the certificate (or articles) of incorporation or the by-laws, or through a subscription agreement, employment contract, or stockholders' agreement. The better practice is probably to handle such arrangements in a separate stockholders' agreement because of the ease of making changes and amendments thereto. A separate voting trust agreement is the usual method of assuring the outcome of voting on business to be transacted at stockholders' meetings. 97 State corporation statutes usually contain provisions re- specting the duration of and necessity of filing such agree- ments, however, and counsel will wish to be sure that such agreement complies with the law. All subscription agree- ments, stockholders' agreements, and employment contracts with officers and directors of the SBIC, and all agreements affecting voting rights must be submitted to SBA in executed or proposed form at the time the License Application is filed with SBA. 98 (p) Tax Year: Counsel should determine with his client after consultation with tax counsel or the SBIC's accountants whether the SBIC will report its income on a calendar year or fiscal year basis and, if the latter, the date on which the fiscal year is to end. In this connection SBA requires the submission by SBICs of financial statements for the 6-month and 12-month periods beginning April 1 of each year. The 12-month statements must be audited by independent public accountants in accordance with the Regulations. 99 (q) Corporate Seal: State incorporation laws usually spec- ify whether the corporation may have a corporate seal and may also prescribe the form of the seal. If the form is not so prescribed, counsel should decide with his client on an appropriate form of corporate seal and such seal should be adopted by the directors at the first meeting of directors. Corporation supply firms specialize in the production of corporate seals for a small fee; such firms may be located through the classified section of the telephone book or through The Corporation Trust Company or similar corpora- tion service organizations. (r) Stock Book and Stock Certificates: Counsel should obtain from the firm selected to supply the corporate seal samples of stock certificates and permit his client to choose the form of certificate for each class of stock to be author- ized. Stock certificates range from the elaborately engraved to the plain unembossed form and vary in price accordingly. It may be possible to use a typewritten certificate rather than a printed form to represent shares in the SBIC, provided requirements of the State corporation law are observed re- specting the content of stock certificates. Of course, before any form is authorized for use as a stock certificate, counsel should make sure it complies with the law in his State. (3) Forms of Charter and By-Laws. The forms and provisions of charter documents vary from State to State so it is not possible to suggest a form for the certificate (or articles) of incorporation or for the by-laws which will be appropriate for use in all States. Forms of those documents, tailored to the corporation law of the State, may usually be obtained from The Corporation Trust Company or similar corporation service organization operating in the State. Friends in the profession or the local bar association may also be able to provide counsel with forms. It is never a good idea to follow anyone's form slavishly since there al- ways will be provisions which will be inappropriate for your transaction, or which counsel will wish to add. In drafting the certificate (or articles) of incorporation for an SBIC, the special provisions and requirements of the Small Busi- ness Investment Act and SBA will also have to be ob- served; 1 " in every case counsel should check the appropriate sections of the statute from which the various provisions in the forms of charter documents have been derived to be sure that such provisions are accurately stated and that there has been no change in the law since the forms were adopted for use. (4) First Meetings. As soon as may be convenient after counsel has been advised that the certificate (or articles) of incorporation have been filed and he is satisfied that the SBIC is a duly constituted body corporate, an organization meeting of the incorporator or incorporators, or of the board of directors (if the initial directors were named in the cer- tificate or articles of incorporation), should be held. The purpose of this meeting is to adopt by-laws, elect directors until the first annual meeting of stockholders, accept the subscriptions of directors for stock (if directors are required to be stockholders) and/or assign the subscrip- tions of the incorporators to the directors (where the in- corporators and directors must be subscribers), and transact such other business as may properly come before the meeting. Immediately after the organization meeting, or as soon as may be practicable, the board of directors should meet to approve and adopt the by-laws adopted by the incorporator or incorporators; to elect officers; to approve and adopt a corporate seal and the form of certificate or certificates selected to represent shares of the capital stock of the corporation; to authorize the execution and submission to SBA of the License Application; to authorize the opening of a custodian account (if desired), an imprest bank account (if desired), and a general bank account with a bank or other appropriate institution; to approve procedures for maintaining dual control over the disbursement of funds and the withdrawal of securities from safekeeping; 1 " 1 to au- thorize the maintenance of a fidelity bond covering officers and employees having control over or access to the cash, securities, and other property of the corporation; 102 to authorize the investment of idle funds in accordance with Section 107.808 of the Regulations under the Act; to ap- prove the employment of independent public accountants; 103 '■'' See Cary, op. cit. pp. 15-21; "Community Development Corpora- tions," 83 Harv. L. Rev. 1558, 1616-1626, May 1970; "New Stock Issue Protection of Minority Shareholders," 45 N.Y.U. Law R. 119, March 1970; "Statutory Protection for Oppressed Minority Share- holders," 55 Reform Va. L. Rev. 1043, October 1969; "Dealings Between Closely Held Corporations and Their Shareholders," 25 Tax L. Rev. 403, March 1970; "Control Distribution Devices," 1969 U. 111. L. Forum 61. 1969 (voting trusts, voting agreements, classes of stock, etc.); "Comparison of the Close Corporation Statutes of Delaware, Florida and New York," 23 U. Miami L. Rev. 515, winter- spring 1969. Also see "Tax and the Closely Held Corporation," 1969 Wis. L. Rev. 1199, 1969. 0Si See Item 8 of License Application in Appendix 10-C. 09 SBA Regs., 13 CFR 107.1102(d)(1) and (2). i"" See 15 USC 681(b) and Item 9 of the License Application in Appendix 10-C. mi See Section 107.1103(b) of the SBA Regulations for the require- ments applicable to bank accounts and signature control. SBA Regs., 13 CFR 107.1103(b). 102 SBA requirements for a fidelity bond are set forth in its Credit and Examination Guide for Small Business Investment Companies annexed to the Regulations under the Small Business Investment Act as Addendum 1. See also SBA Regs., 13 CFR 107.1104(a). los Notification of the name of the accountant selected to perform accounting services for the SBIC is required to be given to the Office of Staff Accountant. Investment Division, Small Business Administra- tion, 1441 L Street. N.W.. Washington, D.C. 20416. The accountant selected is then required to execute and file with the SBA 1PA Statement, 1 Form 56, and will be deemed approved unless the SBIC is otherwise advised by SBA. 44 and to transact such other business as may properly come before the meeting. SBA Regulations also require SBICs to adopt a plan of effective control procedures with respect to its assets and personnel, 1 " 4 and while it does not appear that such pro- cedures must be adopted at the first meetings or submitted to SBA for approval, it is probably a good idea to adopt them at the very outset. Such procedures must in any event be adopted before the first annual audit takes place, since the independent accountants making the audit are charged with, among other things, reviewing the SBICs procedures with regard to internal control. Certified copies of the by-laws, the minutes of the meet- ings at which the officers and directors in office at the time the License Application is filed were elected, and the resolution authorizing the execution and submission to SBA of the License Application must be submitted to SBA with the Application. 105 SBIC Licensing Procedures. 10-15. Procedures for obtaining a license to operate as an SBIC are set forth in Sections 107.102 and 107.103 of the Regulations under the Small Business Investment Act and provide for (1) submission of a license application on SBA Form 415; 106 (2) payment to SBA of a license fee of $500, which is to accompany the license application and which is not refundable (regardless of the action taken on the license); and (3) publication by SBA in the Federal Register of specified information concerning the filing of the appli- cation and publication of a similar notice (as prescribed by SBA) in a newspaper of general circulation in the city, area, or areas where the applicant proposes to commence opera- tions. By law, 107 SBA is enjoined to give due regard in exercising its discretion to issue a license to all relevant factors, includ- ing the need and availability for the financing of small businesses in the geographic area in which the applicant proposes to commence business, the general business reputa- tion and character of the proposed owners and management of the applicant, and the probability of successful operations on the part of applicant, including adequate profitability and financial soundness. Thus, the grant of a license is by no means a certainty after the application is filed. As will be noted from the License Application itself, 1 "* and as indicated earlier in this section, SBA has the right to approve or disapprove a number of key elements in the formation of a prospective licensee, including its name and certificate (or articles) of incorporation. Accordingly, before any substantial effort is made to organize an SBIC under local law, counsel for the prospective SBIC should visit the nearest area or field office of SBA to discuss the proposed application, to obtain necessary forms and other pertinent SBA literature (including copies of the Small Business Investment Act and the Regulations thereunder), and to get some idea of the capitalization which SBA will require the applicant to have. 1 " 9 With regard to the applicant's capitalization, it is known that SBA is not sympathetic to applications where the pro- posed capitalization is less than $300,000. Where there is already a heavy concentration of SBICs (such as in New York and California), the required capital of the SBIC may have to be substantially higher. Therefore, preparing to file a license application, counsel will wish to work closely with SBA officials, and it will usually be possible to submit forms of documents for tentative approval. Before any license is issued it is necessary for the officers and directors, or pro- posed officers and directors, of the applicant to have a personal interview with SBA officials in Washington, where they will be closely questioned as to the policies and opera- tions, or proposed policies and operations, of the prospective licensee and their knowledge and understanding of the applicable statutes and regulations. Managerial Requirements 11 " 10-16. Managing a successful SBIC requires talents of the highest order. The successful manager must know and under- stand the Regulations governing SBIC operations (which are highly technical and difficult to apply in many areas); he also must have a broad background in business and finance and an awareness of the uses and provisions of some highly sophisticated financing instruments, particularly if the SBIC plans to engage in equity financing. The venture capitalist must know more than common stock financing. The financing of small businesses in low-income com- munities may very well pose special problems. 111 Manage- ment of an SBIC is not the place for an unsophisticated amateur. In fact, it is doubtful that the Small Business In- vestment Act or the Regulations thereunder permit com- promise as to managerial competence, 112 and it may be that SBA will decide that managerial capabilities greater than usual are required to run a ghetto-oriented SBIC. On the other hand, the limited capital and initial profit potential of ghetto financing will require economies of opera- tion, and some sort of pooling of managerial talent or office space may be one solution to the problem. In addition, volunteer assistance from business schools and businessmen's associations, banks, law schools and bar associations, civic and community groups, and other volunteer agencies may also be available to fill the gap, either in the management of the SBIC or in the consulting area which is an integral part of the financial package SBICs are expected to provide small businesses. Management of an SBIC is a full-time job requiring dedicated and capable managers. 104 SBA Regs., 13 CFR 107.1103(a). 105 See Items 10-13 of the License Application in Appendix 10-C. Sample minutes and resolutions thought to be adequate to reflect the proper proceedings and action to be taken by the incorporator or incorporators and/or directors appear in Appendixes 10-D and 10-E. Additional items of business transacted at the meetings of incorporators and/or directors should also be reflected in the minutes. mo A form of license application is in Appendix 10-C. i«"See 15 USC 681(c). 10" See Appendix 10-C. i" 9 Under Section 302(a) of the Small Business Investment Act each company authorized to operate under the Act is required to have a combined paid-in capital and paid-in surplus in an amount "(1) not less than $150,000, and (2) adequate to assure a reasonable prospect that the company will be operated soundly and profitably, and managed actively and prudently in accordance with its articles of incorporation." (15 USC 682(a).) See also SBA Regs., 13 CFR 107.101(d). """Community Development Corporations," 83 Harv. L. Rev. 1558, 1646-1654, May 1970; "Symposium: Legal and Economic Problems in the Development of Black Capitalism," 15 Howard L. J. 333 (Spring 1969). HI For an indication of some special problems that may be encountered, see the article in the May-June 1969 issue of the Harvard Business Review titled, "Making Capitalism Work in the Ghettos," by Louis I. Allen, President of Chase Manhattan Capital Corporation. See also "Community Development Corporations," 83 Harv. L. Rev. 1558, 1592, May 1970; "Legal Techniques Available for Obtaining Funds," 25 Business Lawyer 13, September 1969; "Problems of Locally Owned Businesses." 25 Bus. Law. 101, September 1969; "Small Business Financing: Meeting the Need for Equity Capital in the Small Business Sector," 29 Fed. Bar J. 121, spring 1969; and "Symposium: Legal and Economic Problems in the Development of Black Capital- ism," Howard L. J. 333, spring 1969. ii- See 15 USC 681(c). Section 107.101(a) of the Regulations under the Act also provides as follows: "(a) Management. Each licensee shall have and maintain qualified management in charge of its operations and available at its office to the public. A common manager may be employed by two or more Licensees, subject to prior written SBA approval. A general manager, or common manager, shall be deemed an officer of such Licensee." (SBA Regs., 13 CFR 107.101(a), as amended.) 45 BIBLIOGRAPHY Fletcher, William Meade. Corporation Forms Annotated, 3rd ed., Callaghan & Co., 1957. iq_j7 Rohrlich, Chester. Organizing Corporate and Other Business Enter- prises, 4th ed., Matthew Bender, 1967. Bradley. Edwin J. Supplementary Cases and Statutes on Business "Close Corporations: Symposium." 1969 U. III. L.F. 1, 1969. Organizations. Lerner Law Book Co.. Inc., 1965. Zeidman, Young, Harrison, and Davis. "The Small Business Invest- Cary, William J. Cases and Materials on Corporations, 4th ed., un- ment Company — A Tool for Economic Self-Help," 21 Bus. Law. 947, abridged. Foundation Press, Inc., 1969. 1966. 46 Section 11 ADVANTAGES AND DISADVANTAGES OF PROPRIETORSHIPS, PARTNERSHIPS, AND CORPORATIONS CHOICE OF BUSINESS FORM 11—1. Once the potential entrepreneur or Local Economic Development Company has decided to acquire an existing business (see Section 13-7) or to develop a new venture, the appropriate form of business organization must be chosen. While there are many types of available forms and varieties of each type, this discussion is confined to the three major types of organization — sole proprietorship, partnership, and corporation. A bibliography related to the choice of business form ap- pears in Section 11-7. SOLE PROPRIETORSHIP 11-2. The sole proprietorship is a business owned and oper- ated by an individual — the traditional "one man" firm. Here the owner-proprietor holds title personally to all assets used in the business just as he owns all of his other property not used for business purposes. Generally, although there have been major exceptions, the sole proprietorship is small. Frequently, especially where a service business is involved, it takes the form of a "Ma and Pa" enterprise with the family of the proprietor assisting in the business. ( 1 ) Advantages (a) The major advantage of the sole proprietorship is its simplicity. Organizational costs and formalities are mini- mal. Unless a trade name is to be used (which will require in most States the filing of a trade name or doing business certificate) or unless a special operating license is required by some government agency, few start-up or continuing formalities are necessary. (b) The simplicity of the sole proprietorship means few technicalities in the continuing operation of the business. There is no board of directors, no shareholders to deal with and no by-laws limiting the authority of the businessman. The owner is accountable only to himself and to his creditors. Thus business decisions may be made easily and quickly. Many of the tax and other requirements to which corporations are normally subject are not applicable. (c) The business may operate in other States without the formalities of corporation "qualification," although again the filing of a trade name or doing business certificate may be necessary. (2) Disadvantages (a) The major disadvantage of this form of business is the unlimited liability of the proprietor for all debts of his business. The owner and all of his nonbusiness assets are subject to the claims of his creditors. Further, the proprietor is also personally liable for tort claims (personal injuries suffered by a customer, for example) against which, of course, he may be in whole or in part covered by insurance. (b) Operations may be hindered because of the hesita- tion of suppliers and others to do business with employees who may not have or appear to have sufficient authority. (c) The business may collapse when the owner dies or becomes disabled. (d) Greater difficulty may be encountered in obtaining financing than in other forms of business for a variety of reasons. Such reasons include the risks to a lender because of the possible disruption of the business by death or dis- ability of the owner and the lower interest rates that must be paid by an individual due to nonapplicability of the usury laws to corporations. The possible tax disadvantages and poorer fringe benefits available to the proprietorship are discussed later. PARTNERSHIP 11-3. A partnership is the joining of two or more individ- uals, or an individual and a corporation, to operate a busi- ness by uniting their business assets, services, and capital. Like the sole proprietorship, title to the business assets is held directly by the partners, except that the assets are owned "in common." Unlike the sole proprietorship, the partnership is a seprate legal entity for some purposes and can contract, do business, and sue and be sued in its own name. The essential aspect of the partnership is the sharing of profits and losses among the partners in such proportions as the partners determine. Since the partnership is not a legal entity for tax purposes, each partner is taxed on his share of the partnership profits and may deduct his share of the losses. ( 1 ) Advantages (a) As in the sole proprietorship, the use of the partnership form is simpler in organization and operation than the corporate form. (b) Each partner has full authority to act for the part- nership, giving it maximum flexibility of management. (c) Each partner has, in effect, unless otherwise agreed, a veto power over partnership decisions. (d) The partnership may be terminated at any time by any partner, even if the partnership has a stated term by agreement. 1 (e) No person can become a partner without the con- sent of all the partners, except that the partners can, by agreement, provide for admission of additional partners by less than unanimous vote. (2) Disadvantages (a) Unlimited liability of each partner for debts and obligations of the partnership, although there is generally a right of contribution in such event. 1 Uniform Partnership Act, Section 31(2); New York General Business Law, Section 130. 47 (b) The power of each partner to act for the other partners and the partnership is also a disadvantage, in that the partnership and its partners, by being bound by the acts of any partner, are liable for the acts and debts of the others. (c) The partnership becomes dissolved upon the death of any one partner or the withdrawal of a partner, although this in generally only a technicality in terms of continuity of operation. Some of the disadvantages can be eliminated by the use of the limited partnership, a form of business now author- ized by statute in all States. In this type of partnership, individuals — the limited partners — can limit their liability to the amount of their contribution provided they assume no control over the business. There must be at least one general partner. 2 CORPORATION 11-4. The corporation is a separate legal entity holding title to the assets of the business which is run by its officers and directors. The proprietors become "shareholders," receiving stock certificates representing their proportionate interests in the property of the corporation. Although there are varia- tions from State to State, the shareholders generally elect a board of directors which is the policymaking arm of the corporation. The directors in turn appoint and can remove under stated conditions the officers who are the operating managers of the company. ( 1 ) Advantages (a) The main characteristic and major advantage of the corporation is the limited liability enjoyed by the share- holders. This means that only the assets of the corporation are subject to business debts, thus insulating the shareholders' personal assets from business or tort claims. It also protects the corporation from liability in the event of claims by creditors against any of the shareholders personally. (b) Perpetual existence: The corporation, unlike the partnership, is not dissolved upon the death of a principal, nor is the corporation as likely to collapse upon the death or incapacity of a principal as is the sole proprietorship. (c) Increased credit potential because of statutory ex- emption from the usury laws which limit the rate of interest that individuals may be charged. (d) Transfer of interests in the business are generally effected simply and quickly. (e) Greater flexibility in raising capital. (f) Better employee fringe benefits available under tax laws. (2) Disadvantages (a) Greater complexity and formality of incorporation and operation. (b) Necessity of obtaining formal approval of many non-routine actions. (c) Expenses and time expenditure in keeping detailed records and preparing tax and reporting forms not otherwise required. (d) Payment of franchise and corporate income taxes. (e) In addition to item (d), payment by stockholders of taxes on income received from corporate operations. (f ) Another disadvantage of the corporate form is that there are greater restrictions on a corporation doing business outside of its State of incorporation than there are on an individual or a partnership. Also with respect to a corpora- tion, there is the problem of foreign attachment where the corporation is a foreign corporation even though it is regis- tered to do business in the State in which the plaintiff brings the law suit. Many State statutes provide that a suit started by foreign attachment will not be against an individual who is present in the State, but that such suits will be against a foreign corporation even though registered to do business in the State. Corporations generally fall into one of three classes: the "one man" corporation, the "close" corporation, or the "public" corporation. In effect, the "one man" corporation is an incorporated sole proprietorship. Ownership and control rests with the principal businessman. The "close" corporation generally has a limited number of shareholders, and is usually defined as a corporation where the shareholders (or members of their immediate families) are active in the operation and manage- ment of the business. Thus, in a sense, the "close" corpora- tion may be described as an incorporated partnership. The term "public" corporation is generally used to de- scribe the larger company with hundreds or thousands of shareholders, but the term is often applied to small- or medium-sized businesses where shares are held by persons who are not active business participants. It should be noted that there are two types of exceptions to the limited liability rule. The first is as in New York where, by statute, the 10 largest stockholders of corporations not listed on a national securities exchange or regularly quoted over-the-counter are liable to employees for wages due for services rendered to the corporation. 3 The second type of exception, created by case law, ignores the corporate entity and imposes personal liability on share- holders where there is a finding that there was inadequate capitalization of the corporation. A similar result is applied to inadequately capitalized subsidiary corporations. Legal counsel should be consulted in regard to the details of local law as to these types of exceptions. TAX CONSIDERATIONS 11-5. As indicated in general terms previously, the foregoing advantages and disadvantages of the three basic forms of business organization must be considered in the light of the impact of the tax laws. In addition to United States income taxes, imposed by the Internal Revenue Code, 4 the impact of State and city income, franchise, gross receipts, and license taxes, as well as other types of taxes, must be analyzed. For purposes of this book, however, only Federal taxes are discussed. A sole proprietorship is not taxed as an entity separate from its owner. Such owner is taxed on the total income from his business together with other income he may have at the graduated rates applicable to individuals.'"' A partnership also is not a separate entity for income tax purposes. The partnership merely files an "information" re- turn, and each partner pays tax on his share of the taxable income of the partnership, as of course does the sole proprietor. The corporation is a separate entity for tax purposes. It pays a tax of 22 percent on the first $25,000 of income and 48 percent on all income in excess of $25,000." When dis- tributions are made to shareholders, a second tax is paid by the recipient (at either ordinary or capital gain rates depend- ing on the type of distribution made). This result is often referred to as "double taxation" which may, however, be avoided in certain situations. For example, more favorable tax treatment is afforded to a real estate investment trust s and to a regulated investment 2 For a fuller discussion of limited partnerships, see Sections 19-12 and 19 13. :t New York Business Corporation Law. Section 630. ■i United States Code, Title 26. ■' Internal Revenue Code (hereafter IRC), Section I. « IRC Section 701; IRC Section 6031; Reg. Section 1.701-1. » Sec Tax Reform Act of 1969. P.L. 91-172 83 Stat. 487. 8 IRC Section 856 et seq. 48 company. 9 Further, the taxation of income at the corpora- tion level may be avoided by the election allowed under Subchapters of the IRC 10 whereby a small corporation with only one class of stock and no more than 10 shareholders may choose to have its income taxed at the shareholder level only. This election in effect converts the corporation into a partnership for tax purposes. Another common method of minimizing this "double tax," particularly in the small- or medium-size corporation, is to pay a large portion of profits to principal stockholder- employees as salaries. Since salaries are a deductible expense of the corporation this in effect eliminates the "double tax" on those sums so distributed. However, the Internal Revenue Service carefully scrutinizes executive salaries and will disallow deductions for sums which exceed what IRS believes is the fair value of the services rendered. Two important points should be noted here. The IRC pro- vides that a corporation may be required to pay a penalty tax of as much as 38'/2 percent on "improperly accumulated surplus" in excess of SlOO.OOO. 11 Also, if the income of the corporation is from certain types of investments or is received, in some cases, from the personal services of a "principal" shareholder, the corpora- tion may be treated as a personal holding company and a tax rate of 70 percent may be applied to undistributed income. 12 Although generalizations, particularly in the area of taxa- tion, are questionable, it is clear that the applicable tax rates depend on the particular form of organization and that this will be a major factor in determining the form to be used. An analysis of these factors must be made in each case and the appropriate decision reached. FRINGE BENEFITS 11-6. One of the advantages of the corporate form referred to earlier was that the fringe benefits a corporation may offer to its employees are generally better than if a noncorporate form were used. The corporation may establish a qualified profitsharing or pension plan to provide retirement, disability, sickness, and death benefits to its employees. Contributions to a qualified plan are a deductible expense of the corporation but are not currently taxable as part of the employee's income. The employee receives favorable tax treatment of these funds upon retirement, although the Tax Reform Act of 1969 has somewhat lessened these benefits, particularly by the removal of capital gains treatment for lump-sum distributions on retirement to the extent they are attributable to employee contributions for plan years after 1969. However, a 7-year income-averaging provision lessens the burden of this change. 13 The corporation may also provide its employees with other tax-free benefits such as group insurance plans and widow's death benefits, 14 sick pay benefits. 1 "' and health and accident insurance benefits. 1 ' 1 These benefits are not generally avail- able to sole proprietorships or partnerships. In 1962 Congress attempted to rectify this distinction in part and amended the Internal Revenue Code to permit sole proprietors and partnerships to create retirement plans for themselves. A so-called "Keogh Retirement Plan," 17 allow- ing contributions of the lesser of $2,500 or 10 percent of income to the retirement fund may be set up, although the advantages are not as great as a corporate pension or profit- sharing plan. For example, there are penalties for contribu- tions in excess of the deductible amounts. Because of the better tax treatment accorded by the IRC to corporate pension and profitsharing plans, many partner- ships and sole proprietorships have, in recent years, decided to incorporate and in some cases, elect to be taxed as part- nerships under Subchapter S. Such decisions should be re- viewed in the light of the changes in this area contained in the Tax Reform Act of 1969. 1H Under the new law, stock- holder-employees of Subchapter S corporations who own more than 5 percent of the company's stock are required to include in their gross income employer-corporation con- tributions exceeding the lesser of $2,500 or 10 percent of salary. The result of this change is to remove a major induce- ment to incorporate. BIBLIOGRAPHY 11-7. Cary, William L. Cases and Materials on Corporations, 4th ed., unabridged. Foundation Press, Inc., 1969. Cavitch, Zolman. Business Organizations, Matthew Bender and Com- pany, Inc., 1963. Fletcher, William M. Cyclopedia of the Law of Private Corpora- tions, Callaghan and Company, 1931. Herwitz, David R. Business Planning, The Foundation Press, 1966. Hornstein. George D. Corporate Law and Practice, West Publishing Company, 1959. Israels, Carlos L. Corporate Practice, Practising Law Institute, 1969. Knapp, Russell S. and Myron Semmel. Forms of Business Organiza- tion and the Federal Tax Laws, Practising Law Institute, 1966. Mertens, Jacob. Law of Federal Income Taxation, Callaghan and Company, 1942. Rabkin, Jacob and Mark H. Johnson. Federal Income, Gift, and Estate Taxation, Matthew Bender and Co., Inc., 1962. Rchrlich, Chester. Organizing Corporate and Other Business Enter- prises, 4th ed., Matthew Bender and Company, Inc., 1967. White, Frank. New York Corporations, Matthew Bender and Com- pany, Inc., 1963. Maer, Jr., C. and Frances, R. "Whether To Incorporate," 28 Bits. Law. 571. 1967. o IRC Section 851 et seq. 10 IRC Section 1371 et seq. u IRC Section 531 et seq. i- IRC Section 541 et seq. 13 IRC Section 501 et seq. 14 IRC Sections 101(b) and 264. 15 IRC Section 105. IB IRC Section 106. i" See IRS Publication No. 560 (10-68); 1954 Internal Revenue Code sec. 401(c) and Regulation sec. 1.401-10—1.401-13. Official name of plan is Self-Emploved Individual's Tax Retirement Act of 1962. See H.R. 10. i" See "Summary of Tax Reform Act of 1969," 25 Bus. Law. 973, April 1970; "Federal Income Tax Primer for Organizing a Corpora- tion," 43 Fla. B.J. 614, September 1969; "Subchapter S Corporation," 58 III. B.J. 542, May 1970; "The Corporation and the 1969 Tax Reform Act." 30 Milwaukee Bar Association Gavel 25. March 1970; "Recurring and New Problems Under Subchapter S." 27 N.Y.U. Inst. Fed. Tax. 755, 1969; "Tax Reform Act of 1969," 23 Tax Law. No. 3, fall 1969. 49 Section 12 PRESERVATION OF CORPORATE CONTROL BY MINORITY ENTREPRENEUR THE PROBLEM OF CONTROL 1 12-1. The desire of the community to encourage the minor- ity entrepreneur to develop or acquire a business involves certain unique problems caused by the absence of and diffi- culty in obtaining the capital resources usually available to businessmen. Among these is the question of how the pro- spective minority businessman, in many cases without finan- cial resources, can be established in business with some type of community or LEDC support, at the same time permitting him to retain control of the enterprise. The problem of control has three aspects — risk, manage- ment and decision-making, and participation in profits. Further, each of these aspects must be discussed, first, in terms of the relationship among the principal entrepreneurs themselves and, second, as they affect the relationship be- tween the principal entrepreneurs and the nonactive investors and supporters. A bibliography related to the preservation of corporate control by a minority entrepreneur appears in Section 12-8. METHODS OF ALLOCATION 12-2. It is extremely difficult to allocate rights and powers among persons with conflicting interests where the partner- ship form of organization is used. (As stated earlier, the lack of flexibility in this regard is a serious disadvantage of the partnership form. 2 ) Thus, for the purpose of this discussion, it is assumed that the corporate form is being used. It will also be generally true that these questions will arise in the case of small or medium-sized venture, rather than the larger, publicly held corporation. In the case of the traditional "close corporation," the relationships among the principal stockholders, while com- plex, may generally be worked out by means of shareholders' agreements entered into by the major participants. 3 Such an agreement can spell out the rights of each shareholder in regard to questions of management, organization, restrictions on sale of stock, employment and salaries, and the terms of repurchase of a participant's stock upon sale or death. The question of participation in profits and the shareholders' risk of loss will depend upon each of the principal share- holder's percentage of the stock issued and outstanding. If some other sharing arrangement is to be used the corpora- tion will have to create a more complicated capital structure with different classes of securities carrying differing rights. In the case of the small business corporation that requires outside support, the problems of allocation of contiol be- come more complicated. And, as noted earlier, the noimal desire on the part of the minority entrepreneur to retain as much control as possible most likely will be jeopardized by the absence of some of the strength the more economically advantaged businessman brings to the bargaining process. Classes of Securities and Voting Rights 4 12—3. The corporation may be structured so that ownership (profit participation and risk of loss) and management can be allocated through the use of various classes of securities. The issuance of common shares, preferred shares, and debt securities in varying combinations can create the flexi- bility needed to attract the necessary capital yet preserve control. Common stock is referred to as an equity security since it involves ownership of a portion or "share" of the business. The common stockholder is generally given full voting rights and normally receives the entire benefit of corporate profits and appreciation. On the other hand, in the event of diffi- culty, the common shareholder has the most to lose since his interest is subordinate to the interests of preferred share- holders and owners of debt securities. Preferred stock is designed to give the shareholder greater security in terms of investment risk and greater certainty of return at the sacrifice of profit participation and appreciation. This is generally accomplished by giving the preferred share- holder the right to a fixed dividend 5 and providing that the common stockholders can receive no dividends until all pre- ferred dividends, including arrears, have been paid (cumu- lative dividend rights). The preferred shareholder is usually given a liquidation preference which gives him additional security in terms of his investment. Another characteristic of preferred stock is that the corporation has the option to "call" or redeem the issue. Thus the principals can eliminate the outside interests represented by the preferred stock. Another approach to the question of allocation of control is through the use of debt securities as part of the corporate capital structure. The holder of a debt security has no ownership interest in the business. He is, in effect, a creditor. By giving him certain security and protection, his risk of loss is minimized. The bond or debenture usually carries a fixed rate of interest which must be paid whether or not there are corporate profits. Clearly the voting rights of the respective classes of stockholders are critical in terms of control. The share- holders, through the process of electing the directors, have ultimate control of corporate management and policy. In most States, unless provided otherwise in the certificate of 1 See Cary, William L. Cases and Materials on Corporations (4th ed. unabridged) Foundation Press, Inc., 1969, pp. 362-512; "Control Distribution Devices," 1969 U. III. L. Forum 61 (1969). - See Section 1 1-3. 3 See "Dealings Between Closely Held Corporations and Their Shareholders," 25 Tax L. Rev. 403, March 1970; "Close Corporations: Symposium," 1969 U. Ill L. F. 1, 1969. ■' On voting rights see, 19 Am. Jur. 2d Corporations, sec. 637 et seq. (1965); Cary. op. cit., pp. 229-494. On classes of securities, see 18 Am. Jur. 2d Corporations, sec. 211-217, (1965); Cary, op. cit., p. 263 at p. 1030-1177. •"' This does not mean that the shareholder will necessarily be paid a dividend. Even when the dividends are cumulative, the share- holder cannot sue for them if the directors do not declare a dividend. 50 incorporation, shareholders of all classes will have one vote per share for all purposes." This scheme — known as "ordi- nary voting" — will have to be varied where a different control result is sought. One method is to limit, or eliminate entirely, the voting rights of preferred shareholders. By this means the principal entrepreneurs holding the common stock can be given voting control. Another device is the use of "cumulative voting." When ordinary voting is used, a shareholder or shareholders having a total of one vote more than half of the outstanding stock can outvote all minority shareholders and exclude them from participation in the board of directors. In cumulative voting each shareholder may cast, for each share owned, as many votes as there are directors to be elected, thereby permitting a minority stock interest to have representation on the board of directors. The use of cumulative voting would be particu- larly useful in the situation where the principal entrepreneurs cannot receive a majority of the initial issued stock of the corporation. It can be seen from the foregoing discussion that careful structure of the corporation's capital and debt can help achieve the desired goal of giving the local businessmen maximum possible control. Whether these techniques can be useful in a particular case, whether they are advisable, or whether they are obtainable will depend on the facts of each situation and the nature and relative strengths and interests of the parties involved. For example, a foundation will have different interests and will seek different powers within the corporate structure than an industrial corpora- tion, although both may be offering equal economic support. Further, the use of more than one class of stock will pre- clude the corporate election to be a Subchapter S corpora- tion. 7 Accordingly, extreme care should be used in this area and counsel must be consulted at all stages of organization. Stock Options 12—4. Another method of securing the minority entrepreneur is through the use of stock options and warrants. Under an option agreement or a warrant to buy stock, the corporation formally agrees to sell to the holder of the option or warrant shares of its stock at a fixed price within a certain period of time and on conditions set forth under such agreement or warrant. This affords the principal the opportunity to increase his equity ownership in the corpora- tion in the future on favorable terms and may be particu- larly useful where his initial equity in the company is small because of his relative economic weakness. There are also significant income tax advantages resulting from the use of stock options.* As stated earlier, counsel should be consulted on these matters. Preemptive Rights 12-5. In most States, shareholders are entitled to subscribe pro rata to any additional shares the corporation may issue in the future. Such privileges are called "preemptive rights." If this were not available, the issuance of stock to outside interests could only result in dilution of the ownership and control of the principal businessmen. While preemptive rights tend to insure control, they may also make financing more difficult. Certificate of Incorporation and By-Laws 12-6. The certificate of incorporation (known as the "Charter" in some States) and the by-laws may also serve to provide certain protections for the local businessman. It is the certificate of incorporation that contains the basic provisions regarding classes of stock, voting rights, pre- emptive rights, and cumulative voting, all of which have been discussed. But since this instrument forms the basic "constitution" of the corporation, careful drafting of certain other pro- visions can also be important. For example, requiring the principal office of the corporation to be in the community, if reasonable from a business point of view, might be considered. The by-laws may require that certain of the officers and directors be local residents, that shareholders' or directors' meetings be held in the community, or that a meeting quorum must include a fixed number of com- munity shareholders or directors. Community Control of Profit Distribution 12-7. It is entirely possible that the profitmaking company, whether organized in the corporate or noncorporate form, may, because of the support it has received from community groups. Local Economic Development Companies, or indus- trial corporations, desire to distribute a portion of its profits to meet community needs. While principals of the business could select the appropriate recipients themselves, they may wish to broaden the decision-making process by establishing a separate entity for this function. Various possibilities in this regard are discussed in Sections 6, 8, and 9. It should be apparent from the foregoing discussion that the problems faced by the minority entrepreneur are quite similar to those faced by all new businessmen, and that the solution of these problems depends to a large extent on the use of traditional business techniques. The prospective busi- nessman would be wise to consult his attorney and accountant in order to ensure that all available steps are taken to achieve his goal. BIBLIOGRAPHY 12-8. For more information on the preservation of corporate control by minority entrepreneurs, the following sources should be consulted: Cary, William L. Cases and Materials on Corporations, 4th ed., unabridged, Foundation Press, Inc., 1969. Cavitch, Zolman. Business Organizations, Matthew Bender & Co Inc., 1963. Fletcher, William M. Cyclopedia of the Law of Private Corporations, Callaghan & Co., Inc., 1931. Hornstein, George D. Corporate Law and Practice, West Publishing Co.. 1959. Israels, Carlos L. Corporate Practice, Practising Law Institute, 1969. Rohrlich, Chester. Organizing Corporate and Other Business Enter- prises, 4th ed., Matthew Bender & Co., Inc., 1967. Law and Practice in Corporate Control, Baker, Voorhis & Co., 1933. n 19 Am. Jur. 2d Corporations sec. 635 (1965). 7 Internal Revenue Code, Section 1371 et seq.; see discussion of the Subchapter S corporation in Section 11-5. * See "When Do Stock Exchanges Become Taxable?" 44 Law Institutes Journal 62, March 1970. !) See "Community Development Corporations," 83 Harv. L. Rev. 1558, 1616, 1624, May 1970. 51 Section 13 ACQUISITION OF EXISTING FIRMS PROBLEMS FACED BY THE BUYER 13-1. The Local Economic Development Company, as part of its activities in the community, will be seeking to identify profitmaking businesses with growth potential and profits sufficient to both amortize the purchase price and provide income for the new owner. Such businesses may form the core for further economic expansion in the community. Through a variety of managerial assistance approaches, the LEDC can supply supportive counseling and assistance. But the primary decision that must be faced by the buyer, whether a minority entrepreneur acting with the aid and support of an LEDC or an LEDC acting on its own behalf, is whether to buy or not to buy. The discussion below considers the evaluation of the proposed purchase solely on its business merits and assumes that a business has been located that is the proper type and size and is for sale at a fair price. A clear understanding and evaluation of the risks involved in taking over an existing business are vital for successful operation. The proposed purchaser will be called the "buyer," the business sought to be purchased will be called the "acquiree," and the person or persons selling the business the "seller." If the seller is a corporation selling its own assets, the seller and the acquiree will be the same; if the corporate stockholder sells his stock, he will be the seller and the corporation will be the acquiree. The problems faced by the buyer include: ( 1 ) Putting together a negotiating team. (2) Determining whether the acquiree is a good business. (3) Determining what is a fair price. (4) Structuring the purchase in regard to (a) nontax considerations, (b) tax considerations, and (c) financing. (5) Insuring that the acquiree is exactly what it is represented to be. (6) Retaining existing management expertise. (7) Handling breach of contract. PUTTING TOGETHER A NEGOTIATING TEAM 13-2. Ideally, a negotiating team should include a lawyer, a businessman-consultant familiar with the acquiree's type of business, and an auditor. While volunteers may be available to the LEDC under its managerial assistance program, the time and effort needed for careful negotia- tion may require that fees be paid. If the deal is consum- mated, the professional fees are paid by the buyer. If the deal is not consummated and the buyer has limited capital which should be conserved for investment, the LEDC should consider covering the professional expenses involved at some agreed minimal rate from specially designated funds under its management assistance program. DETERMINING WHETHER THE ACQUIREE IS A GOOD BUSINESS TO BUY 13-3. Business conditions and opportunities are so varied and complex that no specific rule can be formulated to decide whether a business should or should not be bought. If there is any general precept, it is that prudence, caution, and skepticism should govern the buyer's approach. The seller may appear to be the most honest of men but ex- perience teaches that the buyer should lend very little credence to anything he is told which he cannot independ- ently substantiate. General factors which may render one type of business preferable to another include: greater growth potential be- cause of the market which may be served; proprietary pro- tection, such as from a patent, a license, a trademark, ex- clusive knowhow, or favorable zoning; high rate of return per investment dollar; less capital requirement for expanded revenue; and low possibility of technological obsolescent. The location should not necessarily be limited to the inner city or depressed areas. In evaluating the worth of a business, key factors might include: adequacy and modernity of its plant and equip- ment, ability of personnel at various management levels, management and employee morale, reputation of its products, and its standing with its suppliers, customers, and bankers or other lenders. However, unfavorable readings on one or more of these points might explain why the business is for sale and may also represent major opportunities for improvement. Putting it another way, a bad business may be a good business to buy, if you know why it is a bad business. Financial Statements 13-4. The key documents to be studied in determining whether to attempt to purchase a business are its financial statements. There are two basic financial statements for any business: the balance sheet and the statement of income or loss (also known as the operating statement). To be useful, financial statements should be, and nearly always are prepared on an accrual basis. On this basis all obligations owed by or to the business are reflected as of the date they arise (accrue) whether or not they are payable or have been paid. ( 1 ) The Balance Sheet. The balance sheet is always as of a specified date. It has two basic columns: an asset column and a liability and equity column. The asset column summarizes assets under three main categories: current, fixed, and miscellaneous. Current assets include cash on hand and in banks amounts owed by customers to the business (called accounts receivable), and inventory. For example, in the case of a manufacturer of widgets inventories break down into raw materials (the wood, steel, etc., to make widgets), work in 52 process (partially completed widgets), and finished goods (widgets completed but not yet sold). Fixed assets include such items as land, buildings, machinery, furniture, fixtures, and the like. Miscellaneous assets might be such items as deposits (for rent, utilities, etc.) or organization expenses. On the liability side of the balance sheet are current liabilities (those due within one year of the balance sheet date) and noncurrent liabilities (those due after one year). Current liabilities might include obligations for money borrowed from banks and others, amount owed for inven- tories and other supplies received but not yet paid for (accounts payable), and sums owed for unpaid wages, taxes, and the like. Noncurrent liabilities are usually mortgages and other indebtedness for money borrowed. The last item on the liability side is the stockholder or proprietorship equity section. It shows the number of shares outstanding, how much capital was paid in on account of the par or so-called stated value of the issued shares (capital), how much was paid for the shares in excess of par or stated values (paid-in capital or capital surplus). There is a separate item, called retained earnings, that shows how much the business has earned since incep- tion or a retained earnings deficit item that shows aggregate losses since inception. The net amount shown in the stockholder equity section is called the "net worth" or "book value" of the business and is always equal to gross assets less gross liabilities (current plus noncurrent). If gross liabilities exceed gross assets, the stockholders equity section adds up to a minus number and the acquiree has a deficit book value or a negative net worth. (2) Statement of Income or Loss. The other basic financial statement is the statement of income or loss, (operating statement). This statement shows how much money the business has made or lost in the specific period covered by the statement. The first item in it is usually called "sales" or "revenues" and shows the volume of sales or other revenue received or accrued for the period. The second item is "cost of sales" and shows the actual cost of the goods or services for which the revenues were received. The main items included under "cost of sales" are material purchases, direct labor, and factory overhead. This last item includes such costs as indirect labor, plant rent, utility costs, depreciation of machinery, and fringe benefits including social security. Inventory is a key item in verifying the cost of sales. To know what costs were incurred to earn the revenues re- ceived or accrued during the period, it is necessary to know how inventory at the end of the period compares with inventory at the beginning of the period. If there is less on hand at the end of the period, part of the cost of the sales was represented by the delivery of old merchandise. If there is now more inventory on hand than before, part of the costs incurred during the period went into the new inventory and were not spent to earn the revenues for the period. In valuing inventory (other than raw materials and supplies), it is an accepted practice to add the cost of so- called factory overhead required in addition to direct labor to produce the inventory. Unless one knows how overhead was assigned to inventory, one can have little confidence in the resulting inventory figures and little confidence in the statement of operations which reflects such inventory figures. The difference between revenues and cost of sales is referred to as "gross profit." One test of the fairness of a statement of income is to compare the gross profit for a number of years. If the ratio of the gross profit to revenue varies materially from year to year, it is likely there has been some manipulation of the inventory figure. There can be adequate explanation: for example, that there was a material change in pricing or in the cost of raw materials or labor. The third item in the income statements of most small businesses is called "selling, shipping, and delivery." This includes items like salesman's commissions, promotion expenses, freight costs, bad debt reserves, and travel and entertainment. The fourth item is "general and administrative expenses." It includes executives' salaries, salaries of the bookkeeping and clerical staff, professional fees, taxes other than those attributable to the factory, dues, subscriptions, and the like. The amount of interest paid by the business is usually an additional item and is next in the statement of opera- tions. Deducting these expenses (selling, general and admini- strative, and interest) from the gross profit yields gross income from operations before Federal taxes on income. Deducting taxes yields net income from operations after Federal income taxes. Extraordinary nonreccuring items such as gain or loss from a fire are then separately set forth with their tax effect. These computations yield a final figure of "net income": how much money the business made or lost in the period. Analyzing Financial Statements 1 13-5. Normally, the buyer should look at the acquiree's recent balance sheet and operating statements for the past 5 fiscal years. In addition, the acquiree may have an operating statment for a period of less than a year follow- ing its last full year's operating statement. Such a statement, called a "stub" period statement, should also be requested. In examining financial statements, these points should be kept in mind: ( 1 ) Audited Statements. Statements may be audited or unaudited. Audited means that the books and records have been examined by accountants who follow certain pro- cedures. The accountant signs a letter addressed to the acquiree that lists the financial statements he has examined. The accountant states that these statements fairly represent the financial condition and results of operations of the acquiree in accordance with generally accepted accounting principles consistently applied plus whatever qualification may be necessary. An unqualified certificate is an indication of relability. However, many accountants sign letters or allow their letterheads to be used for financial statements when in fact they have not audited them. Indeed, the accompaning letter — instead of giving the assurance of an audit — often specifically disclaims the statement's having been audited. (2) Value of Assets. Balance sheets are supposed to show asset values at cost or market value — whichever is lower. This means that the assets included in the accounts may be worth more, but should not be worth less, than the stated amount. This principle is not always followed. For example, some unaudited balance sheets include fixed assets at values representing not cost but the management's belief of the value. Sometimes this "adjustment" is explained in a footnote to the balance sheet, but sometimes not even this is done. (3) The Inventory Asset. Normally, the main item to be questioned is the inventory asset. Generally accepted accounting principles require inventories to be valued at the lower of cost or market. In valuing inventories, the most commonly used methods are the so-called LIFO ("last-in, first-out") or FIFO ("first-in, first-out") methods. i "Basic Concepts of Accounting," 30 Montana L. Rev. 1. fall 1968. 53 Both LIFO and FIFO are arbitrary methods for determin- ing which goods have been sold out of the entire yearly inventory stocks of the acquiree. LIFO assumes that the last acquired goods were first used or sold, and that the goods first bought are still in inventory. FIFO assumes that goods first bought were first used or sold and that the goods last bought are still in inventory. In a rising market, LIFO tends to reduce profits and, in a falling market, tends to increase them. It is important to recognize which method has been used in order to evaluate the effect of changes in market price on the financial statements. Most businesses have on hand significant stocks of items they cannot use or for which they have only limited use. In the case of our hypothetical widget business, the business may have on hand (in its physical inventory) quantities of spare parts for old models which probably will never be used. It may also have a supply of the outdated models for which there is no demand. Unless they are "written down" to their market value, the balance sheet will be mis- leading. (4) Accounts Receivable and Fixed Assets. Similarly, accounts receiveable should be reduced by an adequate reserve to reflect problems which may be faced in collect- ing them, and fixed assets (other than land) should be depreciated to reflect the decline in their value over the period of use. (5) Inclusion of "Intangibles". Accounting principles permit businesses to include in their assets certain so-called intangibles or "soft" assets. Examples are amounts spent on research and development for projects that have not been abandoned but that have not yet produced sufficient revenues to defray research and development costs, amounts spent in obtaining patents, and organization expenses. (6) Additional Liabilities. Accounting principles do not require all liabilities to be included in financial statements. If the acquiree has contracted to purchase supplies but has not yet taken title to them, the obligation is not reflected in the balance sheet. This is similar to sales not yet effected. In addition, contractual liabilities, such as leases, of realty or personalty, or long-term purchase or sales agreements, are not reflected in the accounts and are often not even mentioned in footnotes to the financial statements. (7) The Balance Sheet and the Income Statement. Every inflated value in the balance sheet results in an inflation of the operating statement for the period in which the inflated value was first reflected in the account. This is because the balance sheet reflects the condition at the end of a period. The difference between net worth at the beginning and at the end of an accounting year will be equivalent to the profit or loss for the period. Exceptions are: if another business was acquired during the year, if new capital was put into the business, or if a dividend or other distribution was made. Accordingly, if the balance sheet at the end of the year reflects an inflated value which was not there the year before, profit for the year will be similarly inflated. (8) The Misleading Operating Statement. The statement of operations may be a misleading representation of operating results for a variety of reasons — not only be- cause of the inventory problems referred to above. For example, stockholder-managers may have reduced their salaries during the year so as to show greater profit, or vacation and bonus costs were not accrued in a stub period statement, or in a similar statement the tax credit for income under $25,000 was taken in the shorter period than amortized throughout the whole year. Initial Evaluation of the Acquiree 13-6. An initial examination of the financial statement of a potential acquiree will not reveal all of the respects in which it may be misleading. A full-scale investigation would be required for that, and the goal at the outset of the transaction is merely to determine whether there should be any interest at all. To do this, the financial statements of the acquiree should be carefully analyzed with the negotiat- ing team, and some potential trouble areas should be orally explored with the seller. On the basis of this pre- liminary analysis, the balance sheet and related income statement should be reconstructed in a rough way to present an initial estimate of the facts. The next step is to form an initial evaluation of the acquiree, based on the reconstructed financial statements. Again, the services of the negotiating team are essential. Generally, the questions to be considered include the following: ( 1 ) Is the sales trend up or down? (2) Are gross profit margins increasing or decreasing? (3) Is net income improving or deteriorating? (4) Does the business have enough working capital (cash, inventory, and accounts receivable) to support its operations, or will it require additional financial support? In particular, does it pay its bills on time or is a shortage of working capital indicated by tardy bill payment? (5) Is the business operated efficiently? How do its results compare with those of other similar businesses? (6) What is the rate of inventory turnover (computed for nonseasonal businesses by dividing year-end inventories into year-end sales), and how does the rate compare with competitors? (7) Are collections slow and bad debt experience poor, indicating a low quality of customers? (8) What does the business return on invested capital and what return would it produce at various estimated purchase prices? (9) What kind of a purchase price-earning ratio would be represented by various estimated purchase prices and how do these price-earnings ratios compare with those for similiar businesses? DETERMINING WHAT IS A FAIR PRICE 13-7. What is a fair price depends on the likelihood of potential profit at various levels (called "upside potential") as against the risk of various degrees of loss (called "downside risk"). In determining price, all the factors reviewed in the analysis of acquiree's financial statement are significant, but these considerations may predominate: (1) The hard book value of acquiree, that is to say, its book value after eliminating all "soft" items in its balance sheet. Sometimes it is useful to reduce land, machinery, and equipment to salvage values to evaluate minimum downside risk. (2) Prevailing market evaluation for the particular type of business. For smaller businesses, one will find that there is a prevailing rule of thumb for what is a fair price, such as what is a fair price for a supermarket per square foot, or for a liquor store per dollar of sales, or for an insurance agency per dollar of premiums, etc. If the business is of some size, the price-earnings ratio of public companies of the same type must be discounted by a considerable factor, however, to reflect generally smaller size and that the acquiree is not a "seasoned" company. (3) The seller's reasons for sale. There are many rea- sons for selling: the owner has died; two cc-owners have had a bitter dispute, or ihe business has undistributed excess profit problems (under Section 531 of the Internal Revenue 54 Code). That the business is for sale may not necessarily indicate concern with its prospects; conversely, if there is no apparent reason for sale, the buyer may have more reason to worry and may wish to protect himself with a lower purchase price. (4) The hidden benefits of the business to the seller. To the extent the seller has been realizing "hidden benefits," as from padded travel and entertainment ex- penditures or simple cash register stealing, he may be unwilling to accept a price that does not reflect the loss of this income to him. (5) The acquiree's working capital requirements. If the purchase price will so stretch the buyer's financial resources as to make it impossible for him to provide the needed working capital, some lower or deferred purchase price must be arranged. STRUCTURING THE PURCHASE (NON-TAX CON- SIDERATIONS) 13-8. Acquisitions take three forms: a purchase of stock, a purchase of assets, or a statutory merger. In the present context, it is unlikely that the statutory merger will provide a useful technique; accordingly, the discussion is confined to the purchase of stock and the purchase of assets forms. A stock sale involves the conveyance by the stockholders of the acquiree of their stock in return for cash or other compensation paid by the buyer. An asset sale involves a conveyance of all or substantially all of seller's business. Advantages of Stock Acquisition Approach 13-9. To a buyer a stock acquisition has these main advantages: ( 1 ) It can usually be consummated in a shorter time and with less paperwork than an asset sale. (2) It is a sure way of purchasing the entire business with no problem that some of the assets may inadvertently not have been conveyed. (3 ) It avoids the problem that the acquiree may not be able to convey certain of its assets. For example, the acquiree may be tenant under a lease which does not permit it to assign or even sublet the facility without the consent of the landlord, which consent the landlord may be entitled unrea- sonably to withhold. (4) Control of the acquiree may be achieved by pur- chasing a majority interest in its outstanding stock even if there is a noncooperative minority stock interest or a board of directors which opposes the sale. (5) There is no bulk sales problem. Disadvantages of Stock Acquisition 13-10. The stock purchase method has a number of dis- advantages to the buyer: (1) The major disadvantage of a stock sale is that the buyer assumes the risk that the acquired business has debts, liabilities, or obligations such as open violations of law which were undisclosed or unknown at the time of the purchase. This risk may be minimized by obtaining war- ranties, representations, and indemnifications. (2) If the buyer does not acquire all of the outstanding shares of the selling business, there may be future problems with the minority shareholders. These shareholders may have ideas and interests very different from the buyer and may present later difficulties. (In many States, where the minority interests are 10 percent or less, they may be "merged out" nder binding procedures.) Another problem that may arise is that the sale by the najority of their controlling interest may subject them to iability to the minority shareholders for breach of their fiduciary duties, causing difficulties including possible litiga- tion involving the buyer. (3) If the selling corporation has a large number of shareholders, a stock purchase may be too complicated, particularly in view of the provisions of the Securities Acts. (4) The transaction will be fully taxable to the sellers. As a result, the sellers may demand a higher purchase price in the bargaining process. - (5) In the usual transaction, the stock sale does not affect the basis of the assets of the corporation being ac- quired. Thus the buyer does not receive the benefit of tax savings resulting from obtaining a higher basis. Not only does the buyer take over the acquired corporation's basis, but it takes over its depreciation methods and its potential (or lack of potential) for realizing cash flow from deprecia- tion. It also is bound by its accounting methods and its capital and earnings picture, creating possible problems in regard to accumulated surplus. (6) The buyer has little flexibility in selecting which assets he wishes to purchase. (7) The books and records, particularly the financial records of the selling corporation, may not be in satisfactory form. Advantages of Asset Acquisition Approach 13-11. Asset acquisition has these advantages to the buyer: (1) The buyer may purchase selected assets rather than all of the assets. This will allow him to avoid purchasing assets he does not want and also allows him, in effect, to pay a portion of the purchase price by allowing the seller to retain certain of the assets. (2) The buyer need only assume those liabilities which are disclosed to him and which he desires to assume and may not initially be subject to the liabilities he does not wish to assume. (3) Assuming that the board of directors and stock- holders of the acquiree will vote the necessary approval, an assets sale will permit the acquiree to eliminate a dissenting minority so that the buyer can acquire the entire interest in the business without inheriting the dissenting minority. Disadvantages of Asset Acquisition 13-12. Asset acquisition may be deemed to have these main disadvantages to the buyer: (1) They are complicated. Every asset must be trans- ferred, including real estate, contracts, trademarks, insur- ance policies, etc. (2) Some of the assets may not be transferable. (3) It may not be feasible to obtain the requisite vote of directors and stockholders. (4) A change in the corporate entity which operates the business may tend to disrupt customer, supplier, or em- ployee relations, especially when, in order to avoid assuming undisclosed liabilities, the buyer sends out a so-called "bulk sales notice." (5) Normally, the acquiree will pay the legal and auditing fees in connection with the sale, which results in a diminution of the assets being conveyed. (6) An asset sale will result in a loss of acquiree's ex- perience ratings for workmen's and unemployment com- pensation. STRUCTURING THE PURCHASE (TAX CONSIDERATIONS) 13-13. The Federal tax law is immensely complicated and often provides for tax consequences which appear entirely - See "Techniques To Minimize the Cost of a Taxable Stock Acquisition," 12 J. Taxation 12, January 1970. 55 unreasonable to a person not versed in tax law. Accordingly, no purchase or sale of a business should be structured with- out competent tax advice. What follows is a brief introduc- tion to the general tax considerations governing the sale of an acquiree's assets or of all the stock of an acquiree cor- poration, for cash or for notes. In almost all cases, there will be exceptions to the general rules stated below and refinements to them, for which tax advice is needed. 3 Seller's Profit as Ordinary Income or Capital Gains 4 13-14. A sale such as we are discussing is called a taxable transaction. As a taxable transaction, it may result in profit or loss to the seller, but for purposes of our discussion we will assume it results in a profit. Taxable profit may create one of two kinds of income: ordinary income or capital gain. For individuals, ordinary income is taxable at escalat- ing rates up to a maximum of 70 percent. For corporations, it is taxable at a 48-percent rate (excluding the income tax surcharge, which is at an effective rate of 2.5 percent for calendar year taxpayers in 1970) and is subject to a lower rate for the first $25,000 of such corporate income. Capital gains are realized on sales of assets which qualify for capital gains treatment and have been held for more than 6 months. They are taxed more favorably. Obviously, if a seller has to pay a tax on his profit, he will want to pay a capital gains tax. Profit from the sale of a capital asset is taxable as a capital gain and from other assets as ordinary income. Capital assets include goodwill and (except for a dealer therein) land and all depreciable items. Goodwill means the value of the acquiree as a going business, above the value of its specific tangible or intangible assets. Depreciable property is property such as machinery, equipment, and the like, the cost of which a business cannot deduct in full in the year in which the expenditure is made but which cost it must allocate (depreciate) over the asset's useful life. (In "straight line" depreciation a machine costing $1,000 and having a 10-year useful life is depreciated at the rate of $100 per year, which means that $100 is deducted as an expense each year in calculating the income tax due in that year. "Accelerated" depreciation refers to methods of taking more depreciation in earlier years and less in later years.) On the other hand, inventory or other property held for sale to customers, and accounts and notes receivable arising out of such sales are noncapital assets, and their sale gives rise to ordinary income. If the seller gives a restrictive con- venant and is paid for it, he receives ordinary income (and the buyer can deduct the cost over the life of the covenant). If depreciable property is sold for more than its depreciated cost, part or all of the prior years' depreciation may be subject to "recapture," resulting in treatment of that amount as ordinary income on the sale. Seller's Tax Basis for Assets Sold 13-15. A second concept is that of "basis," which means the tax cost of a property. If a sale is a taxable transaction, the gain or loss is the amount of the proceeds above or below the seller's tax basis for that asset. It is apparent from the foregoing that if the purchase price is to be allocated among the several assets of the acquiree the seller and the buyer will often have opposing interests. The seller will usually want to allocate to those items that produce capital gains, that is capital assets, and not to those items that produce ordinary income. However, the buyer will usually want to increase the basis of inven- tory and other items which produce ordinary income since he can expect to dispose of those items in short order. If they have a high basis, he will realize little or no profit on such disposition and may even incur a loss which can be offset against his other income. To the extent that the buyer cannot allocate the purchase price to inventory-type items, he will want to allocate to depreciable capital assets so that he can at least recover his cost by depreciation thereof over the useful life of the asset. He will be most reluctant to allocate to goodwill since this is not a depreciable item. Tax Aspects of Purchase of Various Business Entities 13-16. A third basic concept relates to taxable entities. A sole proprietorship is not a taxable entity nor is a part- nership. Although partnerships file so-called "information" tax returns, partnerships do not pay taxes; instead, the partners include in their individual taxable income their proportionate share of the partnership's ordinary income and of its capital gains. On the other hand, a corporation is a taxable entity to which separate tax rates apply, as noted above. Distributions of income by a corporation to its stockholders are normally taxable as ordinary income, unless they are liquidating distributions, in which case they are generally taxable as capital gains. If the acquiree is a corporation, the seller will want to pay only one tax — -not a tax at the corporate level on the acquiree's gain and another on the distribution of the proceeds of sale by the acquiree corporation to its stockholders. If the acquiree is a sole proprietorship, or a partnership selling its assets, the sale is considered a sale of the assets of the business. For tax purposes the purchase price must be allocated among the several assets sold. If the buyer and seller place valuations on such assets, the Internal Revenue Service generally will accept such determination, particularly if the interests of the parties are adverse. If no allocation is made in the agreement, each party makes his own allocation on his tax return, but the IRS can compare the allocations and contest them. Gain on capital assets will usually produce capital gain for the seller, and profit on noncapital assets will produce ordinary income. Generally, if all of the partnership interests are sold in- stead of its assets, the result is capital gain. An exception is that, by virtue of express provisions of the law. if the gain is sufficiently attributable to unrealized receivables or to substantially appreciated inventory, ordinary income will accrue. The result of these provisions is that selling the partnership assets, or all the interests of the partners, tends to have the same tax consequences. If the acquiree is a corporation, the sale may be a stock sale or an asset sale. If the sale is of stock, the seller re- ports capital gain on stock held more than 6 months un- less, as one of the principal exceptions, the acquiree is what is termed a "collapsible" corporation (which is most serious for relatively recently formed corporations but which always bears checking out). This result may be fine for the seller, but the buyer who may have paid more for the stock than the net worth (and tax basis) of the acquiree's assets will be very unhappy. The buyer will gel no tax benefit in the form of a "step-up" in basis which will allow him to deduct part of his purchase price fror subsequent income of the acquiree. In order to relieve the hardship on the buyer in such cases, Congress adoptee Section 334(b)(2) of the Internal Revenue Code. In effect ii says that if the buyer is a corporation and within 12 month; purchases at least 80 percent of the acquiree's stock anc 3 See "Tax and Other Considerations in the Sale of a Business,' 27 N.Y.U. Inst, of Fed. Taxation 471, 1969; "Tax Check List fo Acquisitions and Mergers." 25 Business Lawyer 355, November 1969 "Tax Considerations in Mergers and Acquisitions." 47 Taxes 654 November 1969. + 1954 Internal Revenue Code sec. 1223 et seq. See "Capital Gain Tax Changes in 1969," 1969 British Tax Review 154 (May-June 1969) 56 then completely liquidates the acquiree within 2 years of the purchase and distributes the acquiree's assets to the buyer in such liquidation, the liquidation will be tax-free but the buyer can "step-up" the basis of the acquiree's assets to reflect its purchase price of the acquiree's stock. Not only is this procedure a complicated one that must be performed in accordance with applicable rules, but it also creates certain tax problems for the buyer which may be very significant. In the first place, he must establish that his allocation of the "step-up" of the basis to the several assets is a fair one, and he may not be able to avoid a substantial alloca- tion to goodwill. Second, under so-called "recapture" pro- visions the liquidation will not be tax free to the extent that the assets of the acquiree included personal property depreciated since 1961, and also, to a limited extent, real property on which accelerated depreciation was taken since 1963. To the extent of such depreciation previously taken by the acquiree — and indirectly the buyer — will have to pay an ordinary income tax on the Section 334(b)(2) liquidation. In addition, if the acquiree deducted any so- called "investment tax credit" the liquidation may, depend- ing on the time involved, require it to pay an additional tax equal to part or all of the amount it previously de- ducted from its taxes because of that credit (called "re- capturing" the credit). Moreover, ordinary income may be payable on such liquidation by virtue of the acquiree's prior deduction of bad debt reserves, and taxable gain may arise where the acquiree previously reported sales on the installment method. All these items may be substantial in the transaction, and a buyer who purchases stock and intends to follow this route may negotiate for a reduction in price to offset these tax detriments that would have been payable by the acquiree directly if assets rather than stock had been purchased. The other form of sale is a sale of a corporation's assets. As noted above, this may give rise to a double tax — one to be paid by the acquiree on the sale of its assets and another to be paid by the stockholders of the acquiree when the proceeds of sale are distributed to them on liquidation of the acquiree. To avoid this result. Section 337 of the Internal Code was adopted. It says in effect that if a plan of liquidation is adopted, appropriate notice given to the District Director, and the acquiree then sells its assets and liquidates within 12 months, there will be no tax payable by the acquiree and the only tax payable will be at the stockholder level. Since the stockholder pays a capital gains tax, this would appear a very satisfactory technique for the seller, provided he carefully follows the "equirements of the Section. However, here again as in :he Section 334(b)(2) situation, the law provides that in his form of transaction the acquiree must pay ordinary ncome tax on recaptured depreciation and on items like 3ad debt reserves and will be subject to investment credit ecapture. Accordingly, if this form of transaction is em- ployed, the seller may demand an additional purchase 3rice to bear these tax burdens of the transaction. Section '37 is generally unavailable to "collapsible" corporations, ind its application to inventory and installment obligations s subject to limitations. If the acquiree corporation sells its assets but not pur- uant to a 12-month liquidation plan, the same rules apply ts in any other asset sale: the purchase price must be illocated among capital and other items, and recapture nd similar costs must be calculated. Two other tax aspects deserve notice. If the seller (other han a corporate seller in a Section 337 situation) receives ss than 30 percent of the purchase price in the tax year in which the sale occurs and receives subsequent install- ments in later tax years, he can elect to pay capital gains tax in each year only in the proportion that the payment received in such year bears to the entire price. Also, where any installments of the purchase price are payable after one year from the date of sale, the law will "impute" an interest factor of 5 percent per annum to each installment payable more than six months after the sale, unless it is expressly provided between the parties that each such in- stallment includes interest at a rate of at least 4 percent per annum. The purchase price must be adjusted by sub- tracting "imputed" interest from the purchase price in determining whether an installment sale meets the 30 per- cent requirement described above. FINANCING THE PURCHASE 13-17. There are many ways to finance a purchase. Set forth below is a summary of some of the more generally used methods: ( 1 ) The most common method is a purchase using a combination of cash, in payment of part of the purchase price, and promissory notes for the balance. The notes are often made payable out of the future earnings of the com- pany. The seller usually receives sufficient cash to pay whatever taxes may result from the sale. (2) The procedure above is commonly varied by placing the buyer's notes with a bank or other institutional lender so that the seller receives the full purchase price in cash. (3) The transaction can be financed with cash ob- tained from a public or private sale of securities of the buyer's company. (4) A fixed payment can be made upon closing with an agreement to make additional payments over a period of time based on the earnings of the business being acquired. (5) Only a portion of the assets are purchased initially. The remaining assets are leased with an option to purchase them at a later date. (6) Stock of the purchasing company is transferred to the seller in lieu of cash or notes, or a combination of stock, cash, and notes is transferred. (7) An installment purchase is often sought by the seller because of its income tax advantages."' Under this method, the gross profit is prorated over the period of time in which payments are received. The amount re- ported in any year is the sum determined by applying the gross profit percentage resulting from the sale to the pay- ments received in each year. The installment method is available only if the seller receives payments of 30 percent or less of the total contract price in the year of sale. The following discussion will deal more fully with some of these techniques. The Down Payment — The LEDC's Role 13-18. The amount of the down payment is crucial in many deals, both in terms of the seller's interest and the buyer's ability to invest capital funds. The LEDC can play a vital role in two respects: ( 1 ) The seller should be shown the depth of assist- ance and support that will be available to the buyer from the LEDC staff or its consultants. This backing will help to protect the seller if he takes back a large portion of purchase notes. r > 1954 Internal Revenue Code 454. See "Federal Taxation: Application of Installment Sales Provisions in the Sale of a Business," 23 Arkansas L. Rev. 445, fall 1969; "Taxation — Installment Sales," 40 Miss. L. J. 302, March 1969. 57 (2) If necessary, the buyer must be aided in securing commercial or SBA loans to have sufficient capital avail- able to meet the down payment figure agreed upon. Using Notes in Structuring a Purchase 13-19. The buyer should review the various tools which may be available to him for reducing the cash portion of the purchase price and also, in some cases, to reduce the risks assumed in making the acquisition. Such tools include the following: (1) Use of Negotiable and Non-Negotiable Notes for a Portion of Purchase Price. A negotiable note is one which, if negotiated by the seller to a bona fide purchaser for value and without notice, will* give to such transferee the right to sue and collect on the note without the transferee being liable to any claims which the buyer may have against the seller. On the other hand, if the note is non- negotiable, it may still be transferred by the seller to a third party but when the third party seeks to enforce the note, the buyer may offset against the claim any claim which he had against the seller. The simplest way of making a note non-negotiable is simply to say that it is payable to "John Doe" rather than to "John Doe or Order." Another effective way is to state on the face of the note that it is non-negotiable. Especially if a series of notes are to be issued, it is often possible to arrange with the seller that some of the notes shall be non-negotiable, while others will be nego- tiable. Generally, the buyer can assume that if he has been defrauded by the seller, it will take him some time to dis- cover the fraud and, accordingly, he may very well wish to have the later notes non-negotiable so that he has not paid them by the time he has discovered the fraud which was perpetrated upon him. On the other hand, if the notes represent an installment payout over a considerable period, it may be inadvisable to render the very last notes non- negotiable, as the buyer will then be exposed to paying a number of negotiable notes to bona fide purchasers for value long before he gets an opportunity to offset his claim against the non-negotiable notes. (2) Use of Subordinated Notes for a Portion of the Purchase Price. A subordinated note is one which in effect provides that if the maker of the note — in this case the buyer — is insolvent or otherwise unable to make good on a claim for the note, the holder of senior indebtedness (the debt to which the subordinate indebtedness is insub- ordinated) will be allotted the subordinated note holder's share of the buyer's assets, so that he will be paid in full before the subordinated noteholder receives anything on his note. Suppose, for example, that the buyer becomes insol- vent; he owes $15,000 and he has assets worth $3,000. If he owes $5,000 to general creditors, $5,000 to senior note- holders, and $5,000 to subordinate noteholders, the general creditors will get one third ($1,000) and the senior in- debtedness will get two-thirds, while the subordinate note- holder will get nothing. Commonly subordinated notes provide that they are subordinate to banks and other in- stitutional indebtedness, or to any indebtedness for bor- rowed money, and also in some cases to any purchase money obligation. Subordinated notes are generally issued by buyers to ensure that they will be able to make the bank loans and other borrowings required in order to operate the acquiree. Contingent Payouts 13-20. A contingent payout is an acquisition in which all or a portion of the purchase price payable to the seller is dependent on the performance of the acquiree over a designated period. Sometimes contingent payments are based on the acquiree's annual earnings, while in other pur- chases they are based on the acquiree's average earnings over a period. If the contingent payment is dependent on annual earn- ings, express provisions should be made in the event that a loss is suffered in one of the years: Does the loss have to be made up on subsequent years or do the earnings in subsequent years require the payment of an additional pur- chase price without having to make up the prior loss? In many transactions, the payment is made contingent on earnings above a specified minimum. For example, if a business has been earning $50,000 after taxes each year, then it may be bought for a fixed down payment plus an additional amount based upon the amount by which aver- age after-tax earnings over the next 3 or 5 years exceed $50,000. Bootstrap Financing* 3 13-21. The term "bootstrap" refers to various techniques of using the assets of an acquiree corporation in order to finance its purchase. As a general rule, it may be considered that all of the techniques involve complicated tax problems and none should be considered without competent tax ad- vice. Accordingly, as with our prior tax discussion, what follows is merely a guide to the rules to indicate what techniques may be available, but the implications of any technique in a particular situation and the exceptions which may be applicable must be reviewed with a person versed in tax law. (1) The simplest bootstrap technique is increasing the buyer's borrowing power by virtue of the acquisition. A buyer may go to a potential source of funds and say that he would like to borrow a specified amount of money concurrently with his acquisition of the acquiree. This hardly qualifies as a technique, but it is perhaps the com- monest way in which funds are raised in connection with an acquisition. (2) Another elementary bootstrap technique is to permit the seller to retain some of the assets of the acquiree. If the transaction is in the form of a sale of stock, this may be effected by a distribution, prior to the sale of the stock, by the acquiree to the seller, as stockholders of the acquiree, of the acquiree's real estate, or other separable assets. However, this will usually produce ordinary income to the seller. If the transaction is an asset sale, the acquiree may retain some of its assets and distribute them to the seller in liquidation, subject to a capital gains tax to be paid by the seller based on the fair value of the retained assets on the date of distribution. (3) A third general category of bootstrap operation is to acquire all of the acquiree's assets but use some of them to pay the seller. This may be accomplished, for example, by forming a new corporation to purchase the stock of the acquiree, liquidating the acquiree in a Section 334(b) (2) liquidation as described above (and subject to the problems discussed above) and then using the acquiree's assets to pay off the seller, or to borrow the funds with which to pay the seller. One of the advantages of this technique is that the in- terest on money borrowed to pay the seller will be ar obligation of the new corporation, and accordingly will) be a deductible expense of its operations. Another ad-| vantage of this arrangement is that the seller can have ar installment sale whereas, if the transaction is an assetl 11 See "Legal Techniques Available for Obtaining Funds," 22) Business Lawyer 13, September 1969. 58 transaction, the seller cannot get the benefits of the install- ment sale provisions. (4) A fourth approach is the so-called "redemption approach." The buyer purchases a portion of the seller's stock interest in the acquiree corporation. The acquiree corporation then purchases the balance of the seller's stock. In the ordinary case, assuming S owns all the stock of acquiree corporation A, S would sell to B (the buyer) less than 50 percent of the outstanding stock of A (for cash or for notes). A would then buy the remaining majority interest for A's own cash and /or notes. In this form of transaction, A's assets can be used to borrow the funds necessary to redeem the balance of S's stock or A may enter into a sales lease-back arrangement to raise the required funds. In another variation the bal- ance of S's stock can be exchanged for an asset of A (such as real estate); A reports no tax on the transfer of the property in exchange for its own capital stock, and S reports capital gains on the fair market value of the property received over the basis for his stock. This tech- nique is, however, fraught with problems, especially where B is a corporation and subsequently merges with or ac- quires A. (5) A fifth general category is the corporate reorgani- zation. One technique, which may be only sparingly used, is — as in our example — to issue to S a dividend in pre- ferred stock and then to sell the common stock to the buyer. The preferred stock might have a sinking fund provision so that the acquiree would be obliged to redeem it over a period of years and might be callable at any time. (6) A final technique arises out of the possibility of the sale of assets by the acquiree at a price below their tax basis. This technique results in a tax loss to the acquiree which may be carried back by it to recover income taxes previously paid. This fund may be used in effect to make part of the payment which the seller requires as his pur- chase price. ENSURING THAT THE ACQUIREE IS WHAT IT IS REPRESENTED TO BE 13-22. Financial statements have been examined, the prem- ises seen, bankers and others interviewed, a deal negotiated. How can the buyer be sure that when the purchase price is paid the buyer will own the business he thinks he is buying, not just the plant, not just the assets listed on the balance sheet, but the actual going business the buyer wishes to acquire? Pro.ecting the buyer is generally the function of the buyer's lawyer and of the purchase agreement. However, it cannot be stated too often or with too much emphasis that the buyer's pre-purchase investigation is his principal protective device, and that a good purchase agreement cannot compensate for an inadequate pre-purchase investi- gation. The investigation comes first and can prevent a poor deal from being made. At most the best purchase agreement, if executed, may preserve some legal remedies to the buyer: this is never as good as not having entered into a bad deal in the first place. In addition, the purchase agreement generally will only protect against those prob- lems of which the buyer may be aware. The better the investigation, the more pointed and more effective will be the protection which can be written into the purchase agreement. The Purchase Agreement 13-23. The first draft of the purchase agreement is nor- mally prepared by the buyer's attorney. It has two pur- poses: ( 1 ) to protect the buyer's interests, and (2) to ferret out facts which the investigation may have not dis- closed. In general, there are two forms of agreement, one is referred to as a one-step agreement and the other as a two-step agreement. In a one-step agreement, the contract is signed at the time it is closed and the buyer signs the contract, pays the purchase price and receives delivery of the stock or assets he is acquiring all at the same time. In a two-step transaction, the contract is signed at an earlier point and the closing takes place later. The reasons for a two-step transaction may be that the seller does not wish to grant the buyer access to the ac- quiree's books and records and the details of its business until the buyer has signed a purchase contract, or because an audit of the acquiree's financial statements is to be made between the contract and the closing date and the sale is only to be consummated if the audit shows net worth or earnings of specified amounts, or because of some other contingency to occur between the contract and closing dates. What follows is a discussion of the principal provisions of a two-step agreement. A number of these provisions can be dispensed with if the contract is in the one-step form, particularly those in the two-step form of trans- action which relate to preserving the status of the business between the contract and the closing date. Representations and Warranties 13-24. In general, it is not enough to copy a form from some other transaction in preparing the representations and warranties to be included in the purchase agreement. The difference between a skillful set of representations and warranties and a pro forma set will depend upon the extent to which the draft is tailored to the particular needs of the particular acquisition. (1) Corporate Matters, Representations and warranties under this heading generally cover due organization of the acquiree and its subsidiaries; due qualification to do business of the acquires and its subsidiaries; the capitaliza- tion of the acquiree and its subsidiaries, including the num- ber of shares authorized and issued, and a statement of any options or commitments to issue further shares; the free and clear ownership of the outstanding shares of the ac- quiree; certification of the acquiree's charter and by-laws, certification of authority for the transaction, and a repre- sentation that the agreement is properly authorized and does not conflict with the acquiree's charter, by-laws or with any other agreement. (2) Drafting Points to Consider. The following are some of the points to keep in mind in drafting this portion of the agreement: (a) The acquiree may have few and inadequate cor- porate records; the stock book may be missing or, at best, may be incomplete; share certificates issued in the past and returned for one reason or another may bear no en- dorsement, and required stamp taxes may be missing. All of these factors may create grave concern on the part of the buyer. He may not be, as he understands, acquiring the entire interest in the acquiree. In an asset transaction, additional outstanding shares may imperil the validity of the vote on the basis of which the sale is made. Consider- able effort should be expended to obtain endorsements, or where the record cannot be clarified, an appropriate escrow or other device should be employed. (b) Shareholder agreements should be reviewed to be certain that the sale is not in violation of any contractual obligation to others, or that the result of the sale would 59 be the acceleration of some liability which otherwise may be deferred. (c) If the transaction involves the purchase of stock, it is important that none of the sellers are minors or in- competent and that all trustees, executors, etc., have au- thority to make the sale. (d) If the transaction involves the purchase of assets, it is necessary to review the corporate law of the State of incorporation to be sure that all statutory requirements have been met (for example, in New York notice of dis- senters' appraisal rights must be set forth in the notice of stockholders' meeting to approve the sale). (e) If the acquiree does business in several States and is not qualified to do business in each of them, State statutes should be studied to ascertain what exposure re- sults from this deficiency. (3) Financial Condition. This is the heart of the agree- ment and an excess of caution will be worth the effort. The basic financial representation is that the financial state- ments attached to the purchase agreement were "prepared in accordance with generally accepted accounting prin- ciples consistently applied, and fairly and accurately repre- sent the financial condition and results of operations of the acquiree as at that date and for the periods covered." As noted above, however, these words can cover a multi- tude of sins, and the agreement should be more precise with respect to the particular matters that are of concern in the purchase. (a) Overstated Inventory Clause: Overstated inven- tory is the principal financial statement problem. The fol- lowing is a clause which may be used where this problem is of concern: "All of the inventory reflected in the financial state- ments as of (date) attached as Exhibit A to this agreement represents merchandise inventory salable in the ordinary course of the business of the acquiree, priced in each in- stance at the lower of cost and market on a first in-first out basis and after deduction for any obsolescence or other deterioration." (b) Warranty of Operating Results: Another com- mon problem is that excellent operating results were achieved not because of ordinary operations but because of some unusual event: the sale of a corporate asset, the settlement of an obligation, a reduction or waiver of sal- aries, or the like. The following clause will afford some protection against this risk: "None of the income reflected in the Statement of In- come as for the [period ending ] [or for the fiscal year ending ] included in Exhibit A is required by generally accepted accounting principles consistently applied to be reflected as an extraordinary item of income, nor did any such income arise out of any transaction not in the ordinary course of the business of the acquiree, out of any extraordi- nary or nonrecurring event not typical of its operations, or out of any adjustment of its accounts for prior years." (c) Accounts Receivable: At the very least accounts receivable should be represented to be "good and collectible and not subject to any set-off, counter-claim or defense whatsoever." Many agreements contain provisions to guar- antee the collection of the receivables, normally by per- mitting the buyer to turn back to the seller accounts which are uncollected after a certain date in return for a reduction in the purchase price equal to the face value of the returned accounts. Of course, the buyer will want to consider the de- sirability of permitting the seller, who is not interested in the welfare of the business, to sue the buyer's customer. However, if the seller is to remain liable for the uncollected receivables, he may not wish the buyer to be authorized to settle a claim, especially if the buyer is interested in retain- ing the goodwill of the customer. One technique used is discussed below in connection with the "survival" clause (see Section 13-28). Another technique is to allow the buyer to settle claims below a certain amount at the risk of the seller, but to require the consent of the seller before the buyer settles larger claims. In any event, some measure of cer- tainty can be achieved by providing that the first funds received are to be allotted to the oldest invoice unless the funds are earmarked to a particular invoice by the customer. (4) Liabilities. The buyer should seek protection against undisclosed liabilities not known to seller, such as liability for tort claims by persons injured on the buyer's premises. Sellers, on the other hand, usually take the position that such claims are ordinary risks for which the buyer should remain liable. If the seller refuses to represent and warrant that no such liabilities exist, on the ground that he really does not know whether or not they do, the matter could be covered in the "survival" clauses discussed below (Section 13-30). From the buyer's point of view, the best clause is a representation that the acquiree has "no liabilities, abso- lute, fixed, contingent or otherwise, and whether known or unknown, except as disclosed in the (specified) balance sheet or arising out of contracts referred to in this Purchase Agreement or arising out of agreements for the purchase and sale of goods or services in the ordinary course of the acquiree's business, and that no such purchase orders wen at prices above and no such sales orders were at price; below normal prices." The other much mooted liability point relates to Federa income tax. Sellers commonly claim that they have under stated inventory and accordingly have underpaid taxes and take the view that since they are delivering more inventor} than appears on the balance sheet, they should not be liabh for the related tax cost. The relative merits of this clair depend not only on whether inventory was or was not full; reported but also upon the year in which it was understated An understatement in prior years may have permitted ai overstatement of earnings in a more recent period with ; resulting overstatement of the acquiree's present earnini ability. In any event, the tax liability for excess compensa tion or for travel or entertainment charges which afford n< benefit to the acquiree should remain the obligation of th seller. Most liability clauses require the seller to list all pendin claims and all claims which, to the best of his knowledge are threatened. These should expressly include all arbitra tion, litigation, or other proceedings. Since the seller ma maintain that an old claim is no longer threatened, it better to require a list of all claims threatened for a specifie period of time. If patents, trademarks, unfair competitio or the like may give rise to important liabilities in the fori of infringement or other such claims, the representatio should be of no undisclosed threatened claims within th past 5 years. Also, if these items are of significance, thei should be a representation that the seller has no knowledg that the acquiree's business operation does in fact infring the rights of any others, whether or not any such clain have been asserted against the acquiree. (5) Absence of Change Since Balance Sheet Date. Th clause seeks to ensure that the business has been operate under the same set of conditions and has suffered no adver; change since the date of the latest financial statement ii eluded in the agreement. Except as set forth in an exhib to the agreement, this clause typically states that since th date of such financial statement there has not been: tl declaration or payment of any dividend or other distribute to stockholders; any purchase, redemption or other acquis tion by the acquiree of any shares of its own capital stoc any cancellation, waiver, or forgiveness by the acquiree 60 any debt or other claim theretofore made by it or the sur- render without fair consideration therefor of any contrac- tual right to which the acquiree was entitled; any new long- term debt or any additional lien, pledge or encumbrance placed on any property of the acquiree; any new material contract, commitment of liability; any sale, lease or other disposition of any real or personal property other than merchandise inventory in the ordinary course of business; any labor difficulty; any casualty loss; or any other material adverse change in the business, financial condition, prospects, or results of operations of the acquiree. Buyers often learn to their dismay that the acquiree raised salaries toward the end of or after the last accounting period for which financial statements were supplied to the buyer. Accordingly, it is important to obtain a representation that except as disclosed in an exhibit to the agreement, there have not been any material salary increases either during the past full year or thereafter. (6) Assets, Asset Schedule, and Material Contract Sched- ule. These representations and warranties are designed to furnish the buyer with as much detail as possible concerning the assets of the acquiree. The rule here is: the more spe- cifics, the better. All obtainable schedules should be attached as exhibits to the agreement. If feasible, inventories should be listed, but this often cannot be done. What is commonly feasible is a list of machinery, real estate, leases and other important contracts including all which constitute liens or encumbrances on any property of the acquiree, permits, licenses, insurance policies, bank accounts and trademarks, trade names, patents, and the like. The seller should represent and warrant that all the assets are owned free and clear of all liens and encumbrances, ex- cept as set forth in an exhibit or in the balance sheet; that all the contracts are valid and enforcible; that neither the acquiree nor any other party thereto is in default thereunder; and that all of the copies of the contracts supplied to the buyer are true and correct copies of such instruments. With respect to the insurance policies, it is sometimes worthwhile to get a list of prior policies because occasionally there will be outstanding claims against the acquiree which supposedly were covered by prior insurance but where the prior insur- ance was written by worthless carriers. (7) Miscellaneous. One common miscellaneous clause is that there is no broker or finder who brought about the transaction or who may make a claim against the buyer on account thereof. Seller's Affirmative and Negative Covenants 3-25. This section of the purchase agreement seeks to ensure that the seller does nothing to change the condition of the business between the contract and closing dates, to require the seller to do everything he must do in order to complete the transaction, and to permit an examination by the buyer of the acquiree's business between the contract and closing dates. Purchase agreements commonly provide that there will be no change in charter or by-laws, no hanges in or redemption of stock, no new funded debt or Dther material liability incurred. Purchase agreements also provide that the seller will continue to operate the acquiree's Dusiness in usual course and will give notice to the buyer 3f any unusual event; and that the acquiree will comply with laws, will pay all taxes, etc. A typical clause states that he seller will do whatever is required to effect the trans- iction, including holding appropriate directors" and stock- lolders' meetings (in an asset transaction). The clause should ensure that the seller use his best efforts to see that conditions precedent to the closing are satisfied. Clauses 'elating to the examination of the acquiree's business by the uyer are generally designed to permit a full inspection by the buyer or his representatives during usual business hours. Sometimes there is considerable negotiation as to the con- fidentiality of the information being disclosed, with the seller seeking protection against the use of such information by the buyer in the event that the transaction is not effected. Conditions Precedent to the Buyer's Obligation to Close 13-26. The purpose of this portion of the purchase agree- ment is to permit the buyer to refuse to close if there has been any material change in the acquiree's business because required consents or authorizations have not been obtained or because responsible persons associated with the acquiree refuse to give assurances that all is as it is supposed to be. Typical clauses in this section of the agreement state that the buyer shall not be obligated to close if any of the repre- sentations and warranties are not true as of the closing date; if there has been any material adverse change in the business, financial condition, or prospects of the acquiree; any labor trouble or any material casualty loss, whether or not covered by insurance; or if the buyer does not receive an opinion from seller's counsel as to legal matters, a letter from seller's auditor as to accounting matters, or a certificate from ac- quiree's offices as to the representations and warranties. All of these clauses are designed to assure the buyer that the business is as represented. Closing 13-27. This section of the purchase agreement fixes the time and place of closing and should set forth in detail the in- struments that each party is to deliver to the other. In an asset transaction, one of the instruments should be a certifi- cate changing the name of the seller so that the assets can be taken by the buyer in a corporation which will have the same name as the acquiree's. If sales and other transfer taxes are involved appropriate provision should be made in this section of the agreement. It is common to omit provi- sions for certified copies of charters and the like although it is a good idea to include them. Indemnification and Damages 13-28. Determining what are the buyer's damages if the transaction is closed and it then turns out that the seller has misrepresented some aspect of his business is one of the most serious problems in drafting purchase agreements. (1) Where No Clause Exists. The first question to be asked is what the law provides if there is no clause on this subject. The rule governing misrepresentation in the ma- jority of States is the so-called "loss-of-the-bargain" rule. Other States use the "out-of-pocket" rule. 7 For breach of warranty the general rule is that of "loss-of-the-bargain." 8 The difficulty under the "loss-of-the-bargain" rule is to prove both the value of the bargain and the diminished value of what was actually received. Under the "out-of-pocket" rule the difficulty is that of proving diminution of value. If a business is bought at its book value, it is fairly clear that any misrepresentation which resulted in a loss of a dollar of book value resulted in a dollar of damage. Ac- cordingly, except for a procedure with respect to collecting damages, a damage clause is not necessary. However, if a business is bought at some multiple of its book value because of its assumed earning ability, the buyer may claim that for each dollar of loss resulting from a misrepresentation he should recover as his damages, not just the dollar of loss 7 ". . . Measure of damages is difference between price paid by person defrauded and value of property he has received in fact from fraud doer." U. S. v. Ben Grnnstein & Sons, Co., 137 F. Supp. 197, 204 (D.C. N.J.) (1955). s ". . . Allows recovery of difference between actual and represented value of stock sold in event of fraud." Poole v. N.V. Deli Maatschappij, 224 A. 2d 260, 262 (1966). 61 but the number of dollars which he in effect paid for the dollar of earnings. Sellers are usually very reluctant to ac- cede to this measure of damages in the purchase agreement. What commonly happens is that no measure of damages is set forth or attempted to be negotiated: the buyer hopes to be able to prove his measure of damages if there is any misrepresentation, and the seller hopes that if he misrepre- sented, a dollar of loss to the acquiree will only result in a dollar of damages against the seller. If, however, a business is bought on a multiple of earnings basis which substantially exceeds book value and if a damage clause based on this method of computing the price can be obtained, it is a very valuable one and worth some considerable concessions in other areas. (2) "Cushion" Clause. One common clause in this section is the so-called "cushion" clause, designed to protect the seller against being harrassed by the buyer for claims of minor deficiencies in the representations and warranties. The cushion clause provides that the seller shall not be liable to the buyer if the damages incurred by the buyer as a result of a breach of the seller's representations and warranties are less than a specified minimum. There are two types of cushion clauses; one type says that if the aggregate damages suffered by the buyer are less than a specified amount (cushion) the buyer may make no claim against the seller, but that if aggregate damages exceeds this amount, the buyer can claim the total amount of his dam- ages and not just those exceeding the cushion. The other type only allows the buyer to claim from the seller the amount by which the buyer's damages exceed the cushion. Obviously, buyers prefer no cushion clause. If they give one, they offer the first and not the second type. (3) "Survival" Clause. One of the key elements in enforc- ing post-closing liabilities arising under a purchase agree- ment is the so-called "survival" clause. Under the common law, representations and warranties are deemed merged into the closing and are no longer binding against the seller. Accordingly, purchase agreements contain a clause to the effect that the representations and warranties survive the agreement. The buyer would like the period of survival to be as long as the applicable statute of limitations allows while the seller will wish to limit the period of survival as severely as possible. A fair compromise generally is to fix the statutory period for the survival of tax claims, which may not surface for a considerable period, and to fix either 18 months or 2 years for the survival of other types of claims on the ground that they should appear within that time. However, warranties of title are usually made without limitation. A survival clause should be worded so that if a claim is made against the buyer within the period of the survival and the buyer gives notice thereof to the seller, the buyer may recover against the seller even if the buyer actually suffers his damages long after the survival period. (4) Indemnification Clause. The purpose of the indemnifi- cation clause in the purchase agreement is to make clear the seller's liabilities under the agreement and to create a mech- anism for enforcing the buyer's rights to enforce these lia- bilities. Under such a clause, generally defined as "indemni- fied liabilities," the seller is responsible for any liability asserted against the buyer which would constitute a breach of a representation of warranty by the seller, including any damages or deficiencies resulting from such a misrepresen- tation and any legal fees, costs, or disbursements incurred in connection therewith. "Indemnified liabilities" may also be defined to include contingent liabilities arising out of a transaction occurring prior to sale to the buyer. The typical problem in this clause (other than the meas- ure of damage problem, discussed above, which can in effect be left open in this part of the agreement) arises from a claim by a person with whom the acquiree has a continuing business relationship. The buyer would like to honor this claim — especially at the seller's expense — in order to pre- serve the business relationship between the acquiree and the claimant. One way to handle this is to provide that if the claim is for damages in less than a specified amount the buyer may pay or settle the claim and charge the seller therefor; that if it is over the specified amount and does not involve a person with whom the acquiree has a continuing business relationship the seller may be given an opportunity to defend or settle the claim and that the buyer would have no participation so long as no lien is asserted against the acquiree's property by virtue of the claim. If the claim ex- ceeds the specified amount and is by a person with whom the acquiree does have a continuing business relationship, the buyer may pay, settle, or defend the claim as he chooses and then arbitrate with the seller whether or not the amount ultimately paid on account thereof was fairly chargeable to the seller or, in other words, whether the seller was injured by the buyer's failure properly to defend the claim. A cau- tion to be observed in the drafting of indemnification clauses is that the measure of damages on a dollar for dollar basis is not implicit in the wording of the indemnification clause. (5) Miscellaneous. Another clause that the buyer may request is that a sum of money be placed in escrow sufficient to insure him against loss in the event of breach of any oi the seller's warranties or representations. Miscellaneous Clauses 13-29. The most important clause here is the restrictive covenant. Restrictive covenants are clauses to the effect tha the seller cannot directly or indirectly compete with th< acquiree for a designated period, in a designated area, an< in designated activities. 9 Restrictive covenants which are based on employmen agreements are generally of limited enforceability, but thos which are ancillary to the sale of a business may be broa< in scope and still be enforceable. Accordingly, it is commoi to restrict the seller from engaging in a competitive business if the acquiree sells nationally, then throughout the Unitei States, or if it sells only locally, then anywhere in the loci area, for an extensive period such as 5 years. In connectio with the enforceability of restrictive covenants, the selle often argues that the buyer is asking for so much that i fact the restrictions requested by buyer will not be enforce able, but would be enforceable if they were of more limite duration or scope. One technique for the buyer is to accer some reduction in what was originally requested, but onl on condition that the seller's attorney provide an opinio| to the effect that the covenant as modified is enforceable. Another miscellaneous clause relates to which party pajl what expenses if the transaction is not consummated. OtheJ relate to the obligation of the seller to deliver any require confirmatory instruments, and usual miscellaneous mattej such as notice, governing law, etc. In a transaction where the seller does not receive the tot! purchase price in cash, he may request a clause giving hij the right of access to the books and records of the acquirJ or the right to receive copies of the business' financial statl ments after the closing to enable him to determine whethf the balance of the purchase price still outstanding is jeopardy. In an asset acquisition, another often-used clause is til so-called bulk sale provision. Bulk sale statutes provide thl n See "Judicial Treatment of Covenants Not to Compete," Tax L. Rev. 513, May 1969. "Employment Contracts and Nd Competition Agreements," 1969 U. III. L.F. 61, 1969; "Tax Treatmd of Covenants Not To Compete," 24 U. Miami L. Rev. 1, fall 19l 62 where merchandise inventory is sold in bulk, the creditors of the acquiree may claim against the assets acquired unless they are given notice in accordance with the statute prior to effecting the transfer. Accordingly, in order to prevent such claims, the buyer in an asset acquisition normally obtains a covenant from the seller to make all the informa- tion available so that the buyer can comply with the notice provisions of the local bulk sales statute. In situations where there are deferred payments due to the seller, the seller may seek to obtain a clause which would preclude certain actions being taken by the acquiree. For example, the seller might insist that until the purchase price is paid in full, the corporation could not make any loans to officers, directors, or stockholders; make any amend- ments to its certificate of incorporation: make any mortgage or otherwise encumber its assets except in the ordinary course of business; or make or execute any guarantee with respect to the obligations of any other person or firm or pay any dividends or make any other stockholder distributions. Such clauses are designed to secure the seller, but clearly represent restrictions on business operations. The seller may also insist upon clauses in the contract to the effect that the time for payment of deferred payments is to be accelerated should certain events take place, such as the consolidation or merger of the acquiree with any corporation; its liquida- tion or dissolution; the sale, transfer, or lease of substan- tially all of the assets of the acquiree; the making by the acquiree of an assignment for the benefit of creditors; or the commencement by the acquiree of any bankruptcy or creditors' proceedings. Here again, such clauses are designed to protect the seller and may present limitations on the business operations of the purchaser. Another important clause which is generally advisable requires the submission of all disputes to arbitration and prevents such disputes from being solved through litigation. While not all attorneys agree on the advisability of the use of arbitration as a method for resolving disputes, it is gen- erally advisable to include such a clause in contracts for the sale of a business. HANDLING BREACH OF CONTRACT 13-30. It may develop that some of the representations and warranties made by the seller in the contract of sale are breached. The buyer may discover, for example, that inven- tories are overvalued, that debts or liabilities may exist over and above those disclosed, that financial statements are not accurate, or that there is litigation pending that may affect the assets or earnings of the business. Any one of these de- velopments, which would constitute a misrepresentation or breach of warranty, gives the buyer less than he bargained for and is, in effect, a breach of the contract. The following discussion will attempt to briefly analyze the remedies avail- able to the buyer in the event of such breach. Matters Discovered Prior to Closing 13-31. Where the misrepresentation or breach of warranty is discovered prior to the closing of the transaction, the buyer would have a right to refuse to consumate the trans- action provided the breach is a substantial one. The courts would probably not sustain the right of the buyer to refuse to close the deal where the misrepresentation or breach of warranty was inconsequential in terms of the overall size of the transaction or its effect on the value of the business purchased. Even if the breach of warranty or misrepresen- tation is significant, there is always a danger that the refusal to close the transaction will result in litigation. A lawsuit brought by the seller, even if successfully defended by the buyer, would be time consuming and expensive due to the considerable legal fees and other costs that would have to be expended. There is also always the possibility that the court might rule against the buyer. It is more likely that where the breach of warranty or misrepresentation is discovered prior to the closing that the buyer can use the discovery as a means of renegotiating the purchase price or the terms. The buyer may be satisfied to proceed with the transaction if the price is adjusted to reflect the value of the business, taking into account the matters in question. This type of situation illustrates the desirability of giving the buyer, by a provision in the contract, the option to either terminate the contract or renegotiate. Breach of Contract After Closing 13-32. Different problems arise when the misrepresentation or breach of warranty is discovered after the closing of the transaction. In such a case the buyer will probably have to rely on two basic kinds of legal remedies, a suit for the damages resulting from the breach of contract or a suit to rescind the contract in its entirety. A lawsuit to rescind the contract may be brought in very limited cases. In an action to rescind a contract of sale, the buyer must be able to establish that the representations of the seller were fraudulent or that both parties to the con- tract made a mutual mistake of fact. It is difficult to estab- lish either of these criteria and it is unusual for a court to order rescission of a contract after the sale has been con- summated. The fact that it is often impossible, as a prac- tical matter, to undo the transfer of a business makes the use of rescission as a remedy remote. A lawsuit seeking compensation for the damage suffered by the buyer by the breach of warranty or misrepresentation is a more realistic approach. In such an action the court will measure the buyer's damages by comparing the value of the business actually received, taking the misrepresentations and breach of warranty into account, with the value of the busi- ness the buyer would have received had there been no breach of contract. In the event that the contract of sale contains a provision for arbitration, the buyer would proceed to make a claim with the appropriate arbitration agency where the dispute would be heard and determined. In some cases, the buyer may have been successful in negotiating a contract to include a provision requiring that certain funds out of the purchase price be held in escrow to compensate him in the event of a breach of contract. The escrow agreement is generally drafted to establish the procedure whereby the buyer may make claim for these funds. It may be necessary to bring an action against the holder of the escrow money or to submit the claim to arbi- tration in such a case. Where the purchase price is not paid in full at the closing and there are deferred payments owed by the buyer, he may be in a position to offset his damages against the unpaid payments. He may be in a strong bargaining position in such a case and the withholding of any of the deferred pay- ments may force the seller to agree to a reduction in the purchase price in order to avoid the necessity of his bringing an action against the buyer for the balance of the purchase price due. The use of such "self help" by the buyer in this kind of situation might not be available in all cases, par- ticularly in those situations where the seller has been given some security to protect the amounts due him, such as mortgages on the buyer's real estate, chattel mortgages or financing statements on his personal property, or other forms of legal lien. 63 LABOR-MANAGEMENT QUESTIONS 13-33. In acquiring any existing business, whether by virtue of an asset purchase, merger, or a stock purchase, it is im- portant to investigate carefully the labor-management rela- tions of the company and its overall personnel situation. The buyer should review the entire labor history of the business, examine all existing and prior union contracts, and compare the labor relations of the company with other firms in the same or similar business. Various aspects of labor union contracts may present problems for the buyer. If the business is being purchased with a view toward relocating its operations, charges of "runaway shop" may be made. Serious problems can arise in regard to a buyer's desire to make personnel changes. This will be particularly true if a business is located in or is to be relocated into a disadvantaged area and the buyer intends to increase the number of employees who reside in the neighborhood. Many of these people may have diffi- culty meeting existing job criteria or obtaining membership in the existing labor unions. The existence of "union shop" or "closed shop" provisions in labor union contracts may present problems in terms of implementing these goals. The buyer should investigate the union contract to ascertain the the potential liability for severance pay if employees are discharged, whether by virtue of relocation or because of change in business requirements. The contract should also be examined to see whether it is binding on the purchasing corporation. If it is not assignable, the union may be in a position to demand renegotiation. A careful analysis must be made of the hiring practices of the business. Does the company have a good record on the question of minority employment? Is there any history of discriminatory hiring practices? Does the company have an apprentice or training program? Is it the kind of business that will enable it to make jobs available to community residents? Various States have enacted legislation giving tax benefits to companies which create job-training programs in dis- advantaged areas. The possibility as to whether such pro- grams can be utilized should be investigated. 10 If a union contract grants profitsharing benefits to the employees or requires contributions to union health, welfare, or trust funds, the buyer may be reluctant to acquire the business because of the effect on his own employees and their union. Another problem created by existing union contracts is the possibility of jurisdictional disputes between the union representing the seller's employees and the ac- quiree's union. The buyer should also ascertain whether the transaction will bring into operation "wage reopening" or "escalator" provisions of the union contract. A careful analysis of the existing executive personnel must also be made. The buyer must know which executive employees are vital to the business and whether they plan to remain with the company. Other important questions in regard to such key employees are: (1) Do they have employment contracts? (2) Can the buyer afford the compensation of these employees? (3) What will be the effect of the salary scale of the new employees on the executive employees of the buyer? (4) What are the rights of the new executive employ- ees in regard to pension and profitsharing plans, group in- surance, stock purchase plans, and other fringe benefits? How will such benefits, if in existence, affect the executive employees of the buyer? LANDLORD'S RIGHT TO CANCEL LEASE IF STOCK OWNERSHIP CHANGES SUBSTANTIALLY 13-34. It is not uncommon for the lease under which the business operates to provide that if the stock of the operat- ing corporation changes substantially, the landlord may, at his option, terminate the lease. Occasionally, other lease provisions such as rent abatements, lower percentage rent provisions, or renewal options are conditioned on no sub- stantial stock change. A substantial change is usually spelled out to include one or more of the following: (1) Transfer of more than a certain percentage of stock to one not a stockholder at the time of the lease execution. (2) Transfer of any stock or stock above a stated per- centage to a person not approved by the landlord. (3) Transfer of stock to anyone other than an imme- diate relative of an existing stockholder. Such transfer may be by sale, by gift, or by operation of law — which usually means under a will or by intestacy upon the death of a stockholder. Transfers to a corporation affiliated with the tenant or in which stockholders of tenant are majority or sole stock- holders are frequently exempt from the mentioned limita- tions. All of these and similar provisions can be most important to a buyer, particularly if it is a local Economic Develop- ment Company. They can tend to lock-in initial investors, making it difficult to effect broadened community partici- pation, or they can increase the risk to the initial stock- holders, whoever they may be, by making it difficult to negotiate a transfer if the need or desire arises. After narrowing the circumstances requiring the landlord's consent as much as possible, the most common limiting de- vice is to provide in the lease that consent may not unrea- sonably be withheld. RETAINING EXISTING MANAGEMENT EXPERTISE 13-35. The person who knows the most about the acquiree's business is normally the seller. If a business may be said to be no more valuable than its management, and if the seller must be conceded to be the most valuable managemen person in the business of the acquiree, the seller then be comes a very significant portion of the assets of the ac quiree's business. Accordingly, it is common to employ vari- ous techniques to attempt to assure that the seller will a least for a sufficient period of time continue to participatt in managing the acquiree. The goodwill efforts of a potential buyer and seller it seeking to transfer ownership of a smaller scale enterprise may require on-the-job training, or the use of outside com munity consultants. See Section 4 for discussion of this ant other approaches to managerial training and assistano which can be available with the aid of the community organization. Retaining the Seller as a Co-Owner 13-36. The parties may agree to have the buyer purchasl only a portion of the seller's stock, say 80 percent, leavinf the seller with a 20 percent interest. Further covenants maj provide that the buyer will make a later purchase of thl balance of the stock at some higher price that depends oj the results of the acquiree's operation, with the help of thl seller, over a specified period of time. (See also Section 13| 20, "Contingent Payouts.") io New York Commerce law, Article 4-A, creating the New Yoq State Urban Job Incentive Board. 64 Use of an Employment Agreement 13-37. An employment agreement is very rarely a severe restraint on an employer for the reason that the employee's damages upon breach of the agreement are in most States reduced by an obligation to mitigate them. The result is that the employee can only recover the difference between his contractual salary and what it might be expected that he could earn elsewhere. The employment agreement is even less binding by the employer against the employee since there is no way for the employer to compel the employee to work for him. In effect, then, the only effective weapon that a buyer has against a seller to enforce the employment agreement is the restrictive covenant, and there should be a restrictive covenant in the employment agreement as well as one ancillary to the purchase agreement. Commonly, the restrictive covenant in an employment agreement should be of narrower scope than that which is in the purchase agree- ment. In fixing the term of the restrictive covenant, it is important that the restriction begin at the end of the con- tractual employment period: if the employment agreement is for 3 years, then the restriction should be binding from the commencement of employment to a period, say 2 years after the end of the agreement term. The purpose of this is to preserve the restriction from the date of cessation of em- ployment through the originally contemplated restriction period even if the employee should leave his job before the expiration date of his agreement. Relationship With the Seller 13-38. Perhaps as important as economic inducement or the employment agreement is the relationship between the seller as a person and the buyer or the buyer's representatives. Buyers must recognize that the seller has been the owner and manager of the acquiree's business for a considerable time and normally finds it difficult to assume the role of an employee. Any efforts by the buyer to put the seller in his place, as an employee, especially if it takes place before those people for whom the seller has for so long been the "boss," is sure to result in an effective loss of the seller's services. This is not easy to avoid, especially where the business has not been run as well as the buyer would like, and where the buyer is attempting to effect improvements at the same time as he retains the goodwill and assistance of the seller. A general rule is to go slow, to be respectful of the seller's opinions, and to realize that vast improvements cannot be accomplished in a day. The problems are gen- erally more numerous than the buyer realizes even if they were too numerous for the seller to overcome. A patent and cooperative effort will do more than an aggressive attitude. Other Management Problems 13-39. The buyer should use the pre-closing investigation not only as an opportunity to investigate the acquiree's busi- ness but as an opportunity to become acquainted with the middle management and supervisors of the acquiree and to afford them a chance to know the buyer and its repre- sentatives. All of these people generally need assurances that there will be continuity and that they will not be re- replaced without good cause. In addition, the pre-closing period provides an excellent opportunity to identify those people who should be given more responsibility and those who ought to be dispensed with as rapidly as possible. BIBLIOGRAPHY 1 3-40. "Analysis cf the New Capital Gains Provisions of the Tax Reform Act of 1969," 32 J. Taxation 272. May 1970. "Corporation and the 1969 Tax Reform Act." 30 Milwaukee Bar Association Gavel 25. March 1970. Discusses multiple corporations, stock dividends, debt-financed corporate acquisitions, bonds, and other evidences of indebtedness and the stock v. debt concepts as related to the 1969 tax reform. "Tax Reform Act of 1969," 23 Tax Lawyer No. 3. Fall 1969. De- tailed analysis of the changes made by the Reform Act. Smith, F. "Purchase of a Corporation With Its Own Assets or Earnings . . . Revisited," 11 Practical Lawyer 15. 1965. Stephan, E. "Acquisition Trouble Spots," 21 Bus. Law. 401. 1966. Borden, A. M. "Drafting a Purchase Agreement for the Acquisition of a Closely Held Business," 12 Practical LaM'yer 9. 1966. Cavitch, Z. and Hoehner, D. L. "Buying or Selling a Corporate Business — Stock or Assets," 28 Ohio St. L.J. 614. 1967. "Sale of a Corporate Business: A Panel Discussion of the Issues, Including Valuation and Assets v. Stock Techniques," 21 N.Y.U. Inst. Fed. Taxation 1143. 1963. Weithorn, S. S. and Elder, P. "Buyer's and Seller's Points in Sale of Corporate Business — An Outline Checklist," 21 N.Y.U. Inst Fed Taxation 1065. 1963. Mcnyek, R. H. and Kessler, R. L. "Tax Considerations in Buying and Selling a Corporate Business," 16 De Paul L. Rev. 28. 1966. "Symposium: Disposing of the Business of a Close Corporation," 19 U. of So. Cal. School of Law Tax Inst. 21. 1967. Rees, D. W. "Tax Techniques of Bootstrap Acquisitions," 18 West. Res. L. Rev. 803. 1967. McCarthy. Acquisitions and Mergers. New York: Ronald Press Co 1963. Scharf. Techniques for Buying, Selling, and Merging Businesses. Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1964. Hennessy. Acquiring and Merging Businesses. Englewood Cliffs N.J.: Prentice-Hall, Inc., 1966. 65 Section 14 FRANCHISED BUSINESSES WHAT IS FRANCHISING AND HOW DO YOU USE IT? 14—1. Franchising is a flexible procedure for marketing goods or services. The goods or services distributed through franchising range from hamburgers to hotels . . . transmissions to travel agencies . . . tax assistance to tires. Franchising is neither new nor mysterious. What is "new" about franchising is its astonishing growth in recent years: in 1967 it accounted for more than $89 billion in sales. Its form is defined by a contract (the franchise agreement) between two parties — the franchisor and the franchisee. LEDC Should Consider Opportunities 14—2. In seeking opportunities for prospective businessmen, a Local Economic Development Company should consider the many possibilities for obtaining a local franchise from a national corporation. Such a franchise permits local inde- pendent ownership, but gives the owner some of the major advantages of being part of a big chain or national com- pany. Basic Franchising Relationships 14-3. The franchisor identifies the product or services to be sold and organizes and supervises the marketing system. The franchisee operates the franchise and usually deals directly with the public in a specified area or location. The franchisor normally licenses the franchisee to use the name, products and system of the franchisor. The trademark or name marking or system acquired by the franchisee is in some way distinctive or at least could not be duplicated by a local entrepreneur without permission of the franchisor. The relationship between each franchisor and franchisee is usually specified by a written contract: their franchise agree- ment. Each such agreement, rather than a standard, un- changing form called "franchising" defines the obligations of franchisor and franchisee to one another. The franchisor and franchisee are independent parties; each sacrifices some of his freedom and flexibility in return for benefits of the relationship. Who gives up how much to whom is defined in the franchise agreement. The advan- tages of a franchise depend on the obligations of the fran- chisor and the franchisee as defined in their franchise agree- ment. In making sure exactly what he is — and is not — buy- ing, an inexperienced businessman or organization needs the help of the community organization's legal advisor. Advantages of a Franchise for the Minority Businessman 14—4. An established, well-known franchise that provides a marketable product or service can make it possible for the aspiring businessman to open a business without the need to build slowly a reputation and goodwill for his product in the community he serves. If potential customers already know through advertising or experience the product or serv- ice being franchised, they are more inclined to buy that product or service than a similar one that is not familiar to them. (1) Initial Training and On-The-Job Assistance. Perhaps the greatest advantage of franchising for an aggressive but inexperienced person is the opportunity it affords to over- come the problems of inexperience. Most franchisors main- tain special training facilities which their franchisees must attend prior to opening new franchises. The quality of this training varies greatly, but the better franchisors often train their franchisees in simplified accounting, personnel tech- niques, inventory maintenance, purchasing procedures, and many other subjects and also provide on-the-job training in a company-owned operation. For the franchisee who has limited business experience, these introductory programs can be of great assistance, particularly when encountered in an atmosphere very similar to that which the franchisee will experience when he opens his own franchise operation. Many franchisors also have, at no extra cost to the fran- chisee, circuit-riding representatives who are on call as trouble shooters to help franchisees resolve problems as they arise. These representatives often help remedy ineffective procedures even before the franchisee realizes that he has a problem. (2) Established Channels for Equipment and Supplies. The franchisor almost invariably assists the franchisee ir obtaining equipment which has been specially designed foi the needs of the franchise operation. The time and cost of inspecting and pricing various types of equipment is elimi- nated. Many franchisors arrange for volume sales to theii franchisees, with the result that the franchisee pays less for the equipment than he would have to pay if h< ordered the equipment directly from the manufacture or the supplier — assuming that the franchisee ever knew exactly what equipment he needed and from whor it could be obtained, an assumption which is inaccurate i most instances. (3) Financing Assistance. Many franchisors have financ ing plans that make it unnecessary for the franchisee to hav at the very outset the total funds which will be require* for equipment and initial inventory. (4) Volume Purchasing, Site Selection, and Promotion. Ii many cases, a franchisee makes higher profits than woul be possible for an unaffiliated businessman for the simpl reason that, as a franchisee, he enjoys the benefits volume purchasing negotiated by the franchisor for hi franchisees. Furthermore, many franchisors have pre grams designed to improve the quality of the producd and services made available through the franchise. Al though these improvement programs are, in a sense, pail for with some of the franchisee' profits, such program! would seldom be carried out if the franchisee weif totally on his own. Benefits to franchisees vary widely with different frail chiscs. However, many of the better franchise program] can help the franchisee by such services as assisting il 66 a) selection of the franchise location, (b) obtaining and legotiating financing needed by the franchisee, and (c) iromotion of the franchised product or service through Deal, regional, or national advertising and promotion irograms. In every case, of course, part of the franchisee's ricome helps pay for such services; but the return to the ranchisee often makes it worth the cost. )isadvantages of a Franchise for the Minority Businessman 4-5. Franchising can obviously have some disadvantages ,s well as advantages. It may even present particular iroblems for the minority individual or organization onsidering acquiring a franchise. (1) Initial Capital Requirements. A franchisee, like every- >ne else, seldom gets something for nothing. The right to >perate under a well-known name, purchase of equipment nd supplies, construction or renovation of facilities, con- inuing franchise royalties to the franchisor, working apital, advertising fees, business licenses, insurance, taxes — 11 cost money — the franchisee's money. In many cases, t is the lack of money, not racial or religious discrimination hat keeps a member of a minority group from acquiring , franchise. Of course, many of the costs of a franchise also iccur in one form or another in any properly operated idependent business. Nevertheless, capital often is a prob- ;m for the franchisee. 1 (2) Resistance to Low-Income Area Franchises. More ranchisors are recognizing the growing purchasing power if the non-white market. Yet some franchisors still hesi- ate to locate franchises in low-income communities, fear- Ig that an adequate market may not exist. The franchisor rishes to avoid having an empty franchise outlet that /ould advertise the failure of one of his franchisees. (3) Obstacles to Group Ownership of Franchises. One isadvantage of franchising that should be considered is he difficulty which may be encountered in trying to rrange for community or group ownership of a franchise, iroup ownership may be desirable from the potential ranchisee's viewpoint because it permits a pooling of ssets and an opportunity for all those participating to eel that the business is partially theirs. For a number of easons, however, many franchises are not well suited for roup ownership. Few franchises — and few businesses of any kind — can e successful if management decisions cannot be made uickly. The law permits and even requires shareholder otes on certain important issues, but day-to-day business peration is not the best context for participatory politics. a franchise is owned by several persons, a system should e found which insures that the franchisor can deal in onfidence with one or a few specific individuals. Another reason why some franchisors — particularly those at operate smaller franchises — are not inclined to allow franchise to be owned by a substantial number of ersons is because the franchise is based on the premise that e owner will also operate the franchise. Owner-operation minates the need to hire management personnel whose laries must be paid from what would otherwise be owner's icome. Moreover, many franchisors believe that the man- ement must have a stake in the profits of the franchise, not st a salary interest, to insure that the franchise will be m effectively and profitably. Any organization or group which is interested in pur- lasing a franchise to be manager-operated will want to >nsider the probable profit margin which will remain after lyment of management salaries. If it is important to ovide some return on investment to shareholders or embers of the group, some franchises may have to be jected as inappropriate for group ownership. (4) Resale of Franchise Operation. Another disadvantage for the franchisee may be the difficulty of trying to sell the franchise if he decided to leave the business. Most franchise agreements require franchisor approval of any subsequent purchaser; some require that they be permitted to repurchase the franchise themselves, occasionally on terms which are not very favorable to the franchisee. 2 It should also be remembered that, unlike an independently owned business, new franchise outlets usually cannot be added at any time the franchisee sees fit. Most franchise agreements limit the franchisee to one outlet and charge him additional franchise fees for the right to open another outlet. These possible disadvantages can be resolved by careful analysis and negotiation of the franchise agreement. Perhaps the best way to solve these problems is to be sure that you know what you want and what you are buying. (5) Other Disadvantages. The franchisee would be ad- versely affected (1) if his franchisor acquired a poor reputation nationally or (2) if other franchisees in the area have had a history of failure or of unsatisfactory customer relationships. Some practices of some francishors are under investiga- tion by the Federal Trade Commission and by the attorneys general of various States. The publicity thereon might affect the business of the local franchisee even though he himself abandons the practices being investigated. STIMULATING ESTABLISHMENT OF MINORITY-OWNED FRANCHISES 14-6. Some LEDCs establish shopping centers to meet local needs and to provide opportunities for minority business- men to own and operate franchises and other kinds of businesses. The International Franchise Association and a number of private companies such as International Industries, and the Small Business Administration also have programs for stimulating the establishment of minority-owned franchises. A number of minority-owned franchisors are actively seeking franchises. (1) LEDC-Sponsored Shopping Malls. For an LEDC that is attempting to create a range of retail facilities — from dry cleaners to shoe stores to supermarkets to restaurants — the development of a franchising mall or shopping center offers one possible technique. By creating a mall occupied wholly or in part by reputable franchises, an LEDC can provide opportunities for establishing sound, new businesses while removing from its own immediate concern the problems of training, equipping, supplying, and supervising the businesses. In- stead, the LEDC can focus on finding the desired franchises and the franchise owners or managers. With the support of devices such as the lease guarantee program of the Small Business Administration" the LEDC can build the required facilities, while providing a guaranteed source of funds to pay off its construction costs and assuring the franchisor that facilities of the quality required will be available. (2) International Franchise Association. The nature of the franchising industry's opportunity and obligation is being increasingly realized by individual franchisors. In late 1968, the International Franchise Association (IFA), a trade association of more than 200 franchisors, accepted the invitation of the Small Business Administration to form a Franchise Industry Advisory Council (FIAC), whose primary initial purpose would be to recommend pro- 1 Possible sources of capital are discussed in Part 111 of this book. - See Section 14 16. :; See Section 32-3. 67 cedures to stimulate establishment of minority-owned franchises in the rapidly growing franchise industry. Among recommendations which the FIAC is considering are various techniques individual franchisors could adopt to decrease or defer initial capital requirements for minority franchisees. Other subjects include (a) franchise market- ing programs, sponsored jointly by a number of franchisors, designed to reach minority group persons who might be interested in becoming franchisees; (b) recommendations for hiring of non-white individuals or public relations firms that are particularly capable of communicating to the minority community the potential of individual franchises; and (c) better use of government financial assistance programs, such as those of the Small Business Administration. LEDCs should contact the FIAC for possible aid and information. 4 (3) International Industries Program. Private efforts to ex- tend franchising operations to low-income communities include the program of International Industries. This program makes (1969) the International House of Pan- cakes franchise available to minority franchisees on specially modified terms designed to meet their particular problems. The potential franchisee would be "apprenticed" at a good salary for a period of less than a year in an operating franchise. On completion of his apprenticeship, the successful franchisee would get a franchise for $900 down and a 17V2-year no-interest loan on the balance — as opposed to the $25,000 down and 4'2-year loan at IV2 percent for the $20,000 balance which the company normally requires. (4) Small Business Administration Program. SBA has also undertaken a program to identify responsible franchisors who are interested in reaching minority group franchisees. As part of SBA's Project Own — now known as Operation Business Mainstream — franchisors have been encouraged to participate actively in SBA's effort to identify specific business opportunities for minority entrepreneurs. As in- terested franchisors have satisfied SBA that they can docu- ment their records of past or potential franchisee success, SBA has prepared very simple "opportunity bulletins" re- garding the franchise for distribution by SBA offices to interested groups in areas where franchises are available. Information about interested franchisors has also been made available to local SBA offices to assist them in mak- ing a decision on any application for financial assistance by a potential franchisee of the interested franchisor. Some of these franchisors have also adjusted their fee schedules and training programs to make them more responsive to the problems of minority franchisees. (5) Minority Franchisor's Potential and Problems. Some minority-owned franchisors have opened franchised units and are actively seeking franchisees. Because these fran- chisors are owned by minority group individuals, it is rea- sonable to expect that their management may be more sympathetic to the particular problems and interests of minority group franchisees. Hopefully, more minority-owned franchise operations will develop and prosper; certainly, they should if the in- dividual franchise systems prove themselves to be well conceived and well administered. It is important for the potential franchisee to remember, however, that the race of the ownership is hardly the best criterion on which to judge the profit potential of a franchise. When a franchisee pays out his own or borrowed cash, he should be satisfied that the franchisor is capable — and not just willing — to produce what he promises. The franchisee is paying for a desirable product, training, and assistance in opening and operating his franchise — and he should be sure that the franchisor is capable of delivering those ingredients. LOCATING, SELECTING, AND QUALIFYING FOR THE FRANCHISE 14-7. Since hundreds of franchise companies are now existence, with more being created each day, trying t< select the franchise best adapted for an individual entre preneur's needs is no simple task. In the end, the judgmer obviously must be his own. Nevertheless, his judgment ca be more accurate if he knows what he is looking for an understands the criteria on which his selection should made. As stated earlier, the selection process may b greatly assisted by the advice of a competent busines lawyer or an experienced businessman. Sources of Information and Their Use 14-8. Numerous sources provide information about avai able franchises. Two government agencies have a particula interest in identifying franchisors who are willing to mak franchises available to minority businessmen — the Offic of Industry Relations of the Small Business Administr; tion 5 and the Office of Minority Business Enterpri; (OMBE) of the U. S. Department of Commerce. Several other sources provide information which may particularly valuable in getting a general impression of tr nature, criteria, and addresses of various franchisors: National Franchise Reports, 333 North Michigan Av< nue, Chicago, Illinois 60601, annually publishes a sped; edition, The Franchise Annual, which may be purchase directly from NFR for $2.75. The Annual lists franchi: companies by product or service provided, along wit other details on franchise industry developments. The Franchise Journal and Modern Franchising are boi magazines devoted entirely to franchising. They conta advertisements of many franchisors and other informatic of interest to franchisors and franchisees alike. The offic of Franchise Journal are at 892 West 16th Street, Ne\ port Beach, California 92660. Modern Franchising's offic are 1033 First Avenue, Des Plaines, Illinois 60016. Another publication which is older (1968), but whic has a good breakdown of basic information regarding tl franchisors included, is Franchise Company Data /< Equal Opportunity in Business a publication of the Busine and Defense Services Administration, Department of Cor merce, Washington, D.C. 20230. The International Franchise Association can also pr vide information about its more than 200 members. Ti IFA is the major trade association of franchisors in tl nation, and most of the more established franchisors a members. Although its primary concern is with matte of direct interest to its members, it has also been in t forefront of most efforts to eliminate questionable pra tices by franchisors and to prepare statistical informatic on franchising. 7 A final source of information about franchising a franchisors is the Center for the Study of Franchise D tribution and Smaller Business, Boston College, Phil maethia Hall, Boston, Massachusetts 02167. The exister of the Center is itself testimony to the growing importar of franchising in the economy. There is also an evergrowing list of publications abc franchising. Section 14-17 lists some publications whi 4 For information, contact International Franchise Associate address is listed in Section 14-8. Discussed in Section 14-6. " This office, formed in 1969 within the U.S. Department of Co merce, has indicated a special interest in stimulating francr opportunities for the minority businessman. The address of the of] is the Department of Commerce. Washington, D.C. 202.10. 7 It has been deeply involved in SBA's Operation Business Ma stream discussed in Section 14-6. The address of the IFA is One Wacker Drive, Chicago, Illinois 60601. 68 can be particularly helpful both as sources of informa- tion about franchising in general and as some indication of the service or product marketed by specific franchisors. Initial Communications With the Franchisor 14—9. In any case, the final decision regarding the acquisi- tion of any specific franchise will be made by the appli- cant for the franchise and the franchisor. In most cases, the initial inquiry from a potential franchisee will merely result in the franchisor mailing an information packet re- garding the franchise to the inquirer. The packet normally contains an information sheet which the franchisor will ask the interested applicant to return for use by the franchisor in determining whether further negotiations with the applicant are desired. For this reason, it is usually not necessary that the initial letter of inquiry to the franchisor contain a care- fully prepared documentation of the interest, funds, and ability of the franchisee. Nevertheless, the initial letter should be neatly prepared and intelligently written, since some judgment may be made by the franchisor from that initial inquiry and the inquiry will become part of the applicant's file to which the franchisor will be referring in making its future determination. Selecting the Franchise 14-10. In most cases, the information received from a franchisor will be an attractive packet of materials de- scribing the franchise in rather general terms. Remember that this is publicity; the actual obligations of the fran- chisor and franchisee are set forth in the franchise agree- ment and other accompanying legal documents. (1) The Proposed Franchise Agreement. As soon as pos- sible, the applicant should insist on obtaining a copy of the proposed franchise agreement and all other legal docu- ments which he would be required to sign in order to obtain the franchise. The agreement should be examined by a competent business lawyer and discussed with the applicant before the applicant sits down with the fran- chisor's representative to sign on the dotted line. Although franchisors often argue that their agreement cannot be changed in any way, it is the author's experience that adjustments to eliminate a particularly unfair clause can be made in many instances if a sound argument is presented to justify the proposed change. An opportunity to examine the agreement is also im- portant because of the generality of the advertising mate- rials which are normally distributed. Careful analysis of the franchise agreement makes it possible to determine the actual costs involved, as well as the fairness of the agreement. (2) Actual Profit and Loss Statements. The potential fran- chisee should see profit and loss statements for both the franchisor and some of its franchisees. Do not confuse a pro forma statement or estimates with actual profit and loss statements. From these profit and loss statements, a potential fran- chisee can get a good idea of what his actual costs may be and how long it will be before a profit can be expected. It also gives him information about the franchisor to com- pare with the franchisor's representations and advertising. Although many franchisors say they cannot make profit and loss statements available because they are "confiden- tial" or unavailable, in most cases, this is simply not true. If a franchisor has nothing to hide and is seriously in- terested in giving an honest view of his franchise potential, he will produce the requested statements. The actual profit and loss statements can serve another valuable purpose. Although the great majority of reputable, well-operated franchises can provide a reasonable income to the franchisee, and quite a few franchises can provide a very substantial income, not all franchise operations are successful. In some cases the profit potential does not exceed, or may even be less, than can be obtained through regular employment or independently operated businesses. The only way that the profit potential of the franchise can be determined is by an examination of profit and loss statements of other franchisees operating under reasonably similar circumstances. CHECKLISTS FOR SELECTING THE FRANCHISE 14-11. Below are some of the questions the applicant will want to ask about the franchisor itself. The applicant probably will not be able to obtain each and every in- gredient in the franchise agreement that he would prefer, but the checklist can make it possible for him to know if there is further reason for negotiation regarding the terms. About the Franchisor (1) How many years has the franchisor been in operation? (2) How many franchises have been sold and how many are actually operating? (3) How many company-owned stores does the fran- chisor have and has the number increased or decreased over the last 3 years? (4) How many franchises have failed or been resold by franchisees in the past few years? (5) Is the franchisor willing to show you actual profit and loss statements of other franchisees? (6) How large is the administrative and field staff of the franchisor and what experience has the staff had in franchising? (7) Is the franchisor adequately financed to carry out its proposed plan of expansion and franchisee assistance? (8) What can the franchisor do for you which you cannot do for yourself? (9) What is the distinctive trademark, mark, system or product of the franchisor, and how is it protected? For example, is there a copyright on it, is it trademarked, or can anyone use the name, the distinctive coloring on the store, or the product or system? In addition to wanting to know certain information about the franchisor himself, the potential franchisee will also obviously need to know certain information about the terms of the actual franchise. Below are some ques- tions, divided into subject matter areas, which the fran- chisee should ask about each franchise in which he is interested. About the Franchise Itself Cost: (10) What is the total investment required for the franchise? (11) How is the total investment allocated between franchise fee, equipment, signs, goodwill, training, adver- tising, etc.? (12) How much money does the franchisee need at the very beginning? (13) How much working capital will be needed? (14) What kind of financing arrangements and terms are available through the franchisor? 69 Location and Building: (15) Will the franchisor assist the franchisee in finding a good location for his franchise? (16) If so, what procedure is used? (17) Does the franchisee get an exclusive territory for the length of the franchise, or can the franchisor sell other franchises in his territory? (18) What procedure is used for obtaining the neces- sary building? Purchase? Lease? Sub-lease? (19) What costs can the franchisee anticipate for prop- erty taxes and insurance? Supplies and Equipment: (20) Must equipment be purchased or leased from the franchisor? (21) Must the franchisee purchase his supplies from the franchisor? (22) Does the franchisee have to purchase a certain quota of supplies from the franchisor? Does he have a sales quota? Advertising: (23) Does the franchisor operate a central advertising program for which the franchisee must make payments? (24) If so, does the franchisee receive an accounting for franchisor advertising expenses? Are unused funds re- turned to the franchisee? (25) If not, what assistance does the franchisor provide to the franchisee in carrying out his own program? Franchisee Training and Operations: (26) What is the length and nature of the franchisor's training program? (27) Who must attend the training program? (28) Who pays the cost of the training program? (29) What assistance and supervision is provided by the franchisor after the franchisee begins operations? How often and by whom? (30) Must the franchise be open certain hours and days? Termination of the Franchise: (31) What is the term of the franchise? (32) Under what circumstances can the franchisor ter- minate the franchise before the end of the term? (33) Does the franchisee have a period of time in which to "cure" a default before the franchisor can ter- minate? (34) Does the franchisee have the right to renew the franchise at the end of the term? At what additional costs? (35) Under what circumstances may the franchisee ter- minate before the end of the term? (36) If either the franchisor or the franchisee terminates the agreement, are any fees returned to the franchisee? (37) May the franchisee sell the franchise? When, how, to whom, and at what cost? Each of the questions listed above could potentially be of major importance to any franchisee. In most instances, the reason for asking the question and the nature of the answer which the franchisee should be entitled to expect are apparent from earlier discussions in the text and the context of the question itself. COST OF A FRANCHISE 14-12. The cost of a franchise obviously depends on what the franchisee is buying. The average cost of the fran- chises offered by the more than 200 members of the Inter- national Franchise Association has been computed at $23,200. In general, franchisors in the same line of busi- ness tend to have similar franchise fees and other charges. They are competing for franchisees. The important thing for the potential franchisee to know is what kind of fran- chise he wants, what each franchise costs, and what each franchise has to offer. Most franchisors require the payment of a specific, one- time "franchise fee" at the time the franchise agreement is signed. How this franchise fee is used differs from fran- chisor to franchisor. In most cases, however, the franchise fee is not the only payment to the franchisor which the franchisee will have to make. There will be other initial payments and probably more periodic payments throughout the term of the franchise. (1) Continuing Royalties and Fees. In addition to the initial franchise fee, most franchisors charge a continuing fee or royalty to the franchisee, which may be used for purposes such as meeting the expenses of supervising the network of franchisees. Sometimes, there will also be a separate "advertising fee" which is applied to the national advertising program of the franchisor on the theory that such a publicity program is of benefit to all franchisees. The important point to keep in mind regarding these continuing fees is that most such fees are based on a per- centage of the gross income of the franchisee. Since gross income is computed before subtracting the expenses of operating the franchise, it may mean that the franchisee will have to make continuing payments to the franchisor although the franchisee is actually losing money on his franchise. Among the other initial payments which the franchisee may encounter is the fee for his training or the training of other operating personnel. In some instances, the fran- chisor will include this charge in the franchise fee or will at least pay the franchisee for the period when he is re- ceiving training in a company-owned facility. Another payment usually made directly to the franchisor is the charge for the purchase of equipment needed to op- erate the franchise. In some instances, equipment can be purchased through other sources, but many franchisors have specially designed equipment for their franchise out- lets. Although it is usually illegal for the franchisor to insist that the franchisee purchase the equipment only from the franchisor if the franchisee can obtain the equip- ment from other sources, it is usually more convenient and no more costly for the franchisee to buy through the franchisor. Some franchisors make a profit on the sale; others sell at cost. Whether the equipment must be paid for in one lump sum or can be financed over a period of time depends on the individual franchise. Another major cost in franchises which requires the use of a specially designed facility — such as motels or fast- food operations — is the cost of acquiring land, construct- ing the facility, and installing the necessary fixtures. This is often the most expensive part of any franchise operation. In most cases, however, the necessary construction or renovation can be financed in a variety of ways. For in- stance, some franchisors will arrange to have the facility built by a third party, or will build it themselves and then lease the facility to the franchisee. During the early months — or even years — of a franchise operation, the franchisee must insure that he has adequate "working capital" to meet the day-to-day expenses of the franchise. Adequate funds must be available to meet cost of payrolls, utilities, insurance, taxes, advertising, inven- tory and supplies, business licenses, and all the other con- tinuing costs of any business. (2) Adjustment of Fees and Terms. In discussing with any franchisor's representative the fees charged by his company, the potential franchisee may decide that some adjustments are needed in order to make it possible for him to acquire a franchise. Not all franchisors will be responsive to such 70 a request, but it may be helpful for the franchisee to point out the adjustments which have been made by some of the franchisors referred to above, such as International Indus- tries. Although the franchisor may not waive a fee en- tirely he may decrease his profit margin somewhat or agree to extend the period of time in which payment must be made. The existence of these or other payments or fees does not mean that the franchisee is getting an unfair deal; the franchise may be worth every penny. Nevertheless, any potential franchisee should be certain that he understands what the initial and continuing payments to the franchisor and other parties will be. If he is comparing several dif- ferent franchises — as he should be — he should list the fees and charges for each of the franchises, along with the probable income from the franchise. Rather than relying solely on the publicity of the franchisor, the franchisee should compare figures which he has obtained from actual profit and loss statements of other franchisees of the par- ticular franchisors. This subject is discussed more thor- oughly later. FINANCING THE FRANCHISE 14-13. A few potential franchisees may have in cash all the capital they will initially need to acquire and operate a profitable franchise, but most franchisees — and not only minority franchisees — need some financial assistance from other sources. It is the rule, rather than the exception, that part of the income from the franchise is used to pay off loans from some source. Financing is discussed in Part III of this book, but it may be helpful to review briefly, from the point of view of a franchisee, some of the sources which may provide part of the capital needed. (1) Input by the Franchisee. Both the realities of fran- chise operation and the requirements of most financing institutions normally make it impossible to borrow all of the funds which may be needed. In addition, many fran- chisors strongly believe that any franchisee should have some of his own money in the franchise. They argue that unless the franchisee gives something of his own, it is too easy for him to throw up his hands and walk away from some of the inevitable problems which any small business- man may face, particularly in the early years of his busi- ness. This argument becomes irrelevant, of course, if the franchisee has personally borrowed the money to acquire the franchise, since he is then obligated to repay that money. The franchisee is just as interested in accumulating the profits to do so as is the franchisee who has every penny when he begins. (2) Borrowing from the Franchisor. Many franchisors can either arrange financing for or make a direct loan to the franchisee. The use of the franchisor's financing sources can be particularly helpful since the franchisor is familiar with a franchisee's problems and particularly with those of his own franchisees. In most cases, however, financing through the franchisor is limited to the financing of equip- ment needed by the franchisee to open his business. Financ- ing of equipment is usually the easiest part of the financing to obtain, since the lender has the equipment itself as par- tial security for the loan. (3) Borrowing from Commercial Sources. When borrow- ing to acquire a franchise, the franchisee must be able to realize an adequate income after making his regular pay- ments of loan principal and interest. The franchisee should have a clear idea of his anticipated income and expenses. This can be estimated, in some cases, by comparing actual profit and loss statements of other franchisees operating under similar circumstances. 8 A franchisee applying for a loan should be able to demonstrate by specific facts and figures what his esti- mated income and costs will be. Unless he can convince the financing source that his franchise will produce the income which is needed, no loan will be forthcoming. (4) Information to be Prepared for the Potential Lender. Among the information which the franchisee should have in hand when he seeks to borrow money: ° (a) A description of the franchisor and his franchise program. (b) A projected profit and loss statement for the first year of operation. This can be prepared from state- ments of other franchisees of the franchisor who were operating in similar surroundings. These statements should be available to prove that the franchisee has facts to back his figures. (c) A written estimate of how much money the fran- chisee will need altogether, how much he will need to borrow, how much of his own he will have available, and how much will be available from other sources. (d) A list of the personal assets and debts of the franchisee and of the collateral that will be available for the loan. Familiarity with the above items will give the lender some confidence in the franchisee's capabilities and repay- ment potential. It may also be possible and helpful to have a representa- tive of the franchisor accompany the franchisee when he goes "money-hunting." NEGOTIATING KEY CONTRACT TERMS 14-14. Most franchisors have a standard franchise agree- ment. Very often the standard agreement is printed and thereby gives the impression that terms of the agreement are unchangeable. Such a printed or standard form should never deter the prospective franchisee and his advisors from attempt- ing to negotiate changes in the standard agreement. For example, the franchisee should not agree to con- fession of judgment clauses. He should be wary of clauses in the typical franchise agreement that confer broad juris- diction on a court, often located in an inconvenient place, and of clauses which confer equity jurisdiction on the court and permit ex parte injunctions, etc. The prospective franchisee should obtain expert advice in studying every detail of a proposed franchise agreement. Special attention should be given to ( 1 ) the terms under which the franchise may be cancelled or terminated and (2) the terms under which the franchise may be sold or transferred. Cancellation or Termination of the Franchise 14-15. Most franchises require a substantial investment by the franchisee. A franchisee should enter into a franchise relationship anticipating that it will be a long-term and profitable one for both the franchisor and franchisee, but he should be quite clear as to the circumstances under which the franchise relationship may be brought to an end. First of all, the term of the franchise agreement should be sufficiently long to permit the franchisee to recoup his investment and make a reasonable profit on that invest- ment. In other words, if the franchisee must invest $25,000 in a franchise, it would not be reasonable for the term of the franchise to be only 1 or 2 years. At the end of the 8 See Section 14-10. o For information concerning sources of financing, see Part III of this book. 71 short term, there would be no reason, under existing law, why the franchisor could not refuse to permit the fran- chisee to continue to operate the franchise. Short franchise terms would not present any major prob- lem, however, if the franchise agreement gave the fran- chisee an automatic right to renew the franchise for an additional term. The question which would then arise would be whether an additional fee for renewal would be charged, which could make it impossible for the franchisee to re- cover and profit from his investment. A right of automatic renewal also has the disadvantage of making it improbable that the franchisee fee could qualify for the depreciation allowance permitted as an income tax deduction for intangible property rights. With an automatic renewal provision, it becomes difficult to determine the useful life of the franchise — a determination which is essential under Internal Revenue Code Section 167 in order to qualify for the deduction. In most cases the preferred choice would be to have a long-term fran- chise agreement. Few franchisors today attempt to limit the franchise agreement to a short term. Instead, terms of from 10 to 25 years are common. Even under these longer term agreements, however, the question arises as to the condi- tions under which the franchisor may "terminate" or "cancel" the agreement. Under no circumstances should a franchisee sign an agreement which permits a franchisor to cancel or terminate the agreement at will. (There may be an exception to this rule if the agreement provides for adequate notice to the franchisee and for reasonable compensation to the fran- chisee for the present and potential value of the franchise. More will be said about such "buy-back provisions" later.) The franchise agreement should specify the reasons for which the franchise may be terminated by the franchisor or should at least make it clear that termination cannot occur except for violation of one of the provisions of the franchise agreement itself. The franchisee should also insist that the franchise agree- ment specify that the franchisee must be notified in writing of any alleged violation of the franchise agreement for which termination could occur. Furthermore, the franchise agreement should give the franchisee a reasonable and specific period of time in which to "cure" the violation. Although there are cases in which immediate termination of a franchise agreement by a franchisor would be reasonable, a franchisee should have no hesitation about requiring the franchise agreement to specify what those circumstances are. Sale or Transfer of the Franchise: Limitation, Valuation, and Taxation 14-16. Most franchise agreements do not permit the fran- chisee to transfer or sell the franchise to a third party with- out approval of the proposed franchisee by the franchisor. When properly used, such a restriction is not unfair, since the franchisor understandably wants to be sure that the party who will be operating the franchise will meet the standards which the franchisor believes are essential to protect the reputation and operational efficiency of his franchise system. Nevertheless, the franchisee has an interest which deserves protection against undue controls over transfer. He has made a substantial investment in the franchise. He may also face a variety of situations — such as ill health, a desire to retire, or a chance to realize a substantial profit — which give him a valid reason for assuring that sale or transfer can be made under reasonable circumstances. A franchise agreement which absolutely prohibits any sale or transfer of the franchise is overly restrictive. Most reputable franchisors merely require that the franchisoi be given an opportunity to approve the proposed buyer oi transferee of the franchise. The franchisee should, however require that the franchise agreement specify that "approva will not be unreasonably withheld" and should also specif) the period within which the franchisor's approval o disapproval must be given. An increasing number of franchise agreements providi that the franchisor will have "a right of first refusal" to bu> the franchise if the franchisee proposes to sell or transfer If a sale is anticipated, it is not unfair to permit the franchisor to repurchase the franchise at the same pric< and on the same terms as those for which the franchise* proposes to sell. Again, the franchisor should be required tc exercise the right of first refusal within a specified, reason able period of time to prevent the loss of a sale by the franchisee. The franchisor may also require a "first refusal" right a the time of any other transfers — such as when a franchise! dies or transfers his franchise to his son. Here, no specifii offer has been made for the franchise and some othe: method of valuation must be reached. In many cases, i would be unfair to permit the franchisor to repurchase < successful, operating franchise with an established clienteli at the original cost to the franchisee. Some franchise agreements resolve the valuation prob lem by specifying a procedure under which the value ol the franchise will be established by arbitration. This procedure may be fair, but it can also take time, as wel as adding the cost appraisal. A few franchisors now specify that the price of repurchase will be at a certain multiple o the aftertax earnings of the franchise for the previou operating year. An increasing number of franchisors are including "buy back provisions" in their franchise agreements which permi the franchisor to repurchase the franchise from the fran chisee at his discretion. From the point of view of the fran chisee, such a provision is probably not desirable, but i may be acceptable under certain circumstances. First of all, the fair valuation problem discussed above should be resolved in the franchise agreement. Secondly the form of payment by the franchisor should be clarified Instead of receiving a note of the franchisor payable several years or stock of the franchisor, the franchisee may want to have the option of obtaining the "buy-back price" at least partially in cash. The franchisor's note or stock may not have a ready market and, as a result, may have little cash value. If the franchisee does not need cash, the non cash buy-back arrangement may present no real problem. A strong argument can be made for an exchange of stock instead of cash, however. An exchange of stock for the assets of the franchise makes it unnecessary for the selling franchisee to pay tax at the time of exchange or any appreciation in the value of the franchise assets which may have occurred during the franchisee's ownership. From the point of view of the franchisor, the opportunity to exchange stock or his note is important because it eliminates the need to pay out cash which may be needed for other purposes which will enhance the value of the franchisor's stock. With these factors in mind, the franchisee should anticipate as best he can what his cash needs and tax status will be in the future and should resolve this problem accordingly. These and other tax problems which may arise in the formation and operation of a franchise are basically the same problems which are commonly encountered by any small business: whether a sole proprietorship, partnership or corporate form is desirable; the effects of contributions to capital in the form of equity, debt, and services; the 72 compensation of managers, partners, and shareholders; the effects of transfer of the franchise; depreciation and busi- ness expense deductions, etc. 10 BIBLIOGRAPHY 14-17. For more detailed information on franchised businesses, the fol- lowing sources should be consulted: Cavitch. Zolman. Business Organizations, vol. 15, Matthew Bender & Co., 1963. Directory of Franchise Organizations, 1969, Pilot Books, 347 Fifth Avenue, New York, N.Y. 10016. 64 pp. ($2). List of names, addresses, and businesses of more than 500 franchisors. Jones, Thomas B. How the Negro Can Start His Own Business, 1968, Pilot Books. 347 Fifth Avenue, New York, N.Y. 10016. ($2). Kursh, H. The Franchise Boom, rev. ed., 1968. Franchise Annual, National Franchise Reports, 333 No. Michigan Avenue, Chicago, 111. 60601. Lists names, addresses, and businesses of 900 franchisors and 53 consultants to franchisors. Seltz. D. D. How To Get Started in Your Own Franchise Business, 1967, Farnsworth Publishing Co., 381 Sunrise Highway, Lynbrook, N.Y. 11563. 197 pp. ($10). Provides arguments for and against fran- chising and points to consider in selecting a franchise. Lists franchise opportunities and contains copies of representative franchise contracts. Zeidman, Philip F. "The Negro Businessman," Vital Speeches of the Day, vol. 34, No. 7, Jan. 15, 1968. Analysis of the history and potential of minority small businessmen. "Franchising and the Negro Businessman," program on franchising opportunities sponsored by the Interracial Council for Business Opportunity (ICBO) of New York at the Columbia Univer- sity Business School, May 13, 1967. Special Issue on Franchising, New York University Institute of Re- tail Management, 432 Commerce Building, Washington Square, New York, N.Y. 10003. ($3.50). Facts About Franchising, National Better Business Bureau, 230 Park Avenue, New York, N.Y. 10018. 1965. 10 pp., free. Describes ad- vantages, disadvantages, and characteristics of franchise system. Continental Franchise Review, P.O. Box 6360, Denver, Colo. 80206. (26 times a year, $26). Discusses in concise form matters of interest to franchising industry, including legal issues of relevance, proposed legislation, economic data, and financial information. "Some Things To Look for in Franchise Agreements," 31 Ala. Lawyer 65. January 1970. Points out most important provisions in franchise agreements. "Franchise Contract," 14 Antitrust Bulletin 325. Summer 1969. Discusses the contract as being fair, frank, and enforceable above all things, and includes general provisions, start-up provisions, operating provisions, and termination provisions. "Franchising in the Ghetto," 25 Bus. Lawyer 73. September 1969. Article edited from a symposium, analyzing what a franchise is, its advantages, its problems, etc. Discusses choosing a franchise, starting the operation, operating under the franchise, and terminating the franchise. "Making Franchises Available to Ghetto Businessmen," 25 Bus. Lawyer 91. September 1969. Describes human side of dealing with ghetto franchises, as advanced by the Manpower Development Inter- nation Industries, Inc., Beverly Hills, Calif. "Realities of Franchising," 93 Commercial L.J. 371. December 1968. "Financing Franchise Expansion," 74 Commercial L.J. 69. March 1969. 'Present Posture on Franchising," 19 De Paul L. Rev. 102. Autumn 1969. "Article Two of the Uniform Commercial Code and Franchise Distribution Agreements." 1969 Duke L.J. 959. October 1969. "Selected Checklist on the Legal Aspects cf Franchising," 24 Record of the Association of the Bar of the City of New York 262. April 1969. "Some Antitrust Problems in Terminating Franchises," 44 St. John's L. Rev. 23. July 1969. Article to read before terminating a franchise agreement. "Federal Taxation of Franchise Sales," 44 Wash. L. Rev. 617. Spring 1969. Involves the tax treatment to be accorded the proceeds of a franchise transfer. Gross, H. and R. Levy. Franchise Investigation and Contract Negotiation, 1967, Pilot Books, 347 Fifth Avenue, New York, N.Y. 10016. Brown, H. Franchising: Trap for the Trusting, 1969, Little, Brown & Co., Boston, Mass. i ft An analysis of some tax issues of particular interest to a franchisee may be found in Business Organizations, Volume 15, (Matthew Bender & Co.). More extensive analyses of specific Federal tax issues may be found in any of the loose-leaf tax services available in any law library, such as Rabkin & Johnson (Matthew Bender & Co.) and Federal Taxation (Commerce Clearing House). 73 Section 15 COOPERATIVES WHAT IS A COOPERATIVE? 15-1. Today many different enterprises are organized in a cooperative way: food, furniture, optical and drug stores, farming, handicraft manufacturing, housing, market re- search, and domestic services. The word "cooperative" does not by itself denote a distinct type of legal entity. A useful general definition, one which includes the few factors which all of the above operations have in common, is as follows: A cooperative is a group of people faced with a common need who meet that need by organizing to own, control, and patronize their own enterprise. The members organize their own enterprise in order to serve those who use it — not to make money for investors. They want to do something for themselves that no one else has been doing for them. Some cooperatives have been highly successful — par- ticularly in the field of credit unions and in the production and marketing of agricultural products. However, low- income consumer cooperatives have had a high rate of failure. This means that special care should be taken in considering proposals for new co-ops. It is most important not only to consider the theory of cooperatives and all relevant laws but also to realistically weigh the chances for success of the specific cooperative being proposed. A brief bibliography on cooperatives appears in Section 15-16. Co-Ops Compared with Corporations 15-2. Several characteristics of the co-op method of organization which are of special interest to Local Eco- nomic Development Companies may best be introduced by means of an illustration: A co-op supermarket com- pared with an A&P supermarket. (1) Shareholders in a co-op supermarket are the shoppers themselves. There are no large numbers of out- side shareholders as in the case of A&P, since share ownership is an investment with little return except in the form of patronage refunds. Therefore, the shoppers' share- ownership gives them a significantly greater voice in the policies of the supermarket than, say, an A&P shopper who is at the same time an A&P shareholder. (2) An A&P shareholder has as many votes as he has shares. A co-op shareholder has only one vote, no matter how many shares he may hold. (3) The only returns to the co-op member are refunds in proportion to what he has spent at the supermarket, unlike the A&P shareholders each of whom receives an equal amount per share (per class). (4) The profits of the co-op supermarket can be dis- tributed as patronage refunds to its shareholders without being taxed as corporate income. 1 Co-ops are taxed, how- ever, at regular corporate tax rates on any earnings retained by the business. On the other hand, while the returns on money invested in an investor-owned corporation can be unlimited, the dividends on user-owned co-ops are usually limited to maximum of 5 to 8 percent (29 DCCE 822; N.Y. Coopera tive Corporation Law Section 72). Rochdale Principles 15-3. The first cooperative principles were followed by the Rochdale Society formed in England in 1844. Some of the key principles, many of which are explanatory of the significance of co-ops, follow: (1) Open Membership: Membership in a co-op is open to all, regardless of race, color, class, or creed as long as they share the common interests of the co-op. (2) One-Man-One-Vote: Control of a co-op is in the hands of its members. Each member has one vote and only one, regardless of the number of shares he may have. (3) Limited Interest on Invested Capital: The member receives a fair but limited return on his investment. This is to discourage speculation and encourage true cooperation. (4) Patronage Refunds: Surplus profits are distributed each year in proportion to the members' use of the co-op's services. Those members who utilize the co-op more will receive a larger refund. (5) Cash Sales: Co-ops do business for cash. When members need credit, arrangements are sought with a credit union or some other lending institution. (6) Sales at Going Market Prices: Co-ops sell to their members at the same prices charged by other businesses. This is in order to support the co-op's growth and services. Most of these principles have been incorporated into the various State cooperative acts. Changes in Usage for the Low-Income Co-op 15-4. At first glance, the co-op appears to be an institution particularly well suited to disadvantaged areas, since low- income residents can own, manage, and control the institution that serves them — features which other sections of this book stress. On the other hand, the original "Rochdale Principles" set forth above may not necessarily fit the needs of that very same group of low-income citizens. (1) Examples of exceptions to the principles of open membership can be found, for instance, in marketing co-ops. There the existing capacity of the co-ops might be exhausted in helping present members. Additional members might cause the breakdown of the entire co-op if admitted too rapidly. Some co-ops in the service field, where the employees are the members, feel that employees should not be accepted as members until it is clear that they share the common interests of the co-op. Sometimes tenure alone is enough to indicate this interest; in other cases member- i Treasury Regulation Section 1.522-3(a) (1958). 74 ship committees are used to pass on applications for mem- bership. (2) In the case of the one-man-one-vote rule there have also been defections from the principles in low-income communities. Some co-ops have set up nonvoting stock for nonresidents of the low-income community. Other low-income co-ops, with the emergence of the antipoverty program, have endeavored to set up separate classes of stock to allow organizations to be represented within the membership. Some States permit unequal voting rights as well as allowing the one-man-one-vote principle in their co-ops. The New York Cooperative Corporations Law (Section 46) provides that the co-op "may provide in its certificate for proportionate or unequal rights of its members, based upon the patronage of said members except that no member shall be entitled to more than one vote in any case in which a statute requires the affirmative vote of a majority or more of the members . . ." 2 The Mississippi Cooperative Law directly does away with the principle for agricultural co-ops by allowing voting only on the basis of the number of shares a member owns (Miss. Code Annotated, Chapter 5, Article I, Section 4485). (3) The question of the changing use of patronage re- funds is a particularly interesting one and is covered in Section 6-14, "The Problem of Distribution of Coopera- tive Income." (4) When we reach the question of cash sales we reach a problem of major significance to low-income communi- ties. In certain types of co-ops, such as a farming co-op marketing sweet potatoes or a furniture co-op selling furniture to low-income people, credit is a necessity. For the supermarket customer this is a less frequent problem, but the low-income farmer needs immediate cash for his crop, and the low-income consumer needs credit in order to make major purchases and has few sources to meet that need. The hundred-year-old plus Rochdale principles may be in severest danger with this principle. Already low-income co-ops throughout the United States are seeking other sources of credit from loan companies, finance com- panies, or extended bank credits. The fact is that even middle-income co-ops are troubled by the principle of cash sales when faced with the high-pressure usage of credit that goes on today. (5) Again, in the area of selling at the going market prices, the Rochdale principle is being challenged. Truth- fully the defections in this area have occurred more often because the going market price in low-income areas is much higher than in other areas. With this principle, as with the others, the cooperators have to face up to the needs that exist in our nation's low-income areas. To be successful, low-income co-op principles must reflect those needs. FORMS OF COOPERATIVES 15-5. The popular conception of a co-op is solely of an organization owned, managed, and controlled by the consumer. In fact, co-ops include a vast number of differ- ent organizational arrangements. One co-op supermarket sells goods at the wholesale rate, pays no patronage refunds, and lowers operating expenses through a service fee. Another vastly different form is where the consumer who actually buys the end-product is not a member of the co-op. Examples of co-ops working this way are producer co-ops (such as tomato farming) and service co-ops (such as cleaning services). In fact, the co-op has been used to carry out just about any business purpose, some- times to the distress of some of those overseeing our co-op laws. We can, however, divide the co-ops in this country into at least three distinct groups: (1) the Con- sumer Cooperative, where the consumer who purchases the product of the co-op is also the cooperator; (2) the Pro- ducer Cooperative, where the cooperators are the people who produce the product to be sold to nonmembers of the co-op; and (3) the Service Cooperative, where the coopera- tors are the people who are selling services to nonmembers of the co-op. Consumer Cooperatives 15-6. The consumer co-op is used in many different ways by the consumers who control it. Legally its form ranges from an unincorporated membership association to share- selling co-op corporations. Just about any consumer co-op corporation can evolve from an unincorporated association when its needs call for the greater protection and flexibility afforded by a corporation. (1) Unincorporated Associations: Buying Clubs. The best known form of such an unincorporated consumer co-op is the buying club. A buying club is an organization of people who buy goods cooperatively in large quantities at a wholesale price. The membership of such clubs has numbered from 20 persons to many hundreds of people. Members are able to buy goods through the club at a price well below the price charged at a neighborhood store for the reason that, in addition to wholesale purchasing, costs are cut because the members do the buying, packing, and waiting on customers. Free space for the club is often obtained in a church basement, housing project, or local community action program. The buying club may function on an order basis or as a store. When the club functions on an order basis, members usually fill out an order blank, pay in advance, and receive their goods once a week. When the club functions as a store, it stocks the goods most in demand and stays open daily on a volunteer basis. The fact that the buying club is not incorporated may raise problems relating to liability and responsibility of its members. To this end the buying club can relate itself legally, if possible, to another corporate body for protection. For instance, if the club is related to a church or an anti- poverty program it should seek to have the insurance coverage of the other body extended to cover the club's operations. (2) Larger Cooperatives. In the realm of the legally in- corporated co-ops fall most of the consumer-goods co-ops and housing co-ops. This more usual form of consumer co-op operates within the "Rochdale Principles." The consumer-owner who purchases in the co-op store receives a patronage dividend based on what he has spent in the store over the year. He, as well as the nonconsumer-owner, receives a limited dividend on each share he owns. The stores are open to the general public but the cooperator can receive the maximum benefits from it through patronage dividends. Of course, the shareholders may also use the benefits of their businesses in other ways. Rather than distributing their earnings to themselves they can plow them back into the co-op to meet other business needs of the community by, for instance, declaring the dividends of new shares, or they can use the dividends to maintain community services such as a community center or library. An exception to the usual form of consumer co-op is the Ottawa Co-op begun in Canada in the 1960's and now the - Florida, Illinois, and New Hampshire have similar statues: Fla. Stat. Ann. Ch. 618-15; 111. Ann. Stat. Ch. 32 163,14; N.H. Rev. Stat. Ann. Ch. 301.28. 75 subject of emulation in the U.S. today. The Ottawa Co-op follows the usual co-op principles of one-man-one-vote, membership control, and nonprofit status. It departs from those principles, however, on the question of charging the market rate for its products and declaring patronage dividends. Its cooperators buy goods off the shelf at the wholesale price and pay the cost of operating the store, rent, utilities, and wages through a service fee. One major drawback is that the service fee is uniform for all members. A member representing a large family making large pur- chases is therefore getting much the better bargain than an elderly or single person or the member representing a small family. Other organizations as widely, diversified as memorial societies and nurseries are run as consumer co-ops. Some- times these co-ops are organized for monetary reasons and other times because the services could not be available otherwise. (3) Credit Unions. A credit union is another form of consumer co-op; members pool their savings and borrow from the pooled funds at an interest rate not exceeding 1 percent a month on the unpaid balance. The credit union carries out its powers through a charter granted by a State or by the Federal government, rather than through a certificate of incorporation and accompany- ing by-laws. State credit union leagues throughout the United States assist in the formation of new credit unions. 3 The membership of Federal credit unions is limited to groups having a "common bond of occupation or associa- tion" or to groups "within a well-defined neighborhood, community, or rural district" (12 USCA 1759). Examples of such "common bond" could be a church or the organiza- tion where one is employed. Federal credit unions are chartered and supervised through the Bureau of Federal Credit Unions (12 USC 1752a). With the impact of the antipoverty program and the growth of low-income credit unions, the Bureau of Federal Credit Unions has begun to allow the establishment of communitywide credit unions. This could mean, for ex- ample, that all the residents of a small city could be eligible to join a single credit union. The purpose of en- larging the permissible membership size is to enable credit unions to accumulate larger funds and to lower operation costs, thereby enabling credit unions to serve the needs of low-income communities more effectively. As an example of a State credit union membership restriction, the New York statute limits membership to persons who are members of certain enumerated groups: Employees, club members, residents of towns with popula- tion under 10,000, and "who in the judgment of the super- intendent [of banking] have such a community of interest as will insure proper administration" (N.Y. Banking Law 451). In actual operation interest paid by the borrowers to the credit union pays operating expenses, and the balance remaining after these expenses is paid as dividends to the savers. The money saved in the credit union is accumulated as shares of $5 which enables the savers to be voting owners of the credit union only under the one-man-one-vote princi- ple. In the case of Federally-chartered and most State- chartered credit unions (New York is an exception) the lives of borrowers and savers are insured at no extra cost. A key factor in the credit union for low-income people is that loans are made through a credit committee composed of credit union members. These members may be far more sympathetic to lending money to low-income people or even welfare recipients than the local bank. Good examples of this in New York City are the CABS Credit Union in Bedford-Stuyvesant and the Union Settlement Credit Union in East Harlem. Both have lent money regularly to welfar recipients, and both have done extremely well with re payment. That is because the loans are based on confidenc in and knowledge of the borrower's ability and desire t make good on his loan. As in other co-ops control of the management of th credit union is in the hands of the members. The member elect a board of directors and the credit committee at thei meeting. Producer Cooperatives 15-7. In the category of producer co-ops fall most rura co-ops: farm purchasing and marketing co-ops, as well a co-ops dealing with the manufacturing of handicraft item; Farm purchasing co-ops, where farmers buy together th things they need for their farms and homes, are littl different from ordinary consumer co-ops. On the other hand, the form of the marketing co-op i quite different. One difference, of course, is the distributio of income, which is discussed later. Another is the natur of the co-op itself. The producers of the product joi together to sell through their co-op to the nonmembe consumer. The co-op members have learned, among othe things, that they can obtain better prices for their produc if they market collectively rather than individually. Th co-op turns back to its members money above the cost o selling, storing, or processing its product. Most marketin co-ops pay a good advance price to their members whe their product is turned over to the co-op, the balance bein paid after the product has been sold. The producer co-op is governed in most States by th State cooperative corporation laws. The Capper-Volsteac Act of 1922, a Federal law, is sometimes called the "Magn; Carta" of farm co-ops. It recognizes the rights of producer to act together in associations without being in unlawfu restraint of trade. Service Cooperatives 15-8. Service co-ops are those which sell the skills of thei member-employees to others. An example of this might bi a domestic co-op which offers cleaning services to middli or upper class homes while serving as a sort of free employ ment agency for its members. Another example would be ; market research co-op whose member-employees would d( survey work for major firms and share the co-op's profit in co-op fashion. This form of co-op is relatively new. It would seem tha it too could be incorporated under most cooperative laws both State and Federal. However, the registrar for th< District of Columbia has rejected the application of < domestics co-op for a charter under D.C. 642. It will prob ably take much greater interest in this form of co-op befon it is found to be acceptable or unacceptable under the co-0| law. OPERATIONAL ATTRIBUTES AND PROBLEMS OF COOPERATIVES 15-9. The first question for those who want to organize co-op is: Do you really need one? The following are som< factors to consider: ( 1 ) Is the service that the co-op will offer— super market, food catering, etc. — now available in the area? If i is, can it be improved by a co-op offering these services' To answer these questions it is necessary to estimate the a For further information write to CUNA International, Inc. Box 431, Madison, Wise. 55701: and the Bureau of Federal Credi Unions, Department of Health, Education, and Welfare, Washington D.C. 20201. 76 cost at which the co-op could provide the services. For example, the area might have two supermarkets servicing it adequately but at high prices. A group planning a co-op would have to decide whether it could locate in the same area and, more important, whether it could save its members money and still survive. Many co-ops are formed to im- prove services which already exist. For example, a credit union was formed to improve existing financial services by offering its members lower rates of interest, financial coun- seling, etc. (2) The potential membership of the co-op is a sig- nificant factor. The co-op organizers must determine the potential membership, estimate how much each cooperator will patronize the business, and establish an estimated volume necessary to survive. (3) Management of a simple co-op sometimes can be handled directly by a board of directors, usually through a managing director. However, a co-op usually will need full- time management capable of running the business. An important preliminary question is whether that type of management is available. (4) Location of the co-op is an important question. The reason why there are no food stores at a particular location might be because of zoning regulations which would also prohibit a co-op. (5) The cost of a facility and the equipment needed to run it must be determined; this cost, of course, will be related to expected volume of business. (6) Added to the cost of the facility should be the cost of operating the business. Operating costs should in- clude such items as managerial and employee salaries, utilities, and taxes. When these costs are added up and put together with the volume, per-unit cost for mark-up can be approximated and a determination made of whether a co-op corporation will provide savings for its members. (7) A number of other threshold questions must be answered by the co-op organizers. These include questions relating to management, membership, earnings, incorpora- tion, and raising initial capital. These problems are dis- cussed in the following sections. Incorporation 15-10. In general, the reasons for incorporation of a co-op are the same as those for incorporation of any business or nonprofit entity, these factors are discussed in other sections of this book. Obviously limited liability is highly desirable if, for example, food handled by a co-op caused the illness of a purchaser. Many States have statutes which govern specifically the formation of co-op associations and co-op corporations. Others have statutes which govern the forma- tion and operation of nonprofit corporations. If the State in which one wishes to incorporate a co-op does not have a cooperative corporations law or a nonprofit corporations law, then the co-op may be incorporated under the business corporations law of the State. Even in States which have a cooperative corporations law, some co-ops have found it more advantageous to organize under the ordinary business corporations law. Whether an organization will wish to incorporate in a State other than the one in which its activities are to be carried on will, of course, depend on an examination of local law to determine whether it is flexible enough to permit the kind of organization and operation desired. Co-ops in some States without co-op corporations laws have found the District of Columbia statute the most desirable alternative for organization of consumer co-ops. 4 The sale of stock in a co-op corporation for the most part presents the same problems as the sale of stock in any corporation. See Section 28. State statutes list the requirements for the contents of the certificate of incorporation and by-laws. The certificate of incorporation of a co-op corporation, like those for other types of corporations, usually calls for: (1) name of the corporation; (2) purposes and powers of the corporation; (3) proposed duration of the business; (4) location of the main office; (5) names and addresses of the cooperators; (6) minimum and maximum number of directors; (7) names and post office addresses of the directors until the first meet- ing; (8) whether organized with or without shares and, in some cases, the number of shares or memberships subscribed for. It is wise to be very general in describing the powers of the organization in the certificate. Specifics should be covered in the by-laws. These usually include: (1) require- ments of membership and rights and responsibilities of members; (2) how meetings are set up; (3) how meetings are conducted; (4) what voting arrangements are (most State cooperative statutes require that the voting be one vote per member regardless of how many shares are owned); (5) procedures for electing officers and directors, what their duties are, and how long their term of office is; (6) dates of the fiscal year; and (7) what method will be used to distribute the net savings. Two matters provided for in the by-laws which are more than routine matters in the case of co-ops are the relation- ship between members and management and the distribution of earnings. These subjects are discussed in more detail later. In most States limited liability is granted to the members or shareholders of co-op corporations. The privilege is created either by specific statutory pro- vision of State cooperative corporations statutes 5 or by statutory reference to State nonprofit corporation laws and general business corporation laws." Note that the limited liability granted in New York to co-op corporations, as in the case of corporations created under the New York Business Corporation Law, is not complete. Member liability exists for amounts due to em- ployees for wages, provided the statutory notice provisions are met. It should also be noted that the responsibility for wages is placed on all members and directors, not merely the 10 largest shareholders as in the case of a business corporation. 7 •* District of Columbia Code Encyclopedia, Cooperative Corpora- tions Law 29.801 et seq. r| New York Cooperative Corporations Law Sec 47, provides: "1. Members of a cooperative corporation shall not be personally liable for its debts, unless otherwise provided in its certificate of incorporation; provided, however, that each member and director shall jointly and severally be personally liable for all debts due to any of its laborers, servants or employees, other than contractors, for services performed by them for it as defined by section six hundred thirty (b) of the business corporation law. The liability imposed by this para- graph shall be subject to the notice and limitation of action provisions, set out in section six hundred thirty (a) of the business corporation law, and shall be subject to section six hundred thirty (c) of such law." (As amended L. 1966, c.664; Section 12, eff. Sept. 1, 1967.) "2. Every contract, made by the corporation with third parties, for the sale or other disposition of products which the corporation has contracted with members or non-members to market for them, shall in all respects be deemed to be the obligation of the corporation, whether the corporation made such contract as principal or as agent." See also Illinois Statutes, Chapter 32, Section 327. •"• California Corporations Code, Sec. 12205, provides: "The provisions of Division 2 of Title 1 of this code, relating to nonprofit corporations, apply to cooperative corporations formed under this part, except when such provisions are in conflict with those of this part. Corporations formed under this part have and enjoy all rights, powers, and privileges granted generally to corporations by the laws of this State, except as may be inconsistent with the provisions of this part." See also, California Employment Comm. v. Butte County R.G. Assoc, 154 P. 2d 892 (Cal. 1944); Mandell v. Cole 244 N.Y. 221 (1926); Packel, Law of Cooperatives, 37 Section 6, (3rd ed., 1956). ^ New York Business Corporation Law, Sec. 630. (McKinney 1963). 77 Care should be taken to comply with the proper incor- poration statutes; otherwise the co-op may be held to be a partnership or joint venture, making members liable for debts incurred by their representatives in the operation of the co-op. Out-of-State Cooperatives 15-11. Questions may arise as to the legality and advisa- bility of using a co-op corporation created under the laws of one State as a vehicle for operating in another State. This question will usually arise where a co-op corporation is in existence and operating in a "foreign" State and wishes to expand its operations, but it may also arise in States without special statutes dealing with co-op corporations, or where the provisions of the local statutes dealing with busi- ness corporations make it impractical or impossible to incorporate there. The law is quite clear that, except as to a corporation engaged exclusively in interstate or international commerce, a State in which a corporation does business has the power to require it to become registered or "qualified" in that State before it actually commences business therein. Each State has its own procedures whereby the "foreign" corpora- tion qualifies, and the provisions must be met. "Foreign" co-op corporations are covered either by the State's statute dealing with the qualification of regular business corporations or under special statutes dealing with foreign co-op corporations. New York, for example, has a specific provision dealing with qualification of out-of-state co-ops. 8 While there may be an advantage to incorporating a new co-op in an adjoining jurisdiction because it has simple statutory procedures, there are several disadvantages to doing this which must be considered. (If the co-op will actually be doing business in both jurisdictions, these factors are not as crucial.) These are: (1) The co-op will be required to file under additional statutory procedures because of the need to "qualify" in the State of operation in addition to the procedures to be undertaken in the State of incorporation. (2) Presence in two jurisdictions will increase cor- porate formalities and reporting and, in most cases, total State taxes and fees. (3) Additional expenses, particularly legal and ac- counting, will be incurred. (4) The co-op corporation will be subject to suit in an additional jurisdiction remote from its center of operations, which could cause serious problems in the event of litiga- tion. (5) The co-op corporation, because it is a "foreign" corporation in the State of operation, may be placing its assets under risk of attachment before judgment." Although no definitive conclusion can be reached as to the advisability of incorporating a co-op corporation in a jurisdiction other than the one of operation without examin- ing the specific situation, it will probably be advisable to incorporate the co-op in and under the laws of the State of operation, where possible. Roles of Board and Management 15-12. As adaptable as the co-op may be to the present needs of low-income communities, time after time in co-ops in these communities, tension has arisen between the man- agement and the board of directors because of the lack of clarity as to who makes the decisions and who takes the action. The board has the authority to conduct the affairs of the co-op as the representative of the membership. The board usually delegates the actual operation of the business to manager, but it still remains accountable to the members for its performance. The board's legal responsibility are those delegated in the certificate and by-laws and those defined by the laws affect- ing the organization. Its general responsibility is to establish the basic goals and policies of the co-op. It should employ, define the responsibilities of, and supervise the manager Other responsibilities include approving financial trans actions, communicating with the membership, and planning for the co-ops' future. The manager of the co-op should be responsible for planning a program to carry out the policies and goal: decided on by the board of directors. He is normally respon- sible for hiring employees to do the work. Directors shoulc not interfere with the day-to-day management of the co-op and the manager should not attempt to set policy. Each has a separate function to perform. Finally, it should be notec that many low-income co-ops were originally set up as e tool to organize people, not necessarily to carry a business purpose. Where this is the case, there is often tension be tween those who seek to fulfill a business purpose and those who do not. It should be remembered that a co-op is pri marily a business and should be conducted that way. In many cases the savings and hopes of a great number of people are involved in it. Taxation of Cooperatives 15-13. Co-ops are taxed as corporations under the Internal Revenue Code. Regular corporate tax rates, including the surcharge, are applied to the co-op's taxable income. How- ever, the co-op is permitted to deduct in computing its taxable income "patronage dividends" paid to members or shareholders, as well as certain other types of distributions to members or shareholders. Patronage dividends are amounts — in effect, refunds — computed with reference to the net earnings of the co-op from business done with patrons. 1 " This benefit results in a major difference in the taxation of the co-op corporation as compared with the business corporation. In effect, "dividends" paid by the co-op corporation are deductible; whereas dividends paid by a business corporation are not. The member or shareholder includes the "patronage dividend" in his taxable income and is taxed at normal rates. The special benefit given to co-op distributions eliminates the "double tax" on these earnings first at the corporate level and later upon receipt by the member of shareholder. This is a major inducement for a co-op to make qualified distributions. The value of the benefit is increased by the fact that most members or shareholders will generally be in a relatively low tax bracket, thus providing another incentive to make distributions. 11 N New York Cooperative Corporations Law, Sec. 76. (McKinney, 1951) as amended L 1966 C 664 Sec. 13 (1967). '■> New York Civil Practice Law & Rules, Section 6201 provides: "An order of attachment may be granted in any action, except a matrimonial action, where the plaintiff has demanded and would be entitled, in whole or in part, or in the alternative, to a money judgment against one or more defendants, when: "(1) The defendant is a foreign corporation . . ." io To be a deductible dividend the distribution must be based on the quantity or value of business done with or for the patron, and the obligation to pay the dividend must have existed prior to the cooperative's receipt of the earnings being distributed. Moreover, the dividend cannot be attributable to profits from business done with other patrons to whom equal patronage dividends are not distributed, nor can it be from non-patronage income. Int. Rev. Code of 1954. See sec. 1382 (b), sec. 1388 (a); Treas. Neg. Sec. 1.1388-1 (a)(2) (1963). ii Cooperatives are covered by Int. Rev. Code of 1954, Sec. 1381 et seq. See also 2 Rabkin & Johnson, Federal Income, Gift and Estate Taxation, Sec. 21.07. 78 Distribution of Earnings 15-14. Most State statutes require that a certain amount of the profit be set aside in reserve funds before the net savings can be distributed to the patrons of the various co-ops. The District of Columbia statute, for example, requires that not less than 10 percent be placed in a reserve fund until such time as the fund shall equal at least 50 percent of the capital. 12 This and other statutes also require an amount to be allocated to an educational fund to be used in teaching cooperation. 13 As noted above, in the case of consumer co-ops, if there are profits at the end of the year, they are distributed in proportion to the amount spent by the individual patron. Most agricultural co-ops consist only of farmer-producers. The membership usually does not include other people involved in the marketing of the product, such as canners, packers, pickers, or truck drivers. Farmers receive a set price for whatever produce they submit. This is a set, guar- anteed rate. They may be required to pay a membership fee on the basis of how much they produce. For example, in the Dairymen's League of New York, the membership fee is 3 cents per 100 pounds of milk delivered. This co-op of dairy farmers also requires its members to make loans of 10 cents per 100 pounds of milk produced to a revolving fund which is used to pay for operating costs. The member receives 6 percent interest on this loan and receives the principal back 10 years after he loans it. At the end of each year, if there are profits, the farmer- member's share is related to the amount of produce he has delivered. Difficulty in the distribution of profits arises when co-op members hold different positions. For example, an agricul- tural co-op may include as members pickers, growers, and packers as well as the managers who supervise all these people. A business enterprise run as a co-op may consist of members who are workers, secretaries, clerks, and super- visors. It is debatable whether the members of such a co-op should receive refunds solely on the basis of the number of hours they have worked or whether other factors, such as rank in the business (salary) or seniority, should be taken into account. Reasons for having as sole criterion the num- ber of hours worked include the principle that equal treat- ment is an essential characteristic of co-op endeavor; every- one's work is equally essential to the success of the venture no matter what the position. Furthermore, some argue that the difference in rank or position is reflected already in the different salaries of employees. What follows are three sug- gested methods of how to work out the technicalities of this question. A tomato-producing and marketing co-op owns a 12-acre facility which includes a green house and packing and shipping facilities. Some of the co-op's tomatoes are grown here. Some tomatoes are purchased from farmers who own plots outside the 12-acre facility. These farmers are paid a rate as they bring in produce. Memberships in the co-op are purchased for $25. All the workers and growers on the central 12 acres, and most of the outside farmers, are members. When it comes time to divide the profits, outside farmers are grouped in one class and all workers on the central facility are grouped in another. First of all, the pro- fits are divided between the two classes. This is done on the basis of money paid out to the two classes during the year for salaries to workers on the 12 acres and for produce to the outside farmers, respectively. For example, if $200 was paid to outside farmers for their crop during the year and $400 was paid to workers on the central 12 acres for their work during the year, then the workers as a group would get twice as much of the profits as would the outside farmers as a group. Within the group of workers on the 12 acres the profits would be distributed to individuals on the basis of number of hours worked, regardless of the person's job. Within the group of outside farmers the profits would be divided on the basis of how much produce they had sold to the co-op during the year. United Durham Incorporated, a food-store co-op in North Carolina, copes with the problem of distribution of savings by dividing the membership into two groups, each with a different class of stock. Class A stock may be purchased only by persons with low incomes. (The definition of low income is in the cooperative's by-laws: a single person or family of two with an income of $3,000 is a low-income family). Income is no bar to the purchase of class B stock. Only the holders of class A stock may receive a discount on purchases made in the co-op supermarket. This is their method of distributing the profits, and it is clear that one of the main purposes is to aid in the economic development of low-income neighborhoods. A different criterion is reflected in a plan used by a food- catering co-op in Boston. There the stock is divided into five classes. There is a class for the original incorporators, one for employees, one for social service or public agencies which do business with the co-op, one for consumer groups or clubs which do business with the co-op, and, finally, one for area planning and action councils wishing to do business with the co-op. When it comes time to distribute profits, a regular divi- dend is issued on all capital stock, and in addition share- holders are given a patronage dividend on purchases from the co-op. Employees receive a uniform dividend based on wages earned by them. This means the higher paying the em- ployee's position is, the higher his total refund is likely to be. Number of hours worked is also taken into account, since it is the employee's total wages earned in the year which determine his rebate. Initial Capital 15-15. Many co-ops have turned to Federal programs to raise initial capital. These programs are described more fully in Section 26 of this book. The Small Business Administration has determined that the nonprofit nature of the co-op takes it out of the realm of businesses which it is authorized to assist. However, some SBA regional offices have sought ways to allow groups to appear outwardly as business corporations, while retaining the rudiments of a co-op, in order to enable a co-op to take advantage of SBA loan programs. The Office of Economic Opportunity has provided much assistance to co-ops through its Community Action Program and through research and development projects under Sec- tions 204 and 207 of Title II of the Economic Opportunity Act of 1964. Under Title III of the same Act loans and assistance can be made to rural families for several purposes, one of which is to participate in a co-op. The sale of shares remains one of the major methods of raising co-op funds. Some co-ops, in order to avoid secu- rities regulation problems, have raised capital by selling memberships rather than shares. i^ DCCE 29.831 (1). IS DCCE 29.831 (3). 79 BIBLIOGRAPHY Packel Israel. Law of Cooperatives, Matthew Bender & Co., Inc. 1956. ij_ifj "The Formation of a Cooperative," 16 Prac. Law 65. February 1970. Article to aid a developer. Additional information on cooperatives may be found in the fol- "Cooperative Retail Business— A Route to Self Help, Pride, and lowing sources: Profit in Economically Blighted Communities," 23 Tax Law. 315. Fletcher. Cyclopedia of the Law of Private Corporations, Callaghan Winter 1970. Gives practical methods for helping ghetto communities. & C 0i "The Role of the Attorney in a Community-Owned and Operated Hanna. Cooperative Marketing Associations, Ronald Press Co. Cooperative," 25 Bus. Lawyer 195. September 1969. What the lawyer should expect, and the technical assistance he will need. 80 Section 16 THE CHAIN-INDEPENDENT RETAIL STORE THE CONCEPT 16-1. This chapter describes a mechanism for combining some of the best features of the chain and individually owned store in a manner which will foster minority entrepreneurship. The concept was developed by the Balti- more Council for Equal Business Opportunity where it is being applied to supermarkets. While relying on this experi- ence, this chapter also describes possible modifications which other communities may wish to make and suggests methods for applying the concept to other retail fields. The chain independent retail store has five principal components: The technical assistance organization "packages" the chain-independent stores and, through the management com- pany, supervises their operation. The wholesaler sells goods to the retailers and, in addi- tion, provides merchandising, accounting, advertising, super- visory and other services to the retailers through the man- agement company. The management company, which is controlled by the technical assistance organization, provides technical assist- ance and supervision to the retailers. The local development company, using funds borrowed from the Small Business Administration, purchases the land, buildings, and fixtures and leases them to the retailers. The retailers own their businesses and are entitled to all the profits from them. THE STRUCTURE The Technical Assistance Organization 16-2. The Baltimore supermarket program was started by the Baltimore Council for Equal Business Opportunity, which is an independent, nonprofit organization with Ford Foundation funds, whose purpose is to foster minority- owned businesses. In other communities, technical assistance staffs have been established with funds from the Economic Development Administration, Small Business Administra- tion, and Office of Economic Opportunity. Such staffs may be independent, part of local government, or connected with business or community groups. Once the mechanism has been established, the technical assistance staff has control of the management company (which is described below) and, through the management company, continues to have substantial control over the entire operation. The technical assistance organization will continue to work with the retailers to assure that their businesses are profitable and will look for potential business- men and sites to start additional businesses as part of the program. Wholesaler 16-3. The usual wholesaler merely sells goods to retailers. However, in the grocery industry, wholesalers frequently provide additional services to small chains, individually owned stores operating under a common name, and inde- pendent stores. The chain-independent store program ex- pands on this concept of the wholesaler. The wholesaler enters into a contract with the manage- ment company, which in turn contracts with the retailers. The wholesaler agrees to supervise closely the retail stores (in Baltimore, by providing one full-time person for every three stores); to assist the management company in the selection of sites for new stores and in the acquisition and development of these stores; to design the stores, including engineering and layout services; to design and implement a personnel training program for the retailers, including pro- vision of instructors; to prepare a retail pricing program; to provide an advertising and promotional program includ- ing layouts for all advertising media; and to provide ac- counting services. These are actual services, not merely tech- nical assistance, to the management company and, through it, to the retailers. (For a specimen agreement between wholesale supplier and management company, see Appendix 16-B.) The wholesaler "agrees not to sell merchandise to any other customers at prices or on terms more favorable than those offered from time to time to the [retailer]." The wholesaler is allowed to charge only up to $150 a month per retailer for the accounting services and personnel train- ing. The other services are provided without cost to the retailers. The wholesaler finances the opening inventory of the retailers. In Baltimore, the wholesaler agrees to finance $30,000 in "inventory on the following terms and condi- tions — down payment of five percent (5%), in cash, and a note for the balance bearing interest at the then prevail- ing rate and repayable in thirty-six (36) equal monthly installments." The wholesaler obtains financing for these loans from a bank. In return, the management company agrees to have the retailers "purchase all merchandise from the wholesaler, or its accredited suppliers"; "maintain clean and well- lighted stores"; "require all its employees to attend all classes of the personnel training program"; and "pay all vendors' invoices as they become due." Either party may terminate the agreement on 90 days' notice. In the event of termination by either party, the management company must redeem its preferred stock owned by the wholesaler at par value plus any cumulative profit. If the wholesaler terminates the contract, the re- tailer would retain the right "to repay its opening inven- tory obligation over the remaining life of said obligation." Management Company 16-4. The management company, when first organized, is under the full control of the technical assistance group. Five hundred class A "non-profit participating" common shares are issued to the technical assistance group without 81 cost to it. Each 100 shares can elect one director. Each retailer is required to purchase 30 shares of class B com- mon stock at $50 a share at the time of the agreement between the management company and retailer and an- other 70 shares at the same price in the future. Since 100 shares of class B common stock, as of class A, are needed to elect a director, the retailer cannot elect a director until it has fulfilled its obligation to purchase the full 100 shares. However, the contract between the management company and the retailer provides that "the maximum amount of the additional 70 shares which can be pur- chased in any one year cannot exceed 20 percent of the net after-tax profit earned by the [retailer]." Consequently, the technical assistance group is assured of control of the management company until at least six retailers have paid $3,500 apiece for 70 additional shares which requires after- tax profits of $17,500. The management company enters the agreement with the wholesaler described above in which it obtains various benefits for the retailers and, in turn, contracts that the retailers will carry out certain obligations to the whole- saler. The management company then contracts with the retailers to assure that the retailers will carry out these obligations. The contract between the management com- pany and retailer gives broad powers to the management company: 1 The [retailer] hereby appoints the Company to act as its management agent and to determine and approve standards of quality for goods used or sold in the store, levels of inventory to be maintained, standards of service in connection with their sale, standards of quality and utility for all furnishings and equipment used on the prem- ises in connection with the sale. The [retailer] shall con- tinuously operate the business at least upon such days and during such hours as the Company shall determine. The Company may observe the operation of the business and may supervise the operation of such business. The Com- pany's supervisory personnel shall have the right to enter upon the premises at any time for the purpose of examin- ing the same, conferring with the [retailer's] employees and inspecting and checking merchandise, furnishings, equipment, and operating methods, in all divisions and departments, for the purpose of determining whether the business is being conducted in accordance with the afore- said standards and in accordance with this agreement. So long as this agreement shall remain in force and effect, the [retailer] will purchase from authorized sup- pliers designated by the Board of Directors of the Com- pany any and all products sold by said suppliers which the [retailer] may sell at or from the place of business de- scribed above, and the [retailer] shall pay therefor, at standard prices, from time to time fixed by the Company. The [retailer] agrees to deposit his gross receipts, intact, daily, and to abide by the suggested original retail prices as set by the Company. At its own expense, the [retailer] will repair and paint the exterior and interior of the building at reasonable times upon the request of the Company, and at all times will maintain the interior and exterior of the buildings and the surrounding premises in a clean, orderly, and sanitary condition satisfactory to the Company. It is understood and agreed that all of the operating requirements and standards are not set forth herein, and that the Company may, from time to time, through the vote of a majority of the Board of Directors set operating requirements and standards which shall be binding on the [retailer]. The retailer also agrees to keep a variety of insurance in effect for the benefit of the management company and to operate under a common name. It agrees to pay charge for advertising made by the media up to l'/i percent o gross sales. "Until such time as the opening inventory not* to the [wholesaler] is paid in full, the [retailer] agrees tc limit his compensation to a gross salary of $200 a week plus a bonus equal to 40 percent of the after-tax profits if available. The remainder shall be left in the business a equity." The retailer retains the full right to hire and fire employees. The management company agrees, in return, to provid the retailer with "engineering, buying and merchandisinj services, advertising and accounting services and store management supervision when deemed necessary by the Company." These services, as indicated above, are pro vided the management company by the wholesaler. The net effect of these provisions is that the independently owned retailer operates as part of a chain. The retailei uses a common name with all the other retailers entering similar agreements with the management company and uses common advertising. The management company car require that all the retailers have the same prices and main tain the same level of service, personnel training, sanita tion, attractiveness of the store, and the like. The management company has the power, in order to enforce the contract, to take over the retail business anc sell it to a new retailer. In the event that the [retailer's] financial positioi reaches that point at which it cannot pay its creditors a their bills become due, or in the event that the [retailer refuses to adhere to the operating requirements prescribed by the Company after 30 days' notice of a violation, or if it engages in an unlawful activity, the Company can at its option terminate this agreement upon [30] days written notice. The [retailer] appoints the Company as its trustee to acquire its assets and maintain the operation of the store until a new operator is obtained, without interference by the [retailer]. The process shall be as follows: ( 1 ) All assets of the [retailer] including the lease hold interests in the realty, fixtures, and equipment shall be transferred to the Company, as trustee, which shall ap point a manager at the cost and expense of the [retailer] and operate the business until the assets are sold. (2) All profits and/or losses during the period of trusteeship shall inure to the [retailer], but shall be held by the Company until the [retailer's] debts have been satisfied. (3) The assets of the [retailer] shall be offered for sale and a three-man committee composed of one repre- sentative of the [retailer], one representative of the Com- pany, and a third to be chosen by the two representatives, shall decide on and accept the best offer received within sixty (60) days after the assets have been offered for sale. (4) The Company shall redeem its stock from the [retailer] at a price of fifty dollars ($50.00) per share. (5) The Company shall first apply the proceeds received in (2), (3), and (4) above to the satisfaction of all of the [retailer's] debts. The balance, if any, shall be paid over to the [retailer]. If said proceeds are insufficient to satisfy said debts, the deficiency shall be borne by the [retailer] who hereby indemnifies the Company from any liability therefor. The retailer is not permitted "to sell, assign, pledge, or otherwise transfer its business, or any interest therein, with- out the prior written consent of the Company. Said con- sent shall not be unreasonably withheld." 1 This and later quotations are based on the contracts developed by the Baltimore Council for Equal Business Opportunity with only slight modification. 82 The retailer has the right to terminate the contract with the management company only after three years. It then must satisfy all outstanding obligations including the bal- ance of the promissory note to the wholesaler for opening inventory. The retailer must also have exercised its option under the Lease Purchase Agreement with the local de- velopment company to purchase the building and fixtures. "As a condition to said withdrawal, the [retailer] must pay a fee to the Company of 1 percent of the gross re- ceipts of the [retailer] during the preceding 12 full months." Upon termination of the contract with the management company, the retailer "shall not be entitled to use the common name unless consent is given in writing by the Company." The management company is required to re- deem its common stock owned by the retailer at the price originally paid. (See Appendix 16-C for a checklist for agreement between management company and individual member store operator.) Local Development Company 16-5. The local development company, which may be either a profit or non-profit corporation, is formed by community residents or organizations. It is established for the purpose of obtaining direct loans from the Small Business Admin- istration under Section 502 for land, buildings, and equip- ment. The SBA can make 90-percent loans in "ghetto areas," "target areas," or "high-unemployment areas" and 80-percent loans elsewhere with a duration of 25 years at a below-market interest rate of 5Vi percent. The other 10 or 20 percent must be raised by the local development company from such sources as foundations, businesses, or individuals in or outside the neighborhood. The local development company enters into an essen- tially standard Lease Purchase Agreement with the re- tailer. Aside from the usual provisions for rent, mainte- nance and repairs, insurance, payment of taxes, defaults, and the like, the agreement has the following features: The lease is for the same term as the SBA loan to the local development company (up to 25 years) and may not be assigned by the retailer without the consent of the local development company. The retailer can purchase the prem- ises and fixtures at any time "for a price equal to all of the indebtedness against said property plus all costs of effecting said transfer." Since the SBA loan to the local development company is repaid in 25 years, the retailer can obtain the premises without cost to it at that time. (Appendix 16-A is a specimen checklist of terms of a lease purchase agreement between an LEDC and an individual member store operator.) The same local development company can be used to pay for the land, buildings, and fixtures for all the retailers in a neighborhood or for all the retailers in the entire program no matter where located in a particular city. More broadly, if desired, the same local development company can be used for paying for the facilities of many other kinds of businesses. The application of the chain-independ- ent store concept to other businesses is discussed below. Retailer 16-6. The retailer is the owner of the business and receives all profits from it. The retailer's rights and obligations under the contract with the management company and the Lease Purchase Agreement with the local development company have been described above and are therefore not repeated here. THE ADVANTAGES TO THE PARTIES 16-7. Of the five entities described above, only the whole- saler and retailer are part of the traditional retail business. The chain-independent retail store concept offers numerous advantages to both the wholesaler and retailer, as well as to the technical assistance organization and the community. Since the principal purpose of the concept is to promote minority business, we will deal first with the advantages for minority-owned business. Retailer 16-8. Perhaps the most important benefit to the retailer is the opportunity to own a substantial retail business. The typical prospective minority businessman has difficulty in starting a profitable business because he generally has few financial resources and is lacking business experience. The prospective retailer under the chain-independent store program needs little capital to start the business. The land, buildings, and fixtures are paid for by the local development company which obtains a 25-year, 90 or 80 percent loan from the Small Business Administration and needs to raise only 10 or 20 percent from other sources. Ninety-five percent of opening inventory is provided by the wholesaler, with the retailer signing a three-year note and making a down payment of only 5 percent. Besides this 5 percent, the prospective retailer must have funds only for the purchase of a small amount of stock in the management company and for working capital. The figures for the first supermarket in Baltimore are instructive as to how the retailer can own a substantial business with little investment through the chain-independ- ent retail store concept: Land, Building, Equipment — Local Development Company: Land $35,000 Building $95,000 Fixtures $45,000 $175,000 Small Business Administration loan — 90% $157,500 Local share: foundations, community sources — 10% .... 17,500 Inventory 30,000 Wholesaler loan — 95% 28,500 Retailer down payment — 5% 1,500 Working Capital 7,000 Retailer 7,000 Investment in Management Company 1,500 Retailer 1 ,500 $213,500 The retailer has, with a $10,000 investment, obtained the use of funds and property worth a total of $213,500. In addition, the retailer also receives the benefit of a less obvious kind of financing from the wholesaler. Small retail stores, in the grocery and other retail fields, often must pay suppliers upon delivery. Under the arrangements described above, however, the suppliers bill the whole- saler. They are willing to do this because of the whole- saler's superior credit rating and financial resources. The retailer then repays the wholesaler when billed by it in two or three weeks. As a result, the retailer receives credit for several weeks on the merchandise it sells which adds to working capital. This kind of economic leverage could not be obtained in any other way. Ninety-percent loans are not generally available for 25 years at an interest rate of 5'/2 percent. This allows the local development company to lease to the retailer at rents well below the market. If, as is the case in Baltimore, the local development company is not established to make a substantial profit, the rent need cover only principal and interest. The retailer pays all additional costs including taxes, interest, repairs and maintenance. Even if the local development company is established to make a reasonable profit, the rent will still be well below that for other comparable facilities. The retailer similarly could not obtain a 95-percent in- ventory loan for three years from any other source. When 83 the wholesaler obtains these funds from a bank, the in- experienced retailer with little capital is in effect utilizing the much stronger credit of the wholesaler. The retailer also receives, besides extraordinary financing, an unusual amount of technical assistance. The minority entrepreneur generally obtains no more than occasional technical assistance. This is often inadequate in view of his lack of business experience. The chain-independent re- tail store concept provides not merely continuous advice but close supervision and actual services, including mer- chandising and buying, accounting, advertising layout and display, and others. These services are provided by the wholesaler who has long experience in the business and has provided similar, although perhaps less intensive, serv- ices to small chains and independent stores. The whole- saler has accounting and advertising departments and agrees to assign full-time supervisors. In Baltimore, the wholesaler provides all this assistance without charge, ex- cept for $150 a month for complete accounting services and personnel training. The retailer also obtains technical assistance through the technical assistance group and management company. Since these organizations have been established in order to pro- mote minority business, the minority businessman can rely confidently on their advice. They provide assurance to the retailer that the wholesaler is trustworthy, the various con- tracts are favorable, and that the wholesaler is carrying out its obligations. This assurance is particularly important because of the minority businessman's lack of previous experience. The technical assistance group and management company can also provide help beyond that provided by the whole- saler. They can obtain additional technical assistance if the wholesaler does not have competence in a particular field such as insurance, real estate, and remodeling. The man- agement company, as in Baltimore, can convene regular meetings with the wholesaler, retail store owners, and technical assistance group to discuss common problems and solutions. The retailer also receives significant benefits from join- ing together with other retailers. As indicated above, it is their joint purchasing power, their total market, which induces the wholesaler to provide the 95 percent inventory loan and extensive services at low cost. The wholesaler also agrees to sell merchandise at no higher price and on no worse terms than his most favored customer. The use of a common name allows the use of the media for ad- vertising at a lower price per store. In return for these benefits, the retailer surrenders much of its independence. The management company (which is controlled by the technical assistance organization) has broad powers over virtually every detail of store operation and management and, if the retailer refuses to comply with its requirements, the management company can take over the business and sell it to a new owner. If the business is sold, the original owner receives only his investment in the management company and profits from the sale after all debts are paid. This lack of independence is, however, not permanent. The retailers can obtain independence in two possible ways. First, the retailer can participate in running the manage- ment company. In Baltimore, where the technical assistance organization has full power to choose all the directors of the management company at the start, it decided to choose a board consisting of two retailers, the wholesaler, and two staff members of the technical assistance organization. Furthermore, in the reasonably near future, the retailers can obtain full control of the management company. The technical assistance organization chooses five directors of the company. Upon its organization, each retailer is en- titled, and obligated, to purchase 100 common shares at $50 a share and each 100 shares can choose a director. The retailer purchases 30 shares at the time of its contract with the management company and can use 20 percent of its net after-tax profit to purchase shares in the future. Consequently, the retailer can purchase the needed 100 shares to elect a director as soon as it has earned $17,500 in total after-tax profits. When six retailers have earned such earnings, control of the management company passes to the retailers as a group. The management company can terminate the contract with the wholesaler on 90 days' notice. Second, the retailer can obtain complete independence of the management company and local development com- pany. The Lease Purchase Agreement with the local de- velopment company allows the retailer to purchase the land, buildings, and fixtures at any time upon payment of the outstanding indebtedness. Such a purchase is pos- sible by obtaining refinancing from a private financial in- stitution. The contract with the management company allows the retailer to terminate it upon payment of all obligations including the opening inventory loan from the wholesaler (which, by its terms, is fully repaid in three years), exercise of the purchase agreement with the local development company, and payment of 1 percent of gross receipts during the past year to the management company. In short, the retailers can obtain partial or complete independence when they have demonstrated their com- petence to carry on alone. They can obtain control of the management company after they have earned significant profits. Similarly, they can exercise their right to purchase the property from the local development company and terminate their contract with the management company when they have earned sufficient profits and shown sufficient competence to obtain refinancing of the SBA loan from another source. It is possible to utilize the basic elements of the chain- independent store concept while giving the retailer more independence. This could be accomplished by limiting the power of the management company to take over the re- tail stores and sell them to other owners. The management company could be allowed to do so only upon "reasonable cause" with perhaps an arbitrator chosen to decide when reasonable cause existed; the management company could be permitted to take over a store only when a majority of the other retailers agreed; the management company might be allowed only to proscribe a retailer from using the common name and to end all other services provided, without having power to take and sell the business. All such limitations on the authority of the management com- pany, however, are likely to make it more difficult to per- suade a wholesaler to provide the financing and services needed since the wholesaler relies heavily on the expertise and power of the management company. Moreover, if the management company has only limited power to enforce its decisions, this may lead retailers to disregard the advice given them which in turn might undermine the whole "chain" concept. Wholesaler 16-9. The wholesaler would normally not be willing to deal with any retailer, let alone one with probably little prior experience, on such favorable terms. The wholesaler is willing to provide the financing and services because it believes that the independent-chain store concept will be profitable to it. First, the wholesaler has good grounds to believe that the store will be properly managed. The wholesaler, by 84 contract with the management company, provides such critical services as accounting, advertising, store layout, and retail pricing. Under its contract with the retailer, the management company has the power to supervise the re- tailer in minute detail if necessary, and to require the retailer to follow the advice of the wholesaler. Second, the wholesaler principally relies upon the ex- perience the management company can bring to the proj- ect rather than upon the retailer. The wholesaler has con- fidence in the management company because it is con- trolled by the technical assistance organization which has far more business experience than the retailer. The man- agement company guarantees the wholesaler by contract that the retailer will run a clean, well-lighted store, have its employees attend the training sessions, and pay for merchandise when due. The wholesaler depends on the ultimate power of the management company to remove the retailer as owner if the retailer refuses advice given to him by the wholesaler and does not run the business properly. Third, the wholesaler can expect substantial business in the inner city. Under these arrangements, the wholesaler receives exclusive selling rights for each store. The con- tract between the wholesaler and management company provides that . the retailer will purchase all merchandise from the wholesaler. The contract between the manage- ment company and retailer gives the management company the right to determine all suppliers of merchandise to the retailer. The financing and intensive services provided by the wholesaler would not be economically feasible if the whole- saler were to deal with only one store. They become economically feasible if a chain of independent stores can be established. The development of such chains become in- creasingly possible as white businessmen decide to leave inner city neighborhoods and desire to sell their businesses and facilities. These arrangements allow the wholesaler to retain his present business — if he was selling merchan- dise to the former owner — or to expand his business through new retail outlets. Fourth, the wholesaler can look forward to the reason- ably near future when it will need to supply less services to the retailers. As the retailers gain experience and the stores begin to become profitable, they will need less in- tensive help. Technical Assistance Organization 16-10. The technical assistance organization has an interest in ensuring that its activities are effective in promoting minority entrepreneurship. One of the major difficulties experienced by technical assistance organizations is to ob- tain technical assistance resources from private industry and to assure that inexperienced minority businessmen follow the advice given them. The chain-independent re- tail store concept meets both these problems. The technical assistance organization obtains the services and technical assistance of an experienced company in the field, the wholesaler. This does not consist of merely spo- radic advice from volunteers who may or may not be willing to respond when their help is asked. Instead, these services are built into the structure because the whole- saler provides them pursuant to contract. It is in the whole- saler's direct economic self-interest to provide adequate services so that the stores are profitable and purchase the maximum amount of the wholesaler's merchandise. The chain-independent store mechanism also assures that the minority businessman will follow the advice given him. The retailer agrees by contract to use the services of the wholesaler and follow operating requirements of the man- agement company. If it refuses to do so, the management company can take over the business and sell it to a new retailer. Community 16-11. The community benefits from the chain-independent store concept in several different ways. First, the stores will provide better quality goods at lower prices. Consumers in low-income neighborhoods generally pay more for less either because of deliberate exploitation by the owners or because small, under-financed stores can- not economically provide better services. The change from white to minority ownership will not automatically help the consumer, particularly if the new owners do not have the business expertise, financing, and other elements needed to provide better quality goods at lower prices. As indicated above, the wholesaler agrees to sell mer- chandise to the retailer at its most favorable prices and terms because of the joint buying power of the retailers. Supervision by the wholesaler and management company ensures that the retailers will all meet the same standards in pricing policies, cleanliness and attractiveness of the stores, and employee training. The result should be the same quality goods at the same prices with the same serv- ice as stores in more affluent neighborhoods can offer. The chain-independent store concept also gives the com- munity more direct control over prices, quality of goods, and service. The technical assistance organization, which through the management company can exercise control over the retailers, was established to foster economic de- velopment for the benefit of the community and it should be responsive to community desires. Its board, depending on its structure, may have community representatives. Com- munity groups, whether the local development company or others, might also have representatives on the board of directors of the management corporation, which in turn supervises the retailers. On the other hand, it is possible that a wholesaler would have less confidence in dealing with a management company if its board had a substantial number of neighborhood representatives without business experience. Second, the community can earn profits through the local development company. The purpose of the Baltimore local development company is not to earn profits but to assist minority-owned business. However, it is possible to assist minority businessmen at the same time that reason- able profits are earned by setting rents above the expenses of the local development corporation. The profits could then be distributed by a profit-making local development company as dividends to individual community shareholders of the local development company, or could be used by a non-profit local development company to stimulate more economic development (such as to provide the 10- or 20- percent local share on future SBA loans) or to pay for education, health, or other services needed by the low- income community. Third, while in Baltimore the retailers were individual entrepreneurs, they can be profit-making corporations, which in turn can be owned by low-income community residents, nonprofit corporations, or cooperatives. 2 Such community ownership gives the community direct control over prices, quality, and services as soon as the manage- - The retailer itself, as opposed to the organization owning the store, must be a profit-making entity under the regulations of the Small Business Administration in order for the local development company to obtain a 502 loan to buy the property for lease to the retailer. If other funds can be obtained to purchase the appropriate facilities, the retailer itself could be a cooperative or nonprofit corporation. 85 ment company is controlled by the retailers. The profits from the retailers could be distributed broadly among the low-income owners of the corporation or could be used to pay for needed community services. It is important to note, however, that wholesalers may be less willing to enter agreements with community-run businesses be- cause many private businessmen are skeptical of dealing with businesses not run by individual entrepreneurs. Fourth, the community benefits through the stimulation of economic development. Prosperous stores induce other potential entrepreneurs to provide commercial services in the neighborhood. They can deal with other existing mi- nority-owned businesses such as insurance, real estate, trucking, and advertising. Employment is provided to the employees of the stores. Minority businessmen and their employees, who are receiving adequate salaries, and owners, who are earning reasonable profits, spend money in the inner city and often with other minority-owned businesses. Minority businessmen provide leadership in the minority community and are examples of success for young people growing up. COMPARISON WITH OTHER FORMS OF BUSINESS OPERATION 16-12. The chain-independent retail store concept is sig- nificantly different from other forms of business operations — the independently owned store, the association of stores, the chain, or the franchise. In this section, we will compare these various forms of organization. The retailers in the business arrangement described in this chapter are not independent. While they own their own businesses and receive all profits from them, they are super- vised in detail by the wholesaler and management corpora- tion and must follow their requirements. If they do not do so, the management company can take control of the busi- nesses and sell them to other retailers. The retailers can obtain full independence, however, when financially able to repay all obligations and purchase the stores. The advantages in financing and technical assistance and the disadvantages in loss of independence under the chain-independent store concept are discussed above. This arrangement is also not an association of independ- ently owned and run stores. Such an association can provide the advantages of joint buying power, common insurance and pension arrangements, a common name and advertising, and technical assistance. However, each independent store is usually not compelled to follow the decisions of the associa- tion and can leave the association at will. Even if each store enters a contract to abide by the decisions of the association for an agreed-upon period of time, such an association is unlikely to obtain the favorable financing and services pro- vide by the wholesaler for the chain-independent retail stores. For, as indicated above, the wholesaler relies heavily on the business expertise of the management company and technical assistance organization and upon their control over the retailers to assure that sound business practices are followed by the retailers. The wholesaler will probably have less confidence in an association controlled by inexperienced retailers. The retailer in the chain-independent store program is also not part of a real chain. A chain has common control and ownership. While the management corporation exer- cises substantial powers of control over all the retailers, ownership of each store is separate from the management company and from the other retailers. In this way, while the storeowner gets many of the benefits of a chain — joint purchasing power, economical accounting and other services, a common name and advertising — he retains the advantages of working for himself and for his own economic advantage. The community has the advantage of having a broader entrepreneurial class developed than if a single chain domi- nates a particular commercial field throughout low-income neighborhoods of a city. The chain-independent retail store concept has many similarities to franchising. It has, however, several advan- tages for the development of minority-owned businesses. First, the management company and the technical assist- ance organization which controls it protect the retailers from overreaching by the wholesaler. The technical assistance organization has, as its principal purpose, assistance to the minority businessman. It oversees both the original contracts and how they are carried out. In comparison, in the fran- chising field, all too often a strong franchisor is able to overreach a weak and inexperienced franchisee so that the latter has little more than the obligations of ownership without the benefits. Second, the retailers under the chain-independent store concept fully own their businesses and take all profits from them. They receive merchandise from the wholesaler at its most favorable prices and terms and pay only a reasonable fee (in Baltimore $150 a month) for accounting services and personnel training. Franchisors, on the other hand, customarily receive a substantial percentage of the fran- chisees' profits. Third, the retailers have the opportunity to take control of the management company jointly or to become completely independent from it. Franchisees of course have no oppor- tunity to control the franchisors and are never free from their control. Consequently, they never can obtain their freedom no matter how profitable and experienced they may become. Fourth, the locally based wholesaler will often be able to provide more adequate services and technical assistance to the retailers than a nationally based franchise with head- quarters elsewhere. EXPANSION OF THE CONCEPT INTO OTHER FIELDS 16-13. The chain-independent retail store is a model which can be used in other fields besides groceries. It can be most readily applied to fields — like drugs, hardware, and appli- ances — where wholesalers providing all or virtually all the needs of retailers already exist. Such a wholesaler, like the grocery wholesaler, has the economic incentive to provide the intensive services and technical assistance which the retailers require. If a wholesaler sells only a small portion of the merchandise to any particular retailer, it is not economically feasible to provide these services. Similarly, many manufacturers directly supply all or most of the merchandise sold by individual retailers. Examples include shoes, tires, and others. While many of these manu- facturers now use franchising arrangements, they perhaps can be induced to use the chain-independent store concept in minority neighborhoods. It is more difficult to apply the chain-independent store concept to other fields where no wholesaler or manufacturer supplies most of the merchandise which is sold by a particu- lar retailer. For example, clothing stores generally sell goods directly purchased from dozens of individual manufacturers and no one manufacturer can probably be induced to as- sume the same role as the wholesaler. Consequently, the concept can be applied only if the management company itself hires experts to provide the services and technical assistance which the wholesaler in the grocery field provides for the management company. The management company should be able to provide these services to the retailers at a 86 •easonable price since identical services are being provided o a number of similar stores. The management company should be able to persuade nanufacturers selling to a clothing retailer to finance the >pening inventory purchased from each of them on similar erms as the financing provided by the grocery wholesaler, ["he manufacturer is probably being given the opportunity o sell to a new market, is dealing with the management :ompany in which it can have confidence, and has reasonable issurance that the retailer will be well managed. Except that he manufacturer does not become the sole supplier, these ire the same reasons which induced the grocery wholesaler o provide credit to the retailers for opening inventory. Finally, the concept may also be applicable to businesses which provide services. These includes health clinics, day- care centers, dry-cleaning establishments, and the like. Here, as in the case of businesses where a retail store does not deal with a single wholesaler or manufacturer, no existing source of services and technical assistance now exists. How- ever, a management company can be established by the technical assistance organization to provide these services and maintain the same supervision and control over the business dealing directly with the customer. The expertise of the management corporation should be helpful in obtaining direct or guaranteed working capital loans through the Small Business Administration. 87 Section 17 SHOPPING CENTERS THE OPPORTUNITY 17—1. Establishment of a shopping center by a Local Eco- nomic Development Company may be desirable not only as one form of income-producing enterprise, to be owned and operated by the community, but also because many low- income communities need the shops and services that a shopping center can provide. Such a center may be a necessity in redeveloped housing areas and its activities may be an important source of economic and environmental revitalization for the community it serves. TYPES OF SHOPPING CENTERS 17-2. Shopping centers are generally classified in three categories on the basis of size. (1) Neigborhood Shopping Center. The smallest shopping center is often referred to as a "strip" or neighborhood shop- ping center. This type of center caters to the daily needs of the surrounding neighborhood. Characteristically its main tenant is a food supermarket. It also usually includes a small variety store, service stores, drugstores, banks, cleaners, beauty parlors, and other daily service type stores. It is designed to serve from 5,000 to 40,000 people, who live within Vi to Wi miles of the center. In size such a shopping center ranges from 20,000 square feet to as much as 100,000 square feet of gross leasable area. 1 (2) Community Shopping Center. The second type of shopping center which is likely to be built in an urban area or an urban renewal project is the community or inter- mediate-type shopping center. This center usually includes a large junior department store or discount house of 40,000 to 100,000 square feet. When this major store is added to the typical neighborhood center such a center can range up to 200,000 square feet and serve an area of up to 4 miles from the center. This center can serve a population of from 40,000 to 150,000. The main difference between the neighborhood and the community shopping center is that the latter is larger and has more stores than the neighborhood shopping center. It includes a greater number of stores such as cloth- ing and specialty stores, a hardware store, an appliance store, two or more shoe stores, and other types of businesses which enable a customer to do most of the weekly shopping in one location. The frequency of shopping in a community center is less than that of a neighborhood center and it can- not expect to draw the same customers day after day on a daily basis as does a neighborhood center. (3) Regional Shopping Center. Very few regional shop- ping centers are being built in urban areas today. These centers are large enclosed mall regional shopping centers that range from 300,000 to 1,000,000 square feet of gross leasable area. In most situations this type of development is not suitable for downtown or urban areas. However, re- cently such a center was completed in Buffalo, N.Y., and another in New Rochelle, N.Y. These are unusual circum- stances and are not likely to be duplicated with any great frequency throughout the United States. In regional shopping centers, full-line department stores such as Macy's, Gimbels, Wanamakers, and Sears, Roebuck & Company are the dominant retail tenants. These depart- ment stores occupy the largest sites in the centers and may account for up to 75 percent of the total area of the center. ECONOMICS OF SHOPPING CENTERS 17-3. Before undertaking any project for building an urban shopping center, great care must be given to a detailed study of the economics of the project. Many people have wrong ideas as to what profit is involved in a real estate venture such as a shopping center and they are quite surprised to learn that return on investment can be as low as 6 to 10 percent of the funds needed for putting the shopping center together. For this reason a very detailed analysis should be made of the shopping center so that the appropriate eco- nomic projection can be studied by all of the principals in- volved and the people who will be asked to supply the funds and money necessary for the development. The average neighborhood or community shopping center as described above will cost about $12 to $20 a square foot to develop. This cost is all-inclusive except for land which cannot be taken in at a general figure. However, several recent urban shopping centers of 100,000 square feet of gross leasable area have been built at a cost of \Vi to 2 million dollars. As of mid-1969 this cost includes all of the developers' part of the shopping center, contemplates a utilitarian type of structure, and does not include anything for tenant inventory or fixtures. For a more elaborate de- velopment such as an enclosed mall shopping center, the cost will range much higher. The discussion below covers a typical neighborhood shopping center of 100,000 square feet gross leasable area which can be developed for a total cost of Wi million dollars or $15 per square foot. The Prime Factor — Location 17-4. It is often said that there are three primary ingredi- ents in every successful shopping center, location, location, and location. If a shopping center is to be successful in an urban area, it must be situated so as to easily serve the great- est number of potential customers. The only and ultimate test of a good shopping center location is whether or not the tenants who locate in it do business. In order to do business, the market potential must be available and the 1 All references to definitions and terms of art are those selected by the International Council of Shopping Centers and the Urban Land Institute. For source materials referred to in this chapter available from these organizations, write to: International Council of Shopping Centers, 445 Park Avenue, New York, N.Y. 10022, and Urban Land Institute, 1200 Eighteenth Street, N.W., Washington, D.C. 20036. 88 eople must be able to get to the site and do shopping at he site on a convenient and economical basis. 2 (1) Market Analysis — Supermarket. The site can be se- eded and the location can be approved only after a proper larket analysis is made to ascertain whether a shopping enter can economically be supported at the site. Many irge supermarket chains maintain extensive research staffs n order to do this and the service will be given to the ommunity developer without charge. The supermarket or ariety store will gladly check out the location to decide /hether or not it will fit their criteria for a successful ■peration. (2) Market Analysis — Developer. If the market analysis 5 to bf done by the LEDC or a developer it sponsors, there re two ways that this can be accomplished: (a) The first is to hire a professional market analysis rganization which undertakes the complete research of a ite and ascertains whether a shopping center will be suc- essful on a given location. If the shopping center to be ieveloped is the first done by the LEDC, it is suggested that, f at all possible, money be expended to have a professional irganization do the analysis and that the analysis, itself, then ie studied for future reference. Once the technique of analy- is is mastered, local men on the community developer's earn can do it on their own without the expense of hiring he professional. However, if professionals can be afforded, t is highly recommended that they be employed to do at east the first market research analysis. (b) Banks and Department Stores: Many local banks nd department stores maintain full research and analysis taffs to enable them to decide where they should locate iranch offices and units in shopping centers. An approach hould be made to these people on a community basis so s to obtain their help and expertise in selecting the appro- bate site for a shopping center in an urban area. (c) Local Urban Renewal or Planning Organization: •lanning organizations and municipal and county-wide irban renewal divisions should be approached and their lelp solicited by the LEDC for assistance in seeking out ppropriate shopping center sites in urban areas. In many cases the town or city has a master plan which ets forth what areas of the urban center can be developed ,s a shopping center. These parcels are already zoned and eady for shopping center development. It is important for any community developer in an urban irea to establish a close rapport with local planning agencies. INITIAL FINANCING NEEDS .7-5. It can be anticipated that "front money" of about 10 >ercent will be needed to get the shopping center project )ff the ground. For a shopping center of the size being :onsidered, about $150,000 will be required. Money is teeded to obtain zoning and to lay out preliminary plans or the shopping center before tenants or leases are even )btained. Major tenants who are going to take space in a ihopping center want to see a complete set-up and prelim- nary architectural sketches of the project before they com- nit themselves to locate in the center. For this reason some noney will have to be expended before any approach can )e made to a bank for financing. It is not wise and often mpossible to start discussing mortgaging of a project before mch advance planning and some leasing is done. "Seed" noney from grants or equity financing must be initially Available to the LEDC planning such a project. If a shop- Ding center is properly put together by a developer and appropriate expertise is applied to the project, there should seldom be any requirement for more than 15 percent of the money to be put up by the developers over and above the construction or permanent mortgage. In many cases, developers can obtain up to 100 percent financing. After the initial layout of the center is finished and some leasing is accomplished, it is time to seek permanent financing. The financing of shopping centers can involve the specialized adaption of a number of complex and so- phisticated real estate financing techniques, such as "basket- money" financing, sale lease-back, wrap-around mortgages, and ground-lease financing. The legal advisor to an LEDC interested in sponsoring the development of a shopping cen- ter should familiarize himself with these more elaborate forms of financing, as well as with the particular require- ments of mortgage lenders where shopping centers are con- cerned. 3 This discussion is restricted to putting conventional financing in the framework of the needs of the LEDC. (1) Financing Land Acquisition. One method of financing land acquisition which is stressed in conventional shopping center development is the ground lease. While ground leas- ing has the significant advantage over land purchase of re- quiring a smaller initial investment, the possibility of using ground leasing seldom arises in an urban area because of the smallness of the parcel. The best method of purchasing land for an urban shop- ping center is buying urban renewal land itself. Because of the "original blighted" nature of the land its cost to the developer is relatively low. Also the terms of the disposition contract of purchase allow the developer plenty of lead time to obtain tenants and financing. Therefore, a developer is often able to complete all of his preliminary work on the shopping center before putting up money for purchase of the land. However, a note of caution. Obtaining actual possession of urban renewal land is often a very long and time con- suming procedure. The wheels of many agencies move very slowly in purchasing, clearing, and relocating. Be sure the land is available and possession can be delivered in a rea- sonable time. (2) Construction Financing. During construction of a shopping center, it will be necessary to have available up to 100 percent of the construction funds necessary to pay for labor and material as incorporated into the site. To do this, the developer obtains what is commonly known as "construction financing" from a local commercial bank. This financing is available to the developer only if the developer has the promise of a permanent mortgage from a lender who has agreed to take this mortgage when the building is com- plete. The construction lender lends on the credit of the ultimate mortgagee who is probably an insurance company, commercial bank, pension fund, or other source of conven- tional financing. Construction financing is ordinarily granted as the project proceeds and once the construction loan and permanent commitment are obtained there is usually no requirement for additional "front money." For the average urban shopping center, savings and loan institutions and commercial banks which are familiar with the developer and the location are the best sources of initial financing. Large insurance companies have also become active in urban financing and many shopping centers are now financed by these institutions. 2 Mass transportation sources must be analyzed with great detail as most urban centers will rely heavily on families who have no car or only one car. Most daytime shopping will be by foot traffic or mass transit lines. 3 A bibliography of works containing such information is in Section 17-20. The complexities of this financing are such that no useful purpose is served by summarizing them. 89 LOCAL FINANCING SOURCE TO BE CONSIDERED 17-6. The urban shopping center financing opportunities are quite varied and there are many more options than in suburban shopping centers. (1) The local business community has become aware of the need for maintaining the downtown urban retail charac- teristics of a town; therefore, the community and financial institutions in it are much more apt to help in the financing of a shopping center. (2) Joint ventures are discussed in Section 17-18 in connection with some expertise to be used by an LEDC. Financing can also be obtained through these joint ventures with major money suppliers or manufacturers. (3) Many large industrial corporations have now gone heavily into real estate ventures and are committed to help- ing downtown areas. These corporations are willing to put up substantially all the money necessary for the develop- ment and in return they obtain a partnership interest in the shopping center itself. 4 (4) Many building materials companies are now getting into this business and the building trade literature can be checked for the names of these suppliers. (5) There has been a great trend recently for the major money suppliers in the country such as stock brokerage houses and mortgage bankers to also get into the real estate business by way of partnership with developers. There are cases where the money lenders or money suppliers are willing to put up most of the money in return for an interest in the project. PUTTING THE TENANTS TOGETHER 17-7. After a site has been selected, the first order of busi- ness is to ascertain whether anyone is interested in leasing a store in the potential shopping center. The first tenant usually obtained in any urban shopping center is a food supermarket. Since the food supermarket takes up from between 15,000 to 30,000 square feet of gross leasable area, it is by far the largest tenant in the strip shopping center and, therefore, the most dominant. The supermarket is easily approached through its own real estate department and an answer can usually be obtained within a matter of weeks as to whether any interest is engendered on behalf of the particular supermarket. A developer should not be- come discouraged if he is turned down by any particular supermarket; each food chain has its own criteria as to what makes a good location. What may be a good location for one supermarket would not fit the criteria of another. Each supermarket should be approached in sequence until the best tenant is obtained for a given location. The advice of experienced real estate sources described in Section 17-16 will be of aid in pinpointing which supermarket chain best fits into the area to be developed. Other key tenants for such a center would be a variety or 5 & 10-cent store, a drugstore, and a bank; no center can truly serve the needs of the people unless it contains a super- market, bank, drugstore, and variety store. These key tenants must be approached vigorously and an attempt made to secure them as tenants. Each tenant should be approached with the community need in mind and some idea of a market research report which can show the individual tenant that business is available in the area and that he has com- munity acceptance for his particular operation. The same criteria used by a developer for selecting a site will be used by the tenant to ascertain whether he is interested in develop- ing a store in a given shopping center. Once the key tenants are picked, the next order of busi- ness is to approach the local or community tenants. These tenants, often referred to as "Mom and Pop stores," are the real backbone of any shopping center and offer prime op- portunities for local entrepreneurial development. Such local tenants bring a community flavor to the project and usually give more service and more personal attention to the cus- tomer. When approaching local tenants for a shopping cen- ter, the developer should carefully consider the background and history of the tenant; supportive assistance to ascertain whether local prospects are or can become good retail mer- chants can be offered by the LEDC. The SBA Lease Guar- antee Program, described in Section 32 can play an impor- tant role in enabling local tenants to participate in the shopping center. The center may also be a good location for one or more franchise operations, discussed in Sec- tion 14. LEGAL PITFALLS IN ACQUIRING THE SITE 17-8. Most provisions of a normal real estate contract apply to the purchase of an urban site for a shopping cen- ter. However, many additional provisions must be inserted in such a contract to protect the buyer who will be the ultimate developer of the shopping center. Zoning 17-9. Before the buyer takes title, the premises should be finally and effectively zoned (without further right of appeal) in full compliance with all planning board, subdivision, zoning board, and other governmental requirements so that the entire site may be used for any retail business structures, including the right to use all other areas for parking motor vehicles. (Sometimes zoning requires that there must be so many car parking spaces for every so many square feet of office or retail space.) This covenant should also extend to the buyer's right to satisfy himself that he will have un- limited ingress and egress from all abutting streets. Such permits for ingress and egress should be obtained prior to settlement. Often a zoning ordinance spells out that a particular piece of land is zoned for general commercial use and then goes on to enumerate the exact use to which the site may be put. This "use provision" often delineates the actual sizes of stores that can be built and what kind of stores may be built. Some zoning ordinances require that no super- market in an urban area can exceed 10,000 square feet. This is only one example and all should be checked and a provision should be put into the contract to protect pro- hibitive use clauses. Utilities 17-10. The buyer should have ample time to satisfy himself that all utilities, including water, gas, electricity, and sanitary and storm sewer lines, are available at the perimeter of the site and are of sufficient capacity to serve the needs of the contemplated shopping center. An investigation should be conducted to ascertain whether abutting streets are fully paved or are scheduled for major repairs or improvements. Aside from the problem of disrupting business, there is the question of major taxes and assessments for such new improvements. The urban area differs greatly from a suburban shopping center inasmuch as urban utilities can seldom be increased in size and the developer must make do with what land is first available. * Representative companies that have become involved in such ven- tures include (1969): Gulf Oil Corporation; Easdill, Inc., a subsidiary of Eastman Dillon Union Securities & Co.; Alcoa, Inc.; Reynolds Metal Company; P.I.C., Inc., a subsidiary of the Prudential Insurance Company of America; Cities Service Oil Company; Boise Cascade, Inc.; United States Steel Corporation; General Electric Co.; "One Bank" holding companies; mortgage investment bankers; and many local public utility companies. 90 Building and Fire Codes 17-11. The contract of sale should give the developer the right to cancel the contract if examination of the building and fire codes shows that a shopping center could not for economic reasons be built at this location. Some downtown areas have such antiquated fire and building codes as to prohibit a complex of stores commonly referred to as a shopping center. These antiquated codes are structured so as to permit only a series of individual or free-standing buildings. Test Borings 17-12. Prior to the settlement, the buyer should have the right to test the soil and subsoil to ascertain whether any unusual or adverse conditions exist. If conditions are found that would adversely affect construction of the shopping center buildings, the buyer should have the right to ter- minate the agreement. Many times a developer learns that a piece of land he thought to be "cheap" has turned out to be extremely costly after draining creeks, filling ditches, and sinking abnormal foundations. In city areas there is frequently an underground easement problem whereby sewers, utility lines, subways, and the like run under much of the downtown land. The contract must protect the de- veloper against his inability to develop because of hardships imposed by these problems. THE MORTGAGE APPLICATION 17-13. A mortgage application and presentation must be made in order to obtain permanent mortgage financing of any kind. The following is a short outline of some ap- proaches and pitfalls of this application which should be studied and which has proven to be useful in the past: (1) Economic Projection — Be sure that your project is economically feasible and that the work papers are in order and correct. (2) Pictures and Model — If possible a colored render- ing and a model of the development should be presented to the institutional investor. (3) Plans and Specifications — Preliminary plans and specifications for the project should spell out the general type of construction which will be used and what materials will be specified. (4) Maps — The project should be spelled out on maps and the trading area delineated so that the mortgage com- pany can see just what the economic "draw" is of this project. These maps should be tied into an economic survey and feasibility report. (5) Lease Form — The typical lease to be used in the shopping center should be presented to the lender. The lender should be asked to approve the form of the lease before it is signed by the developer. (6) Application Pitfalls — In many cases, a developer does not understand an application and many problems and misunderstandings arise in later stages of the project. To insure that this will not happen, the following pitfalls should be closely watched. (a) Be sure your application is accurate and com- plete. Read it in detail and make sure you understand all of the terms and nomenclature. (b) Be sure that you have ample time and leeway to start and complete the project. (c) Watch for "hidden" fees and costs which must be paid by the borrower at the time of closing. You should attempt to put on a limit for attorney's fees, appraiser's fees, and the like. These fees can run into several percentage points if not fixed at the time of the mortgage commitment. (d) Standby Fee — Be sure that this is a standby fee to be returned upon the closing and not an actual earned fee by the mortgagee. Naturally, if an earned fee is what is required, it should be spelled out in detail. THE SHOPPING CENTER LEASE 17_14. The first lease drawn in any shopping center is the most important because it is the guideline by which all following leases must be measured and negotiated. Since the key tenant's lease will always be the first one negotiated, it will contain restrictions and obligations on the part of the developer which must be perpetuated in the develop- ment of the center. The large supermarket which so often serves as the anchor of the shopping center likes to nego- tiate its leases so that they dictate the layout, policy, size, and operation of the entire center forever. Poor negotiation of the major store lease can hamstring the developer in all future negotiations. If the major lease is inadequately ne- gotiated, the developer and his lawyer will find themselves continually in trouble and going back to the original tenant and requesting waivers and modifications for each and every new tenant. 5 When dealing with small local tenants, a form lease can be used for the most part. However, no major tenant will accept a form lease; leases for such tenants must be tailor- made and individually negotiated. As noted above, the lender is vitally interested in the terms of the lease, so his interests and desires will have to be taken into account in negotiating with tenants. Standard form leases are said to be more favorable to the landlord, and many of their strict provisions represent protection which lenders insist upon. This may present problems for shopping centers which are being developed with the relatively inexperienced minority entrepreneur in mind as prospective tenant. WHERE TO SEEK HELP 17-15. Although the shopping center business is only 15 or so years old, a considerable body of expertise has been built up through trade organizations and private developer groups. (Appendix 17-A is a specimen checklist of factors to be considered in developing a shopping center.) International Council of Shopping Centers 17-16. Probably the largest organization devoted to shop- ping centers is the International Council of Shopping Cen- ters, Inc. (ICSC).' ; This organization is made up of thou- sands of shopping center developers, tenants, bankers, brok- ers, builders, architects, and other individuals closely asso- ciated with the shopping center business. ICSC puts out monographs and books on shopping center development and all of its phases. Membership in this organization is a "must" for any serious developer who is going to undertake a shop- ping center in the United States today. Entree to every . source of information can be had through ICSC and a liberal exchange of information is encouraged by the membership. Questions which are directed to the executive vice president of ICSC are re-routed to the appropriate member who can best answer the question; the inquiry is usually answered by an ICSC member at no expense to the one who inquires. In recent years, ICSC has encouraged many research projects in the shopping center fields and has published the results which are available to all members. ICSC puts out periodic newsletters and monographs of wide interest to ■ r ' Forms of shopping center leases and discussion of the individual clauses may be found in the books and articles on leasing in the bibliography in Section 17-20. u See footnote 1 for address. 91 shopping center developers. It has also recently established a special department for the promotion of urban and urban renewal shopping center projects. Urban Land Institute 17-17. A closely allied organization to ICSC is the Urban Land Institute. 7 ICSC and the Urban Land Institute work closely together in many research projects for the benefit of their respective members. Probably the best known work of the Urban Land Institute is an annual study of the shop- ping center industry known as "The Dollars and Cents of Shopping Centers." This book is a handbook required for every developer and contains all the facts and figures on shopping center development — from the cost of building to the cost of maintenance and upkeep of shopping centers after they are built. Any developer undertaking an urban project should become allied with these two organizations and avail himself of the materials and expertise available through their offices. Joint Venture with Experienced Developer 17-18. Another source of technical assistance for an LEDC which would want to engage in the development of a shop- ping center would be a tie-in of some sort with a presently operating shopping center developer or organization with expertise. This sort of liaison can take the form of either a joint venture or a partnership of some kind. It is often said that the cheapest kind of expertise to obtain is that which you "marry." The marriage between LEDCs and private developers is an excellent one and should give rise to many healthy shopping centers. In many cases, a private developer is quite knowledgeable in the building of single- family homes or high-rise apartments in urban areas but has no way of putting together a shopping center. In cases such as this, there is the possibility of a tri-part partnership with the LEDC, the residential builder, and the private shopping center developer. Naturally, these partnerships can take any form and any arrangement can be made as to the sharing of profits and workload. However, any LEDC which enters into such an arrangement should take special care so that the organization is ultimately set up in such a way as to best inform and educate the LEDC for future projects. Tie-In With Major Chain 17-19. Another possibility is for an LEDC to tie-in with a chain store outlet seeking additional branch units. In most cases it will be the LEDC who first finds the site and then seeks the chain store or supermarket as the prime tenant. In exchange for the right to be the first chain leased in the shopping center, the chain store can pledge its help and expertise to the LEDC. Most chain store organizations have extensive real estate departments which can be of immeas- urable help to LEDCs about to embark on an urban project. As a matter of fact, there is in many cases a close tie-in between public shopping center developers and chain stores. BIBLIOGRAPHY 17-20. The following sources provide additional information on shopping centers: Anderson, Seneca P. "The Mortgagee Looks at the Ground Lease," 10 Fla. Law Rev. 1. 1957. Anderson, Seneca P. "The Mortgagee Looks at the Commercial Lease," 10 Fla. Law Rev. 484. 1959. Colburn. "A Guide to Problems in Shopping Center Leases," 2 Brooklyn Law Rev. 227. 1962. Faletti, Richard J. "Financing the Shopping Center," Univ. of III. Law Forum, vol. 1955, p. 151. Friedman, Milton R. Preparation of Leases, Practising Law Institute. February 1962 edition, p. 145. Friedman, Milton R. "Store Leases," 37 N.Y. Stale Bar Journ., p. 126. Goldstein, Bernard H. Practical Aspects of Real Estate Develop- ments: Illustrated by a Shopping Center Project, N.Y.U. 18th Inst, on Fed. Taxation. 1960. Gruen & Smith. Shopping Towns, USA, Reinhold. 1960. Gunning. Francis P. Lender's Examination of Shopping Center Leases, International Council of Shopping Centers, Report No. 13. 1964. Gunning, Francis P. New Techniques in Financing, International Council of Shopping Centers, Report No. 17. 1966. Gunning, Francis P. On Submitting Mortgage Applications, Inter- national Council of Shopping Centers, Report No. 20. 1969. Hemingway, Richard W. "Selected Problems in Leasing of Com- munity and Regional Shopping Centers," 16 Baylor Law Rev. 1. 1964. Hyde, Harry B. "The Real Estate Lease As a Credit Instrument," 20 Business Lawyer 359. 1965. Kranzdorf, Baum, Faletti, Van der Kamp, Crampton, and Aucel. "Collection of Articles on Shopping Centers," Univ. of III. Law Forum. 1965. Morris, Jack Sidney. "Shopping Centers — The Role of the Lawyer," Univ. of III. Law Forum, vol. 1955, winter. No. 4, p. 681. Newman, Harry. The Unsubordinated Ground Lease, International Council Of Shopping Centers, Report No. 12. 1964. Note, "Lessor's Covenants Restricting Competition: Drafting Prob- lems," 63 Harv. Law Rev. 1400. 1950. Note, "Restrictive Covenants in Shopping Center Leases," 34 N.Y.U. Law Rev. 1959. Pollack, Benjamin. "Shopping Center Leases," 9 Kansas Law Rev. 379. 1961. Practising Law Institute, Business and Legal Problems of Shopping Centers Transcript. 1970. Practising Law Institute, Real Estate Financing Transcript. 1968. Practising Law Institute, Financing Corporate Growth. 1970. Report, Committee on Leases, "Drafting Shopping Center Leases," 2 Real Prop., Prob. & Tr. J. 222. 1967. Tulley, "The Shopping Center Lease," ch. 32 of California Land Security and Development, pp. 841-931. 1960. Williams. Ralph C, "The High Credit Lease as Security — A Lawyer's Viewpoint," 12 Ass'n of Life Ins. Counsel Pract. 1955. "The Role of the Commercial Lease in Corporate Finance," 22 Business Lawyer 751. 1967. "Another View of the SBA Lease Guarantee Program," 25 Bus. Lawyer 1053. April 1970. at 1058. Observations on the requirements of tenant's space and lease, breaches by the landlord, and a breakdown of the provisions required to be complied with to be eligible for guarantee. "Clauses in a Shopping Center Lease," 16 Practising Law 31. 1970. This article is geared for developers and the extent of their responsi- bilities. See footnote 1 for address of Urban Land Institute. 92 Section 18 HOUSING PROJECTS THE IMPACT OF HOUSING PROJECTS ON THE COMMUNITY 18-1. In the development of multifamily housing for low- and middle-income occupants, there are many areas for active participation by community and minority groups for whom the housing is created. They are in a position to participate in the planning, design, and execution of new and rehabilitated projects. A project may be for lease or sale to the tenants and may be either built by the sponsor organizations or acquired in a finished state. Various forms of government aid are intended to permit the eventual rental or carrying charge to be reduced to the level of low- or middle-income housing. When local or community groups participate in the sponsorship of housing projects, they may do so either as profit making, limited dividend, or non-profit organiza- tions, or as a housing development corporation. The par- ticular form will depend upon the government aid pro- grams employed in development of the project. To enable Local Economic Development Companies to decide what patterns of participation are possible, the attributes of sponsorship and the various Federal programs are discussed below, together with a general survey of the categories of supporting State and local programs which are available. HOW TO DEVELOP A HOUSING PROJECT 18-2. The development of urban multifamily housing under any of the programs discussed below will require the fol- lowing: ( 1 ) There must be a development team financially capable and experienced enough to see the project through from initial conception to finalling out and operation after completion. (2) A suitable site must be available. (3) The methods of financing all aspects of the proj- ect must be worked out. The Development Team 18-3. An essential ingredient in developing a housing project is a development team of skilled professionals capable of processing the project through the complex of government agencies. This development team generally consists of (1) a sponsor or developer, (2) an investor to furnish "front" or "seed" money and long-term equity money where needed. (3) a housing or real estate con- sultant, (4) a builder, (5) an architect, (6) an attorney, and (7) an accountant. In many instances, one or more of these specialties can be combined and handled by one individual. The lawyer, if familiar with government housing programs, often doubles as housing consultant or processor; the builder may provide the front or seed money, the initial equity and working capital, or even the long-term equity investment. The role each of these specialists plays depends on ar- rangements worked out among themselves. An experienced housing consultant may limit the role of the lawyer to preparation of legal documents, or the lawyer may limit the housing consultant to preparation of the rent roll. Generally, the key professional who exercises control and welds the team into a smooth functioning unit is the lawyer or housing consultant. The sponsor is the agency or vehicle through which development of the project is initiated and carried through. (Usually the sponsor sets up a separate legal entity to hold title to the property which is eligible to receive whatever subsidies are required to make the project feasible.) A number of the programs described in this section require that the sponsor be a nonprofit or limited-profit organization. The following are excerpts from an FHA form instruc- tion sheet regarding qualifications for eligibility as a non- profit sponsor. These FHA requirements are quite for- midable and might tend to scare off community groups that might otherwise like to assist in a housing program. Nonetheless, many local sponsors are qualified to sup- port FHA-assisted housing projects. There are other forms of assistance accessible to smaller or less qualified spon- sors. For example, a sponsor not qualified to participate in an FHA-assisted program could participate in local housing authority projects in various ways: locating ten- ants, providing social services, acting as housing manage- ment, acting in an advisory capacity to the local authority, supporting a Housing Assistance Administration program, etc. To perform many of these functions, a local sponsor would not necessarily need the strong qualifications de- scribed in this FHA instruction sheet. (1) Qualifications for Successful Sponsorship. It is most important that nonprofit sponsors should have continuity and a serious and long-range desire to provide housing for low- and moderate-income families and individuals. Well- established institutional sponsors, such as churches, labor unions, and fraternal organizations, are more likely to have continuity and a history of community and social service than a group organized for the specific purpose of initiating the project. In certain circumstances, however, a nonprofit group could have been recently formed with a sufficiently broad base of community or neighborhood support to assure continuity and successful operation of the proposed project. A group with deep roots in the community or neighbor- hood will probably be stronger than a national or regiona' organization without such roots. Moreover, a locally ori- ented sponsor is more likely to produce tenants for the project. A nonprofit sponsor should be motivated not only by a desire to develop an adequate housing project but also by a concern for the project's continuing successful operation. The entire membership of the sponsoring organization, 93 not just a few of its representatives, should be thus moti- vated. (2) Establishing Eligibility. To establish that a nonprofit sponsor is properly qualified to initiate, complete, and operate a housing project for low- and moderate-income families, FHA requires that: (a) The sponsor is acting on its own behalf and is not, either knowingly or unwittingly, under the influence, control, or direction of any outside party seeking to derive profit or gain from the proposed project, such as a land- owner, real estate broker, contractor, or consultant. (b) The sponsor fully understands the responsibilities and obligations of a housing project and its continuing successful operation. The principals and membership of the nonprofit organization should be prepared to explore in depth with the FHA director problems connected with land acquisition, interim and permanent financing, selec- tion of architects and contractors, construction, rent-up and management. (c) The sponsor is prepared by resolution of its di- rectors or trustees to acknowledge the responsibilities and obligations of sponsorship and continuing ownership and that this position reflects the will of its membership. (d) The sponsor is reliable on the basis of its reputa- tion and past performance or that of its principals. In determining reliability, consideration will be given to any experience the sponsor has had in providing housing or related social or community services. (e) The sponsor either has within its own organization or has made arrangements for the necessary professional and management skills which are essential for successful initiation, development, completion, and operation of the proposed project. (3) Capacity of Sponsor. The proposed project should not be beyond the capacity of the sponsor. One would not expect a small bank to take on the underwriting of a major industrial financing venture. Simi- larly, it would not be reasonable to expect a small church to assume responsibility for a large housing project. The size of the project must be in keeping with the size and capabilities of the sponsoring organization. If a well-motivated and reliable sponsor proposes a project beyond its capabilities, efforts should be made to obtain co-sponsors which will permit the combining of capabilities to the extent needed to satisfy the requirements of the proposal; or else the size of the project should be reduced. (4) Potential Sponsors. Although it is not desirable to attempt to establish rigid criteria for determining eligibility of nonprofit sponsors, certain factors will indicate strength, other factors will suggest weakness, and some factors will make the sponsor ineligible. An evaluation of factors appli- cable to a particular sponsor will assist in reaching a judg- ment about the eligibility of the sponsor and his ability to successfully carry out the project. Among factors which indicate strength are: (a) a seri- ous desire to provide housing for qualified low- and moderate income families and individuals; (b) deep roots in the neighborhood and community; (c) experience in successfully operating housing projects; (d) widespread support for the proposal within the membership of the nonprofit organization; (e) professional expertise within the nonprofit organization or available to it from qualified outside sources; (f) adequate financial capacity to meet initial expenses and to provide for unforeseen contingencies during construction and operation of the project; and (g) absence of conflicts of interest. Among factors which suggest weakness are: (a) no housing experience; (b) no experience or contacts in the neighborhood where the project would be located; (c) evidence that a builder, landowner, consultant, or some other party expecting to benefit financially had initiated the project and dominates the sponsorship; (d) lack of as- sured continuity of support by the nonprofit group as a whole, or the support of individuals who may not continue their association with the sponsoring organization; (e) heavy commitments in other fields which would tax the financial capacity of the group and weaken its support of the proposed project in times of stress; and (f ) lack of pro- fessional competence to build and operate the project successfully. The Need for Seed Money 18-4. The fees of the professionals mentioned above are eventually paid as part of the total development cost of the project. These fees are not paid until the project has been approved and initial mortgage closing has occurred. This creates a problem because most of the work of the develop- ment team (except the builder's job of construction and the sponsor's investment of working capital and long-term equity money) must be done prior to approval and initial mortgage closing. Until such approval is obtained it is not known whether the project will be successful; conse- quently, money cannot be advanced under the various financing programs which are needed to fund the project. Therefore, high-risk front or seed money is required to process the project up to the point of approval. Front or seed money usually is needed for: (1) Surveys (2) Borings (3) Legal fees and disbursements (4) Architects' fees and disbursements (5) Real estate surveys and reports (6) Technical analyses of costs and expenditures (7) Fees for processing services (8) Agency filing fees (9) Payments made on land-deposits, rent, purchase price. Depending on the size of the project and the amount required to be paid on the land prior to initial mortgage closing, the seed money required on a project can vary from a low of about one hundred thousand to several mil- lion dollars. When an LEDC acts as advisor to a local housing au- thority or works in conjunction with a local housing authority in the development of low-income public housing, in most instances the local authority will be able to finance the initial stages of the housing development, and the LEDC will not need its own seed money. Usually front or seed money is furnished by the sponsor- developer or the builder who is willing to invest this high- risk money to develop the project in the hope of realizing an ultimate profit on its successful consummation. How- ever, if the sponsor is a nonprofit or community group without funds and cannot obtain a builder to finance it, then the front or seed money must be obtained either by grant, usually from foundations, or by loan, usually from Federal, State, or municipal seed-money programs. Seed money for nonprofit sponsors in the form of interest- free loans of up to 80 percent of the "reasonable costs expected to be incurred" for pre-construction expenses is provided for under Section 106(b) of the Housing and Urban Development Act of 1968 (12 USCA 1701 (x) (bl). The Project Site 18-5. Selection of a suitable site for the project requires a number of threshold decisions as to the nature of the 94 project sought to be developed. The nature of the project can be determined by: (1) Conditions of marketability in the area, or (2) Social goals of the sponsor and the supervising governmental agencies. (1) Marketability as the Criterion. If ordinary real estate principles of marketability determine the nature of the project, the usual factors of location, zoning, neighborhood facilities, etc., must be evaluated. From this evaluation a bottom line figure of rental or carrying charge (for coop- eratives or condominiums) must be arrived at; then a decision must be made as to the financing programs which must be employed to attain the desired rental figure. The extent of government aid or subsidy is determined by the requirement that the least possible government aid must be employed and the maximum participation of pri- vate sources of funds is required, since government aid ar subsidy is available to such projects only if there is no Dther means of producing them. The initial determination of which programs to use for ievelopment of a particular site is a highly complex one nvolving an intimate knowledge of the available govern- ment programs and matching them to the characterisiics )f the site in question and the rent level to be achieved. Zoning can have a major influence on what may be developed on the site. Proximity to community facilities, ransportation, jobs, etc., also bears heavily on what kind )f project can be developed on the site. However, the nature of the site cannot alone determine he nature of the project that will be placed upon it. Be- :ause of the scarcity of urban sites, inner-city programs or community needs must be determined by criteria other han site availability or suitability. (2) Social Goals of the Project. If social goals such as he need for low-income or racially integrated housing are nvolved, then government aid or subsidy programs can >e employed on a particular site even though they are not leeded strictly to make the project economically feasible. 7 or example, if the site is in an area where marketability .t middle-income levels is feasible but where it is desired, or social reasons, to provide low-income housing, then ;reater government subsidy may be furnished to attain he lower rent levels. •election of Financing Program and Sponsor 8-6. Finding a sponsor is essential to the financing pro- ;ram. The program consists of the sponsor's investment, he institutional or government loans, and the subsidies ranted to the project. The goals of the potential sponsor nd the available mortgage and subsidy programs must >e reconciled. (1) As to an Urban Renewal Project. Selection of mort- age program and sponsor involves considerable overlap nd interrelationship with the planning function in develop- ment of the site. Theoretically, if a redevelopment plan as been properly and thoroughly prepared, selection of mortgage program will be conditioned by the goals of le redevelopment plan, and selection of the sponsor will e influenced by the various organizations that participated i defining the plan's objectives. In practice, however, the ecisions will be influenced not only by the plan and the articipants in the planning process but, more important, y the availability of sponsors and mortgagors. If urban renewal land is involved, the Local Public Lgency (LPA) should have determined and clearly de- ned, prior to selection of the mortgage program and ponsor, the following: (a) Source of capital funding for land acquisition and write-down (b) Land re-use (choice between housing and other uses) (c) Housing market to be served and the rent level to be achieved (d) Specific boundaries of the site (e) Timing of acquisition, relocation, demolition, and disposition (f ) Density (zoning) and design controls (g) Potential and interested sponsor organizations (h) Timing of public improvements and supporting facilities. If urban renewal land is involved it is important that the redevelopment planners determine land re-use and de- fine the housing market to be served in broad and flexible terms. During the planning stage, it is also important that redevelopment planners identify potential sponsors, but without making commitments. These are necessary condi- tions to provide the Local Public Agency with sufficient flexibility in developing a feasible housing project on the site, because frequently the LPA and the lending agency are independent bodies with somewhat different goals and viewpoints. In urban renewal areas, potential sponsors often make themselves known during the preparation of the redevelop- ment plan. Since development of a housing project always has an effect on the neighborhood in which the site is located, most Local Public Agencies favor sponsorship by organizations active in the affairs of the local community. With the wide range of mortgage and insurance programs, there is one available to achieve almost every redevelop- ment goal. Sponsors having working capital, or having an interim source of working capital available to them, generally are favored by an LPA over sponsors totally lacking funds, because even the initial steps of application for mortgage financing require some cash outflow. Builders, particularly of cooperative projects, are often willing to make equity and working capital advances on behalf of nonprofit spon- sors in return for being selected by the sponsor as general contractor. If such a relationship has been established between a potential sponsor and a builder, an LPA will consider it favorably in making its decision. It is, there- fore, advantageous for local community organizations to develop contacts with an established builder during the preparation of a redevelopment plan, so that when the plan is approved a "builder-sponsor" (and architect) team can make an immediate request for sponsorship. If the potential sponsors are profitmaking organizations, the possible combinations of mortgage programs is further limited, since there are no 100-percent mortgage programs for limited-profit sponsors. Furthermore, large projects, re- quiring heavy cash outlays under conditions of unusual risk prior to a mortgage commitment by the lending agency, may require the selection of a private/public corporation with special powers, such as the New York State Urban Development Corporation, as sponsor. Lastly, it must be remembered that LPAs are creations of municipalities and operate in a political environment. Local politics often play a major role in the selection of sponsors on government-owned or urban renewal land, particularly when more than one of the potential sponsors is capable of undertaking the project. Pragmatic politics have been known to prevail over fair play and reason in sponsor selection. (2) As to Government-Owned Land. If the site is owned by the Federal, State, county, or municipal government, sponsor and mortgage program selection is generally similar 95 to the process employed as - to urban renewal land. In many cases, however, the disposition of such land is gov- erned by statutes requiring public auction or other restric- tions which limit the control which can be exercised as to potential re-use of the site. In such cases the ordinary elements of real estate marketability will determine the nature of the project and the program to be used and the sponsor will be the highest bidder. On the other hand, if the government owner of the site may sell by negotiation, it may control development of the site to whatever extent is deemed desirable and the principles of sponsor selection and mortgage program discussed above as to urban renewal land would apply. (3) As to Privately Owned Land. On privately owned land, of course, the objectives of the municipality play a much lessor role. Usually the basic issue is whether the project is feasible and acceptable to the lending agency. If the LPA is the lender, or if the municipality grants a zoning change or financial assistance in the form of tax exemp- tion, obtaining a sponsor may depend on the applicant's acceptance of certain controls, such as design standards, apartment distribution, and ethnic and economic integra- tion. There also may be limitations on maximum allowable land cost, even though the sponsor owns the site outright or has it under option. Mortgage Processing 18-7. After the sponsor and the financing program have been determined, it is the responsibility of the sponsor to process the project through steps of the housing production pipeline. (1) Pre-Feasibility Processing. The sponsor must obtain a preliminary indication from agencies subsidizing or in- suring the project that the proposed redevelopment is feasible, that the site is acceptable, and that the sponsor is an eligible mortgagor. This preliminary approval can be quite complex. A privately owned project on privately owned land with no tax exemption requires only FHA approval if the mortgage is to be insured and no zoning change is required. If a zoning change is required, the sponsor must obtain either a preliminary or final ruling from the local planning body approving the necessary change; a public hearing may be required. If the project is to receive tax exemption, the municipal agency authorized to grant such exemption must give preliminary or final approval to the exemption; an- other public hearing may be required. It is conceivable that Federal, State, and city agencies could all be involved in preliminary approvals. In States where the mortgage loan or subsidies are made by a State agency, but the project receives Federal subsidies (for example, Rent Supplement l or Section 236 2 interest rate subsidy) and city subsidies (for example, tax exemption 3 ) to achieve a specific social goal, preliminary approvals by all agencies are required to guarantee that at initial mort- gage closing the combination of subsidies will be made available to the project. The first step in obtaining preliminary approval usually is an informal meeting between the proposed sponsor, his development team, and the lending or insuring agency. At this meeting the problems facing the project and the proc- essing procedures are discussed in general terms and the agency will agree to review a formal mortgage loan appli- cation. One part of the formal application consists of a form (for example, FHA forms #2012 and #3433) or list of information to be completed by the sponsor relative to his ability to carry out the particular project. The lending agency then inspects the site and conducts credit checks on the sponsor. If the lending agency determines that the proposed project is feasible and the proposed sponsor an eligible mortgagor, the sponsor is approved and invited to make a more detailed submission on a prescribed form (for example, FHA form #2013 or HDA form #P-100). There is no fee due to the lending agency at this point. (2) Feasibility Approval. It is then the responsibility of the development team to prepare a detailed feasibility submission to the lending agency (for example, on FHA form #2013 or HDA form #P-100). If the project is to be subsidized under a BMIR mortgage program, 4 rent supplement program, 5 or public housing program, the spon- sor also must apply for a reservation of subsidy funds. The submission of FHA form #2013 must be accompanied by an application fee of 1.5 percent (V4 of the total commit- ment fee) of the mortgage amount. The form provides for more detailed analysis of the project, including pre- liminary plans, specifications, and rough cost estimates. This stage usually requires an expenditure of funds for surveys, borings, preliminary architectural plans and speci- fications, certificates of incorporation, organizational and legal work, printing, etc. Architect's fees, legal fees, and organization expenses are usually 15 percent, 10 percent, and 10 percent respectively, of the total fees for these services at the point of feasibility submission. Fees for borings and surveys are based on actual costs. Options, if not already obtained, must be purchased at this point, for most lending agencies will not conduct a feasibility analysis on land in which the applicant has no actual or enforceable interest. In addition to the first expenditure of funds, projects sometimes encounter serious difficulties in the feasibility stage because some hard decisions have to be made. Gen- erally these decisions involve conflicts between cost factors and design factors. In the preparation of a feasibility sub- mission, important items must be decided, such as the apartment distribution (which can help or impair market- ability); the density; the design standards; and the amount of open space, community space, and commercial space. The housing consultant or lawyer, as the case may be, plays an important role here — keeping the architect within the bounds of practicality. This is especially important when the mortgage loan program utilized has statutory limitations on the maximum mortgage per dwelling unit. More than one Section 221(d)(3) BMIR project, for ex- ample, has been forced to undergo time-consuming and costly redesign because it could not be built under the FHA mortgage limitations. (This redesign, incidentally, does not increase the architect's fee.) It is helpful if (1) the builder periodically reviews the architect's progress and concepts; (2) the housing consultant is sufficiently aware of the relationship between construction costs and design to make sound decisions on what can and cannot be done within a given site; or (3) the architect himself is knowl- edgeable concerning costs and mortgage program con- straints. Furthermore, if the project is in a redevelopment area, the architect must be familiar with whatever controls, in addition to normal zoning, may have been imposed on the project by the LPA. Such innovations as special zoning districts, planned unit development, and open-space or community-space bonuses may be available. The architect should consider how they affect the maximum number iSee 18-12. 2 See 18-12. •fSee 18-17. 4 See 18-12. ■ r >See 18-12. 96 Df dwelling units and most economic design, as well as their aesthetic desirability. Upon completion of preliminary plans and specifications, the architect and general contractor cost-out the project. This information is added to the cost of abnormal founda- tions (determined from borings), demolition, site work, and bonding costs to arrive at total construction costs. On this amount the legal, architectural, organizational, and builder's fees are computed. Land acquisition costs, relocation costs, selling or rental costs, and interim carrying charges are then added in to compute the estimated development cost. (Relocation, demolition, and workin. capital may or may not be includsd in the estimated total development cost, depending on what mortgage program and land write-down program, if any, is utilized.) From this estimated development cost, the mortgage and equity requirements are computed, and an estimated annual operat- ing statement (a revised FHA #2013 or HDA #P-100) is developed. If the project is to receive interest reduction payments under Section 236 of the National Housing Act, FHA form #3126, which computes the annual subsidy required and shows the effect of it on tenant rents, must be prepared. Request for Preliminary Reservation of Funds also must be prepared. (3) Mortgage Commitment. The lending or insuring agency reviews all of the above material and, if it is satis- factory, issues a mortgage commitment. In FHA projects this is called a "preliminary commitment"; it authorizes the sponsor to commence working drawings and to prepare final cost and financial estimates, which, if approved, lead to "final commitment." State and municipally aided projects receive final commitment in one step before preparation of working drawings. Mortgage commitment means that upon completion of working drawings and of all details necessary to close a mortgage loan, the lending or insuring agency will grant the loan. In FHA projects, of course, this is a commitment by FHA to insure a privately held mortgage loan or to make subsidy payments; in State and city aided projects it is a commitment to disburse cash. This formal type of commitment is necessary before a sponsor can proceed to develop working drawings and advance the project to initial mortgage closing. Another 40 percent, 25 percent, and 25 percent of the total archi- tectural, legal, and organizational expenses, respectively, are required during this period and no sponsor could risk the expenditure of sums totalling approximately $350 per dwelling unit without some assurance that reimbursement from loan proceeds would be forthcoming within 3 to 4 months. At mortgage commitment the lending or insuring agency also determines the land value. This value is most important to the sponsor of a project on privately-owned land, and it may be greater or less than the purchase price, depending on the government agency's appraisal. If the sponsor has held the land for a long time or if a zoning change has increased its value, there is opportunity for a nontaxable step-up in basis. On the other hand, the lending or insuring agency may determine that the economic value of the land is less than the purchase price and may only allow a portion of the purchase price as a mortgageable cost. Estimated abnormal foundation costs due to subsurface soil conditions or topography also affect the allowable land cost. Generally lending or insuring agencies are wary of windfall profits in land valuation and do not ordinarily allow land values different from recent arms-length sales prices for similar parcels. After mortgage commitment the sponsor proceeds to develop final working drawings, specifications, and cost estimates. This period usually takes 3 to 6 months depend- ing on the size of the project, but with a major element of risk removed the development team is usually working at full capacity. The sponsor is required also to arrange with a private lender for permanent mortgage financing (in the case of FHA market interest rate (MIR projects) or for a construction loan (in the case of all FHA projects ). u Under many State- and city-aided programs, projects receive construction loans from the State or city, although under some circumstances a construction loan is obtained pri- vately. If the permanent mortgage loan or construction loan must be privately financed and the money market condi- tions are such that a lender demands a higher rate than the maximum allowable (currently 8Vi percent for FHA- insured mortgages), the lender may require a discount (or "points") to be paid to him to increase the yield. In recognition of this problem, FHA allows a one-time financ- ing fee to the private lender of up to 2 percent of the total mortgage amount. Also during the period between mortgage commitment and initial mortgage closing, the sponsor and builder, if they are not the same entity, negotiate the final construc- tion price. Following a final review of working drawings, specifica- tions, construction price, and financial estimates by the lending or insuring agency, an initial mortgage closing is held. (4) Initial Mortgage Closing. At initial mortgage closing, five key transactions occur: (a) A construction loan is made by the interim lender in return for a first lien on the property. (b) A construction contract is executed between the mortgagor and the builder. (c) Payment and performance bonds are posted by the builder. (d) Title to the land may be transferred if the mortgagor has not previously exercised his options. (e) FHA may insure the mortgage or execute an interest reduction or other subsidy contract. If the project is on urban renewal land, the following additional items take place: (a) A land disposition contract between the mortgagor and the city is executed conveying title to the redeveloper at a HUD-approved price and for a specific purpose. (b) Equal opportunity nondiscrimination agreements are executed by the mortgagor and general contractor. At the initial mortgage closing the sponsor is entitled to draw upon mortgage funds to reimburse many of his out- of-pocket expenses, such as 75 percent of the total archi- tectural and engineering, and all the legal, organizational, and financing expenses. Under FHA Section 207 the mort- gagor must await final closing to be paid for his land. The mortgagor also must put up a working capital deposit, as required by the lending or insuring agency, at initial mortgage closing. This deposit is not included as part of the mortgage in FHA MIR projects but is in FHA Section 221(d)(3) nonprofit projects and certain State and city assisted projects. The deposit must be in cash or negotiable securities and may be drawn upon for renting expenses or for initial operating losses subject to FHA approval. Where the project is a cooperative or a condominum the sale of apartments usually occurs between the time of commitment and initial mortgage closing. Most financing programs require the sale of a specified number of apart- ments before initial mortgage closing can be had. This is "Section 305(i) of the National Housing Act (12 USCA 1720(i)) provides for insured advances by the Government National Mortgage Association (GNMA) on certain mortgages during construction. 97 to insure success of the project and to make available the equity money needed above the mortgage financing to pay for the project. Where sales cannot be successfully effected before construction begins, the project can be started as a rental job on an investor-sponsor basis and later converted to a cooperative when enough of the apartments are sold during the construction period or after the building is finished. (5) Construction. Construction generally starts almost im- mediately after initial mortgage closing, but it may be started prior to initial mortgage closing under agreement with the lending and insuring agency, if the construction price is agreed upon. To actually commence construction, necessary building permits must be obtained after the plans and specifications are approved by the local building de- partment. Construction is carefully checked by the super- vising government agency and by the mortgage lender to insure compliance with the plans and specifications and with good building practices. In most government-aided pro- grams the construction contract is for a fixed price with cost certification. This means that the builder cannot get more than the fixed price if his costs exceed the estimates; but if the job costs him less than estimated, he only receives his actual cost plus the agreed builder's fee and the un- audited home office overhead allowance. The usual reserves are set up to take care of contingencies and change orders that may be allowed during construction. Rental of apartments usually starts several months after construction has started in an effort to rent up the entire building by the time the certificate of occupancy is obtained from the local building department and FHA. When that occurs the move-in of tenants must be supervised by the real estate consultant. While the building is being occupied and thereafter, cost records of the builder and sponsor are audited and costs are certified. Construction defects and "punch list" items are required to be cleared up, and the project is then ready to be finalled out. (6) Finalling Out. At final mortgage closing the certified final total project cost is placed in permanent long-term financing and the construction loan is repaid. In FHA projects the sponsor must certify that he has invested at least 3 percent of the total mortgage in the project in cash, exclusive of the 2 percent working capital reserve and his builder-sponsor profit and overhead allowance. If he has not invested this amount, it must be placed in escrow for at least 3 years after final closing as a reserve against operating losses. FEDERAL FINANCING PROGRAMS UNDER HUD 18-8. Turning to the specific financing programs available throughout the country, we will first look to the U.S. Department of Housing and Urban Development and its subdivisions. Only financing programs that provide generally for the development of low- and middle-income housing will be considered. "Workable Program" Prerequisite 18-9. Section 101(c) of Title I of the Housing Act of 1949, as amended, provides that a locality must have a "workable program" for community improvement as a condition to obtaining a loan or grant under the following Title 1 programs: (1) Urban Renewal Program, (2) Neighborhood Development Program, (3) Concentrated Code Enforce- ment Program, (4) Interim Assistance for Blighted Areas, (5) Demolition Grant Program, (6) Community Renewal Program, (7) General Neighborhood Renewal Plan, (8) Rehabilitation Grant Program, (9) Certified Area Program. Under the 1969 amendment to the Housing Act, the Low- Rent Public Housing Program no longer requires a "work- able program." The Independent Office and Department of Housing and Urban Development Act of 1968 requires either a workable program or "local official approval" to be obtained before rent supplements combined with Section 236 financing can be obtained. The workable program is designed to ensure that cities recognize the causes of slums and blight and are willing to work in concert with the Federal Goverment in eradicating them. It requires that a locality receiving Federal financial assistance give evidence of having taken steps in the follow- ing areas: (1) adoption and enforcement of housing, building, and related codes, (2) establishment of a con- tinuing public planning and programming process for the community as a whole, (3) development of a program for providing housing to low- and moderate-income persons and relocation of all persons and business concerns dis- placed by public action toward the provision of such hous- ing, and (4) citizen involvement in planning and carrying out HUD-assisted programs related to the workable pro- gram. Public Housing for Low-Income Families 18-10. The Local Public Agency and the various groups involved in the planning process may decide that housing to be developed on a given site should serve low-income families. Housing for low-income families generally means housing financed by a local Public Housing Agency and subsidized by the Federal, State, or municipal government. The meaning of low-income varies considerably, since rent subsidies adopt the local housing authority definition for a given area. Low rents under the public housing program are achieved by direct subsidy, paid by the government agency subsidiz- ing the program of the debt service, both interest and amortization, on the bonds and notes issued by the Public Housing Agency to finance the project along with tax abatement or exemption granted by the municipality. Rental income from tenants usually is required to cover only management expenses, maintenance expenses, operating expenses, reserves for replacement and repair, and any payments for real estate taxes or payments in lieu of such taxes. Sites for public housing are usually acquired by negotiation, wherever possible. As a last resort, they may be acquired by condemnation. (1) Developed and Owned by tbe Public Housing Agency. Public housing for low-income families is usually developed and owned by the local Public Housing Agency, an entity created by State legislation. When urban renewal land is involved the Public Housing Agency is named sponsor of the redevelopment site by the LPA and then carries out each of the steps of the housing production pipeline. Traditionally, private enterprises played no important role in the develop- ment of public housing. Administrative action as well as legislation has expanded the role of private enterprise in the provision of public housing. (2) Privately Developed. (a) Turnkey I or Acquisition Public Housing: By allow- for the acquisition of existing structures, the Housing Act of 1937, as amended, provides another method for develop- ment of public housing for low-income families. The turn- key method is one form of acquiring public housing. Under the turnkey method a developer or builder who owns a site or an option, or who can obtain one, may submit to a local Public Housing Agency a proposal to build 98 lousing for low-income families. If the proposal is accept- ible to the Public Housing Agency and the government igency (HUD) which will ultimately subsidize the project's lebt service when it is in occupancy, the Public Housing Agency contracts to purchase the completed development, rhis contract is backed by the HUD commitment to ubsidize the debt service of the bonds and notes issued by he local Public Housing Agency to provide the funds with vhich to purchase the project. Turnkey public housing can be either new construction or ehabilitation. There are no minimum or maximum limits is to the number or type of dwelling units which can be old to the Public Housing Agency, but the construction :ost for a turnkey project cannot exceed $4,200 per room $5,500 per room for projects designed specifically for the :lderly). Any type of developer, for example, a corporation, mrtnership, trust, or individual, is eligible to develop a urnkey project. (b) Turnkey II and Turnkey III: There are two other urnkey programs. Turnkey II provides for management of lublic housing projects by private management firms which :an be nonprofit, profitmaking, or tenant organizations. The >rivate firm executes a management contract with the 'ublic Housing Agency. Turnkey III is a homeownership program. The public lousing tenant signs a lease-purchase agreement, which inables him to acquire his unit. The agreement gives him xedit for self-maintenance and, in some cases, self-help luring construction. It is possible to combine the various turnkey programs, rhe role for an LEDC under Turnkey II is self-evident, but >y working with the developer and the Public Housing \gency it could also influence site selection, unit design, ind tenant selection. (c) The Leased Public Housing Program: Section 23 of he Housing Act of 1937 provides another vehicle for irivate enterprise to participate in the provision of low-cost mblic housing. Under this program, the Public Housing Vgency leases units in new or existing housing which it in urn sublets to qualified tenants. lousing for Middle-, Moderate-, and Lower-Income Families 18-11. The definition of middle-, moderate-, and lower- ncome families varies geographically. A useful definition s to include in this category families whose incomes make hem ineligible for low-income public housing, but who :annot afford nonsubsidized housing provided by the private narket. However, not all these families have incomes over he maximum for public housing. To reach this segment of the housing market. Federal, State, and local governments have created programs of tnancial assistance which directly or indirectly subsidize he development of privately owned housing. These subsi- lies take various forms, but all have the effect of reducing :he rental payments of tenants by reducing the annual :xpenses of the housing project in one or more of the Allowing categories: (1) Land cost (2) Annual debt service (interest and amortization) (3) Direct reduction or financing of tenant rents, carry- ng charges, or purchase price (4) Annual real property taxes (5) Direct financing of capital cost. It should be borne in mind that in all instances of private development of housing with government aid the ;xtent of assistance from government in the above categories is the minimum amount required to reach the desired iltimate rent or carry-charge level. The desired level of "ent or carrying charge is determined either by the social goals sought to be attained trough the project or by the level of marketability in the neighborhood. FHA Programs 18-12. The Federal Housing Administration (FHA), part of HUD, deals basically with mortgage financing. Under the latest reorganization of the Federal Department of Housing and Urban Development (HUD) in Septemeber 1970, special offices such as the FHA, etc., are being eliminated and in their place Area and Regional Offices are being set up. In this chapter, however, we will continue to refer to the old FHA programs which are being continued under the newly organized office structure. Until recently, FHA only insured loans made by private lenders; however, some FHA programs now involve more than mortgage insurance. FHA administers nine basic pro- grams for the development of luxury-, middle-, moderate-, and lower-income privately owned multifamily housing. Each program is named after the section of National Housing Act which created it. (FHA also administers programs for one-four family homes and military housing, which is not discussed in this paper.) Features common to FHA mortgage insurance and subsidy programs are described in detail below. Only in Section 207 and Section 232 is it stated that the projects must be economically sound. They can be built on owned or leased land and can be owned by individuals, partner- ships, syndicates, trusts, corporations, or associations. Section 241 of the National Housing Act was enacted in 1968 to permit "supplemental loans" to finance improve- ments to projects constructed under an FHA-insured mortgage. The programs are applicable to new construc- tion and rehabilitation of detached, semidetached, row, or high-rise buildings; the maximum interest rate is 8V2 percent; the maximum amortization period is 40 years or 3 4 of the remaining economic life, whichever is less; commercial and community facilities may be included to a limited extent in the project as a mortgagable cost; there are total and per unit mortgage limits; the project must be a multiple dwelling; and there are V2 percent insurance premium and other fees payable to FHA. Under FHA mortgage insurance programs an approved lender must be obtained before insurance can be placed. Where the maximum interest rate is below the market rate for similar mortgages (as occurs in tight money markets) arrangements can be made to make up the difference in rate by the payment of "points." These are discounts paid at the outset of the mortgage term which when spread over the life of the mortgage will make up for the difference in interest rate between the maximum allowable FHA rate and the market rate at the time of mortgaging. Points must be approved by FHA, and all charges imposed by the mortgagee must be revealed to FHA. This, of course, has no applicability to programs such as the BMIR 221(d)(3) and 236 programs discussed more fully below. Included in mortgages insured by FHA are all project costs: land and land improvement; brick and mortar costs of constructing dwellings, garages and commercial and community facilities; architectural fees; interest, taxes, and insurance during construction; FHA premiums; title and recording fees, including title insurance; legal fees and organizational expenses; and allowance for builder-sponsor risk, profit, and overhead expenses. Fees payable to the architect, attorney, and builder-sponsor vary with con- struction cost. Land cost is usually fixed, based on FHA land appraisals. However, if urban renewal land is involved, prior agree- ment may be obtained to the effect that FHA will allow the land cost fixed in the disposition agreement. The same 99 procedure is followed if the project site consists of leased land. All project costs, except the builder-sponsor's profit and overhead, must be cost certified as actually paid. The builder-sponsor's profit and overhead may be considered part of owner equity and not withdrawn from the project as taxable income if the builder-sponsor so desires. Builders must be bonded in amounts ranging from 10 percent to 100 percent of construction cost, depending on the program involved. After construction, projects with FHA-insured mortgages are subject to FHA supervision. Rental levels, return on investment, and the level of maintenance and reserves for replacement are subject to FHA review and approval. This supervision is authorized by prior agreement with the owner and the mortgagee. (1) Section 221(d) (3) 7 Section 221(d) (3), a market- interest rate (MIR) program, was added to the National Housing Act in 1959. The below-market interest rate (BMIR) program was added in 1961 for the purpose of financing construction or rehabilitation of rental coopera- tive detached, semidetached, row, walk-up or elevator type housing to low- and moderate-income families or individuals 62 years or older or handicapped. To date, this program, which is currently being phased out and substituted for by the Section 236 program described below, has offered the most significant vehicle for the participation of community organizations. The future of this program is described in the legislative history to the Section 221(d)(3) program as follows (1968 U.S. Code Cong, and Adm. News, p. 2894): "The 221(d)(3) program has been successful in pro- viding much needed rental and cooperative housing for these families. However, it has the limitation of depending on direct Federal lending from the special assistance funds of FNMA to support its 3-percent mortgages. The limited availability of these funds will not permit the production of the large volume of rental and cooperative housing for low- and moderate-income families needed to meet the goals contemplated by this bill. It is therefore neecssary to obtain financing from the private mortgage market. This would be done under the new Section 236. "The new 236 program is intended to replace the 221(d)(3) BMIR program as well as the program of direct 3-percent loans for the elderly and the handicapped authorized under Section 202 of the Housing Act of 1959, but only after the new program is fully operational and adequately funded." The community in which the project is located must have a workable program approved by HUD, although the project itself need not be in an urban redevelopment area. No more than 10 percent of a Section 221(d)(3) project may be occupied by low- or moderate-income single persons under 65 years of age. Priority is to be given to families displaced by urban renewal or other government action, or by natural disaster. The maximum mortgage amount insurable by FHA is $12,500,000 and the limitations on the maximum mortgage amount insurable by apartment size and type are as follows: Number of bedrooms: Elevator Walk-up $10,925 $9,200 1 15,525 12.937 2 18,400 15,525 3 23,000 19,550 4+ 26,164 22,137 These limitations may be increased at the discretion of the Secretary of HUD up to 45 percent in high-cost con- struction areas. Even with the 45-percent increase it is becoming increasingly difficult in high-cost areas to develop Section 221(d)(3) housing of even minimal design stan- dards within the per-unit mortgage limitations. The loan-to-value ratio under Section 221(d)(3) is 100 percent if the mortgagor is a nonprofit, cooperative, public agency, builder-seller, or investor-sponsor-mortgagor entity. A limited-distributon mortgagor (limited to a 6-percent return on equity) is restricted to 90 percent loan-to-value ratio. In the case of new construction, amount of the maxi- mum mortgage is based on estimated replacement cost; in the case of rehabilitation, the amount is based on the estimated rehabilitation cost plus the value, as appraised by FHA, before rehabilitation. If the property to be rehabili- tated has existing mortgage indebtedness or must be purchased, FHA allows the lesser of existing indebtedness, purchase price, or FHA appraisal prior to rehabilitation in determining the maximum mortgage amount. In all cases the mortgage loan cannot exceed 5 times the estimated cost of rehabilitation and therefore Section 221(d)(3) cannot be used to refinance existing indebtedness without sub- stantial rehabilitation. The amortization period under Section 221(d)(3) is at the discretion of the FHA Commissioner but is not to exceed 40 years or 3 A of the remaining economic life of the property, whichever is less. The interest rate cannot exceed 8V5 percent if the project is to be a market interest rate (MIR) project whose mortgage is held by a private mortgagee. As noted above, since 1961, Section 221(d)(3) also provides for a below-market interest rate (BMIR) after construction is completed and the permanent long- term mortgage is closed. Since no private lender will take a mortgage at 3 percent, only the construction loan is financed privately at the market rate, the Government National Mortgage Association (GNMA or "Ginnie May"), furnishes the mortgage loan directly from funds provided by Congress for this purpose. 8 Both nonprofit and limited- distribution sponsors qualify for BMIR financing by GNMA. The monthly debt service and, therefore, rents in Section 221(d)(3) BMIR projects are lower than in the other FHA programs which are financed at the market interest rate. Section 221(d)(3) MIR projects must pay to FHA the Vi percent insurance premium on the privately held FHA-insured mortgage. This premium is waived for Section 221(d)(3) BMIR projects. In either case the initial one-time service charge of 2 percent of the original mortgage amount, and application, commitment, and in- spection fees of about $8 per $1,000 of insured mortgage must be paid. These are included in the mortgage, and the mortgagor may be reimbursed at the initial closing. To insure that BMIR mortgage programs serve the moderate- to low-income tenant, the FHA Commissioner has established limitations on the incomes of tenants eligible for occupancy in Section 221(d)(3) BMIR projects. In New York, a high-cost area, the following limitations have been established (in effect in September 1970): Number of Initial persons: occupancy 1 $7,750 2 9,400 3^ 11,050 5-6 12,700 7+ 14,350 The FHA Commissioner also determines the maximum rents required to maintain the economic soundness of a Section 221(d)(3) BMIR project. In New York City the 1 A complete set of documents for implementing a 221(d)(3) proj- ect has been published by the nonprofit Housing Center of Urban America, Inc., 1717 Massachusetts Ave., Washington, D.C. 20036. H Advances on certain mortgages by GNMA during construction are provided for by Section 305 (i) of the National Housing Act (12 USCA 1720(i)). 100 maximum monthly rents which may be charged in a BMIR project is (in effect in September 1970) as follows: No. of bedrooms: Maximum monthly rent $129.17 1 156.67 2 184.17 3 211.67 4+ 239.17 The FHA rent scales have proved to be too high to enable low-income persons to be served by even the BMIR addition to the 221(d)(3) program without the added assistance of rent supplements and generally some form of tax abatement. Although the mortgage limits apply to both MIR and BMIR projects, the above-income and rent limits apply only to BMIR projects. The income and rent limits make it difficult to develop BMIR projects in high-cost areas. Even if a project can be designed within the mortgage limits, the allowed rent may not generate sufficient cash flow after payment of manage- ment fees, maintenance and operating expenses, reserves for replacement, and local real estate taxes to pay off the debt service on the mortgage, even at the low 3-percent interest rate. The combination of high construction costs, high operating costs, and tight statutory and administrative restrictions on maximum mortgage amount and maximum rental income has made the Section 221(d)(3) BMIR program largely unworkable in high-cost areas, although it is successful in lower cost areas of the United States. Where tax abatement or exemption is available under local law, it is possible to develop 221(d)(3) projects in high cost areas; for the rental income which would otherwise be too low to cover costs might be sufficient by virtue of the lower tax cost. The mortgagor of a Section 221(d)(3) project can be (a) a builder-seller mortgagor who will build and sell the project at a fixed profit (a percentage of construction cost) to a nonprofit organization, (b) a public agency mortgagor, (c) a limited-distribution mortgagor, (d) a management- type cooperative corporation, or an investor-sponsor will- ing to sell to a management-type cooperative corporation, (e) a nonprofit mortgagor, and (f) any other mortgagor approved by the FHA Commissioner. The sponsor can be an individual, partnership, syndicate, trust, corporation, or association if it is either nonprofit or limited distribution. Despite the limitation of a 6-percent return on equity, the after-tax cash flow return on actual investment to high- tax bracket partnerships or individuals can be lucrative. For some individuals it is worth investing in a limited- distribution project for the depreciation shield alone. This is particularly so since the 1969 amendments to the Federal Tax Law, where real estate tax shelters through accelerated depreciation have been largely eliminated, except as to low- and middle-income housing subsidized under the various subsidy programs. As to rehabilitations, a five-year accler- ated depreciation is allowed. The change is opening up a new flow of equity capital into new and rehabilitated low and middle income government-aided housing. (2) Section 236. Section 236, which was added to the National Housing Act by the Housing and Urban Develop- ment Act of 1968, and is substituting for the 221(d)(3) BMIR program, authorized the Secretary of HUD to make monthly contractual payments to private or public mortgage lenders on behalf of the owner of a housing project designed for and occupied by lower-income families. The monthly payment is a direct subsidy by HUD of the interest rate on the mortgage loan made by the mortgagee, rather than a below-market interest rate direct mortgage loan program. The purpose of Section 236 is twofold: (1) to further reduce to a minimum of 1 percent the interest expense paid by the mortgagor below the 3-percent Section 221(d)(3) and (2) to accomplish this reduction in a manner which permits private and public entities other than HUD to make the mortgage loan. Thus the program primarily applies to rental and cooperative housing heretofore insured by FHA under Section 221(d)(3). It is also applicable, however, to rental or cooperative housing projects owned by private nonprofit or limited-dividend housing corporations or entities, which are financed under a State or local program of direct loan, loan insurance, or tax abatement. Section 236 does not apply to projects developed under Sections 207, 213, 220, 231, 232 or 234. When a project receives assistance under Section 236, the limitations (for example, purpose of the loan, type construction, minimum number of units, maximum loan, loan-to-value ratio, term of loan, maximum interest rate, insurance premiums, fees, eligible sponsors, etc.) depend on the mortgage loan or mortgage insurance program under which it is being developed. For example, the maximum mortgage amount by unit size and type construction under Section 221(d)(3) applies to a Section 221(d)(3) project receiving Section 236 interest-reduction assistance. The interest rate received by the mortgagee cannot exceed 8'/2 percent. Of this, the housing project pays a minimum of 1 percent and HUD pays the remainder. At initial mortgage closing, HUD, the lender, and the sponsor execute a tripartite interest-reduction contract which obligates the mortgagor to pay to the lender a minimum debt service amount (interest and amortization) computed under a level-payment plan at 1 percent interest and which obligates HUD to pay the difference between the mortgagor's pay- ment and the debt service computed at the market interest rate, up to the legal maximum of 8V2 percent. Payments begin at final endorsement of the loan for insurance. By executing the subsidy contract at initial mortgage closing, the interest rate during the construction is reduced to 1 percent and thus lowers the interim interest charges in- cluded as development costs. Although the interest-reduction contract obligates HUD to pay a fixed monthly amount, the income limitations of the Section 236 program affect the actual amount of subsidy paid by HUD. Each tenant or cooperative member must: (1) have personal income below the statutory limits estab- lished by Section 236, and (2) pay a basic rental charge, computed on the basis of a 1 -percent interest rate or a minimum of 25 percent of his income, whichever is greater. The income limits established by Section 236 in New York are as follows: Number of Section 236 Section 236 persons: Regular Exception Limitation 1 $ 5,835 $ 7,000 2 7,390 8,450 3-4 8,555 9,950 5-6 10,095 11,450 7+ 10,660 12,900 The maximum monthly rents which may be charged in New York in a Section 236 project are as follows: Section 236 Number of bedrooms: Maximum monthly rent Exception Limitation $121.56 25 percent of income. 1 153.96 25 percent of income. 2 178.23 25 percent of income. 3 210.31 25 percent of income. 4+ 222.08 25 percent of income. The proportion of interest paid by the mortgagor and HUD, therefore, is determined by the incomes of the tenants occupying the project. If 25 percent of tenant incomes yield a rent roll greater than that required at a 1 -percent interest rate, the mortgagor is obligated to return this excess amount to HUD for use in other Section 236 101 projects. To be eligible for assisted admission to a Section 236 project a family's income cannot exceed 135 percent of the maximum initial occupancy limits established for public housing projects in the area or 90 percent of the income limits for occupancy of Section 221(d)(3) BMIR projects, whichever is greater. Only 20 percent of the authorized funds for Section 236 may be applied to interest reduction payments with respect to families whose incomes exceeded the former limitation at the time of initial renting of the project. This limitation does not apply to tenants who move in after the initial renting. In computing maximum actual entry income, a 5-percent standard deduction and a $300 deduction for each minor child living in the household are allowed. Biannual recerti- fication of incomes is required. Up to 20 percent of the dwelling units may be occupied by tenants receiving Federal rent supplements. Although the Act does not mention it, HUD has administratively ruled that this 20 percent also includes public housing units leased in private accommodations under Section 23 of the Housing Act of 1937. As noted above, Section 236 programs do not require a workable program. Section 236 has two major operational problems in high-cost areas. First, since the maximum mortgage limitations of the mortgage insurance apply, it will be almost impossible to build high-rise fireproof con- struction projects in high-cost areas without amending the statutory limits; it will even be difficult to develop feasible semifireproof or rehabilitation projects. Secondly, the statutory requirements that a tenant pay 25 percent of his income as rent and that this income not exceed 135 percent of the public housing limits combine to restrict the market to a very narrow segment of income. The program may therefore have marketing problems, particularly in the case of the large family. (3) Section 235. This program, also introduced by the HUD Act of 1968, provides assistance for lower income families to acquire home ownership or membership in a cooperative in a manner similar to the Section 236 pro- gram; that is, by interest subsidy payments to bring the borrower's mortgage and tax costs down to the equivalent of 20 percent of his income but with a limit equal to a 1-percent minimum interest payment. The family income limitations are similar to those of Section 236, discussed above. In general, assistance is available only for new or substantially rehabilitated units. This program is of limited applicability in many urban areas because of high construction and maintenance costs. (4) Section 221(b) and Section 235(j) Programs — Rehabili- tation Sales. These programs are designed to achieve home ownership (rather than rental housing) through the acqui- sition and rehabilitation of substandard or deteriorating structures by a nonprofit corporation for subsequent resale to low-income families. The nonprofit sponsor can obtain financing up to 100 percent of the appraised value of the property before rehabilitation plus the estimated cost of rehabilitation. The programs differ in two main respects. First, low-income families under the 221(h) program must have incomes below the maximum limits applicable under the Rent Supplement Program. Income limits for Section 235 (j) are slightly higher in most areas. Secondly, under the Section 221(h) program the mort- gage will bear a minimum 1-percent interest rate and will have a maturity determined by the FHA (usually 20 to 25 years). Under the Section 235(j) program, however, FHA insures a market-interest mortgage and makes mortgage assistance payments which may reduce the interest rate to 1 percent minimum. The assistance formula is the same as that discussed in Section 235 above. The nonprofit sponsor has to agree to sell the rehabili- tated dwellings to low-income buyers whose individual mortgages will also be insured by the FHA. The buyer must pay at least $200 down, which may be applied to the closing costs. To be eligible for insurance under this program, a mort- gage will have to cover property or properties containing four or more single-family dwellings of detached, semi- detached, or row construction or four or more units in a condominium structure. When an individual unit is sold to a low-income purchaser, such dwelling unit shall be released from the lein of the principal mortgage. Unsold 221(h) dwelling units will be held and operated by the original nonprofit sponsor as though they were rental units in a 221(d)(3) below-market interest rate project. The Secretary of HUD is to prescribe terms for operating the unsold Section 235(j) units. The low-income purchaser must buy the dwelling unit for his own occupancy; if he does not contiue to occupy the property, the special low interest rate (1 percent) will terminate and the interest rate will automatically rise to the highest permissible rate. However, the special low interest rate will remain in effect if he resells the property to the original nonprofit sponsor or to a public housing authority, or to another approved low-income purchaser. (5) Rent Supplements. Other FHA programs discussed in in this chapter operate to affect, directly, or indirectly, the monthly debt service. The rent supplement program created by Section 101 of the Housing and Urban Development Act of 1965 authorized the Secretary of HUD to supple- ment the rent paid by qualified tenants by making direct payments to owners of projects constructed or rehabilitated under specified sections of the National Housing Act, Section 202 of the Housing Act of 1959, or financed under certain State and local programs. The payment is made on behalf of the tenant and, as such, is rental income. The purpose of the rent supplement program is to pro- vide a mechanism for private enterprise to develop housing under FHA's low- and moderate-income insurance programs for persons eligible for public housing. In addition, it was hoped that the program would promote racial and social integration both within the project and within the wider community. Housing owners, eligible for approval to receive rent supplement payments are: (a) a private nonprofit, limited-dividend, or cooperative corporation or entity which has a mortgage insured under the National Housing Act 221(d)(3) MIR or BMIR programs; (b) a private nonprofit corporation or entity which has a mortgage insured under Section 231(c)(3) of the National Housing Act; (c) a private nonprofit, limited-dividend, or cooperative corporation or entity which is the owner of a housing proj- ect financed under certain State or local programs. Only 20 percent of the dwelling units in a Section 236 project may receive rent supplement payments. In addition, only 5 percent of the total annual payments for rent supple- ment be made to Section 221(d)(3) BMIR housing owners; and owners of Section 231 housing for the elderly may also receive in aggregate only 5 percent of the total annual payments. Application for rent supplements is made to FHA as part ° A case study containing the step-by-step documents Implementing the Rent Supplement program under Section 221(d)(3) is available from Urban America, Inc., Non-Profit Housing Center, 1717 Mass. Avenue, N.W., Washington, D.C. 20036. 102 of the initial project feasibility submission, and FHA will reserve a specific allocation of rent supplement funds when it approves feasibility. Project feasibility is enhanced if it is not totally dependent on rent supplements. It is required that the community have a workable program for com- munity improvement in effect or that the rent supplement program obtain local governmental approval in order for rent supplement payments to be made. By statute for an individual or family to be seleceted as a "qualified tenant," it must be shown that the individual or family income is below the maximum amount established for admission to low-rent public housing in the area. The tenant must also meet one of the following requirements: (a) He must have been displaced by government action. (b) Either he or his spouse must be physically handi- capped. (c) He must now live in substandard housing. (d) He must have lived in housing destroyed or damaged by natural disaster. In addition, tenants eligible for rent supplements must be within the asset limitation established by FHA. FHA has also established annual income limits, occupancy limits, and maximum monthly rent limits for projects receivng rent supplements. These vary according to locality. Bi- annual income recertification is required. The amount of rent supplement for any tenant is the difference between the market rent for the dwelling unit and 25 percent of the tenant's income, except that the rent supplement cannot exceed 70 percent or be less than 10 percent of the market rent. Individual tenant applications are processed by the housing sponsor and are reviewed by FHA. Since its enactment in 1965 the rent supplement program has been underfunded by Congress. If sufficiently funded, rent supplements provide a mechanism to serve the very lowest income families, for they provide a greater subsidy (70 percent of the nonsubsidized rental) than the maximum (6!i percent) interest rate subsidy under Section 236, or the debt service of local Public Housing Agency bonds and notes. Rehabilitation Loans 18-13. Section 312 of the Housing Act of 1964 provides a program of loans for rehabilitation, improvement, and repair of real property in conjunction with Federally as- sisted programs for urban renewal, concentrated code en- forcement, and meeting insurance standards. The purpose of the program is to enable recipients to meet the standards of one of the programs listed below, and in some instances to provide funds for general improvement of their property. Section 312 loans may be made to owners of property (for tenants of non-residential property whose leases will not expire di-ring the loan term) whose property lies within: (1) a Federally assisted urban renewal area; (2) a Fed- erally assisted code enforcement area, in which a program of concentrated code enforcement is being carried out by a locality; (3) a certified area, for which the local governing body has certified to the Secretary of HUD, among other things, that a substantial number of structures need rehabili- tation and are planned for rehabilitation or concentrated code enforcement within a reasonable time (loans are for owner-occupied 1-4 family residential property only); or (4) a FAIR area (Fair Access to Insurance Requirements), in which the property has been determined to be uninsur- able because of physical hazards after an inspection pursu- ant to a statewide property insurance plan approved by HUD under Title XII of the National Housing Act. Unlike the BMIR programs. Section 312 loans are ad- ministered at the Federal level by HUD's Renewal Assist- ance Administration (RAA) rather than Mortgage Credit (FHA). The LPA or other local governmental entity is responsible for all dealings with applicants for loans and for most of the processing of applications including the making of recommendations of approval or disapproval to RAA, which has the duty to approve or disapprove loans and to review appraised valuations of properties under consideration. Rehabilitation loans are made with Federal funds for a period not to exceed the lesser of 20 years or three- quarters of the remaining economic life of the structure at a rate of interest not to exceed 3 percent per annum. A rehabilitation loan for residential property, in addition to other limitations, cannot exceed $12,000 per dwelling unit (or 45 percent above $12,000 — or $17,400 — in high cost areas) or the actual cost of rehabilitation. HUD requires that for loans over $2,500, the general contractor must be selected by public bidding, and for loans over $10,000 compliance is required with the Equal Employment Opportunity Executive Order No. 11246. Be- cause the LPA must assure that no violations of local codes or standards exist in rehabilitated buildings and that suffi- cient financing is available to complete the work, the LPA rather than the general contractor is required to develop specifications and cost estimates. In many cases, the applicant is a resident homeowner of a one-four family dwelling, although multiple dwellings are also eligible. The LPA must review, in addition to the economics of the loan, the personal income, assets, and liabilities of the applicant, who must sign the note personally. Due to the specific nature and objectives of the program, it is of less general application than other Federally assisted rehabilitation programs. Nevertheless, it can be an effective tool to upgrade and maintain buildings in the areas mentioned above. Other Housing Programs 18-14. Only the most important programs involving low-, moderate-, and middle-income housing have been discussed above. Numerous other programs, some of which involve upper-income housing, have not been discussed. A list of all of the Federal programs with a one-sentence description of each appears on the last page of Basic Laws and Authorities on Housing and Urban Development. (See Section 18-27.) Summaries of the programs of particular interest to the community development organization appear in the Urban Coalition pamphlet. Finally, HUD pamphlets for each program with forms and instructions are listed in the catalog of HUD publications. Urban Renewal 1 " 18-15. A brief reference to urban renewal has been made in Section 18-9 describing the "workable program" require- ment. It is safe to say that users of this book who are connected with an LEDC in an urban area will find that an urban renewal program, in one of the stages described below, is in effect in their city. LEDCs in urban areas should be familiar with the urban renewal process not only because it may be a preliminary to their participation in the housing programs described above, but because various steps in the process may provide opportunities for local business and employment involvement in clearance and demolition as well as construction, but also because plans 111 Introductory remarks by the editors. 103 for clearance and redevelopment or rehabilitation may be under way which will affect planning for business develop- ment. As this section is restricted to the topic of the LEDC's involvement in the business of housing development, only a summary of the urban renewal process is included here. While the urban renewal process is carried out by govern- mental or quasi-governmental organization — the Local Public Agency — "citizen participation" in decisions at vari- ous stages is required, as noted below. (a) Federal planning programs: With the enactment of the Housing Act of 1949 the Federal Government embarked upon its program of aiding local communities to clear their slums and blighted areas and redevelop them by a com- bination of financial aid and technical assistance. In its broadest sense, the urban renewal process generally commences with the decision of a municipality to under- take a development planning study. Most municipalities have made provisions for an on-going planning function administered by a government agency, authority, board, or commission. Planning for Federally assisted programs involves such mechanisms for participation by the general public as open public hearings and the establishment of citizens committees which help formulate and review de- velopment plans prior to public hearings. Such studies are initiated by the LPA. The "workable program" requirement, discussed in Sec- tion 18-9, is a prerequisite for urban renewal loans and grants. The Congress has established a number of financial assistance programs to assist municipalities in the prepara- tion of comprehensive master plans, large area plans, and neighborhood plans. Section 701 of the Housing Act of 1954 authorizes HUD to make planning grants to State and regional planning agencies, counties, municipalities, and local subdivisions of municipalities (for example, community planning boards) for the purpose of solving complex, comprehensive plan- ing problems involving housing, transportation, public facili- ties, economic development, etc. These grants of % (% in some instances) of the cost of a planning project can be used for the development and implementation of plans and policies and the coordination of related plans and activities being carried on at various levels of government. Section 103 of the Housing Act of 1949, as amended (Title I), authorizes HUD to make grants to an authorized public body of up to 2 /3 of the cost of preparing, completing, or revising a Community Renewal Program (CRP). A CRP is an on-going, city-wide survey which identifies blighted and deteriorating areas, measures the degree of blight, estimates the type and amount of financial resources re- quired to redevelop such areas, and establishes priorities for renewal action among various areas so identified. Section 104(a) of the Demonstration Cities and Metro- politan Development Act of 1966 (Model Cities Program) authorizes HUD to make grants to city agencies, usually the LPA, responsible for administering the Model Cities Program, for the purpose of planning and developing com- prehensive Model Cities Programs within areas designated as Model Cities areas. Section 102(d) of Title I authorizes HUD to make ad- vances of funds to LPAs or other authorized local public bodies for the preparation of General Neighborhood Re- newal Plans (GNRP). GNRP are plans for areas smaller than city-wide but which are of sufficient size that com- mencement of urban renewal activities must be staged over a period not to exceed 8 years. Hence GNRP concerns areas smaller than those covered by the CRP but larger than a single urban renewal area and, in some instances, areas in which some redevolpment is underway. (b) In addition to GNRP advances, under Section 102 HUD may also make advances of funds to LPA's for survey and planning of specific urban renewal areas to determine the feasibility of undertaking renewal therein. The above-mentioned methods for initiating and fund- ing planning all require "community participation" in the planning process. The mechanism for this participation varies widely in different municipalities, as does the mean- ing of "participation" itself. In some communities, pro- fessional planners on the staff of the local planning commission and LPA consult in closed sessions with "community leaders" to formulate a plan with a minimum of publicity in advance of the required public hearing and approval by the local legislative body. At the other end of the spectrum, the planning commission or LPA may authorize direct planning grants to representative local planning bodies or may engage "advocate planners" to work closely in open meetings with all factions claiming to represent the community in determining the urban renewal plan. The Model Cities program particularly has emphasized total community involvement in the planning process. 11 (c) Survey and planning: The first step in undertaking an urban renewal project is generally the making by HUD of an advance for survey and planning, authorized by Section 102 of Title I, which will be used to plan voluntary rehabilitation work, prepare for land acquisition by con- ducting title searches, appraisals and other preliminary work. It is also used to plan for the enforcement oi State and local laws, codes, and regulations relating tc land use and occupancy and compulsory repair, rehabilita tion, or demolition of structures. In a few instances the survey and planning advance is preceded by an advance for a feasibility survey to deter mine whether an urban renewal project is practical from the standpoint of adequacy of existing legal powers, availability of relocation resources, and local financial support. Sinc< these advances must be repaid from the first loan fundi made available for the undertaking of the project involved an LPA may use its own funds for such purposes in the instance. Upon completion of survey and planning, the LPA must, in most cases, make a determination that an are< is slum or blighted, deteriorating or deteriorated, in ac cordance with State and local law. In addition, the ares must meet HUD's criteria for qualification as an urbai renewal area. Once HUD has approved an area for urbai renewal, the LPA must submit an urban renewal plan t( the appropriate local public body for approval after a public hearing. The plan also must be approved by HUD. (d) Loan and grant contracts: After HUD has ap proved the urban renewal plan, it enters a loan and gran contract with the LPA under which HUD agrees to pay Vi (or % in cities with populations of 50,000 or less, or ir certain depressed areas) of the net project cost of th< urban renewal activities. The LPA's share may be con tributed in the form of cash or in noncash grants-in-ak such as donations of land, demolition and removal work project improvements, and construction of public facilities Net project cost is calculated by subtracting the amoun of the proceeds from sale and rental of project land frorr the value of local grants-in-aid plus the cost of projec activities such as purchase of land, clearing of land, re habilitation activities by the LPA, and administration. ii Cf. note, "Citizens Participation in Urban Renewal," 66 Columbit Law Review, 485 (1966); Krasnowiecki, Housing and Urban Develop mem — Cases and Materials (1968), pp. 427, et seq. 104 In addition to paying % (or 3 A ) of the net project cost, IUD pays 100 percent of most relocation payments made o displaced persons and businesses. It also pays 100 per- ent of rehabilitation grant payments made, pursuant to lection 115 of Title I, to owners or occupants of residen- ial properties in the urban renewal area in order to make heir homes conform to housing code or other legal stand- irds. When an urban renewal project is a part of an ap- >roved Model Cities program, the percentage of Federal ;rant may be increased to include up to 100 percent of he local share in addition to the % (or % ) grant. HUD Jso provides Federal loan funds or guarantees private narket loans to the LPA to cover initial project expendi- ures not paid for by land disposition proceeds or grant >ayments. (e) Land acquisition: Unless special permission is given >y HUD, all acquisition of land for a project is made iter approval of the urban renewal plan and execution if the loan and grant contract by HUD. HUD encourages ^PAs to negotiate a fair purchase price for land before esorting to condemnation proceedings. In order to assure i fair price HUD generally requires that two independent ippraisals be made of each property and that an initial >ffer be made of the full amount of the price deemed air by the LPA on the basis of the appraisals and HUD :oncurrence. (f) Relocation: Section 105(c)(1) of Title I provides hat the LPA must have "a feasible method for the tem- )orary relocation of individuals and families displaced rom the urban renewal area," and that "decent safe and anitary dwellings" are being made available to those dis- )laced by renewal activities. Section 105(c)(2) requires he LPA, within a reasonable time prior to actual displace- nent, to assure HUD that such dwellings are available or the relocation of the displacees. The LPA may not )roceed with renewal activities until HUD has approved ts relocation plan. (g) Demolition: After completion of relocation, the -PA prepares demolition cost estimates, solicits public bids, wards the contract to the lowest bidder and supervises lemolition work until the site is cleared. (h) Neighborhood Development Program: The Neigh- borhood Development Program (NDP), created by the housing and Urban Development Act of 1968, provides immunities with an alternative method of conducting trban renewal activities. Its purpose is to aid communities o provide tangible results in a shorter span of time than vith the conventional method of urban renewal. This is iccomplished by substituting for a single large project, jften involving clearance of large areas, one or more smaller areas (not necessarily contiguous) which lend hemselves to rehabilitation or rapid redevelopment. Whereas urban renewal is carried out on the basis of a single grant reservation to fund a project, NDP is carried )ut on the basis of annual increments, under separate :ontracts for each year's activities with no Federal guaran- ee of a succeeding year. Planning in the initial stages )f NDP does not have to be as detailed as with the con- 'entional program and may not be financed by an advance rom HUD, although planning costs incurred in subsequent 'ears may be paid for from program funds. (i) Disposition: After demolition has been completed ind the site cleared of all existing structures, the site is eady for disposition to the sponsor for redevelopment. Disposition, or transfer of title from the LPA to the re- leveloper, usually occurs at initial mortgage closing when nortgage loan proceeds are made available to the rede- 'eloper for purchase of the land and the start of construc- tion. Under some circumstances title may be transferred in advance of initial mortgage closing. The two principal methods of sponsor selection and land disposition are competition and negotiation. Negotia- tion is the most common method because it permits early sponsor selection and greater control by the LPA over sponsorship. There are variations of each method which are sometimes used to select sponsors. One is the "design competition," where the LPA supervises a controlled con- test among sponsor-architect teams. A variation of the competitive method is the matched bid, where a sponsor is selected by negotiation early in the planning process, who in return for time and funds expended during plan- ning has the right to match the highest bid at public auction. When the sponsor has been selected, the land cleared, and a mortgage commitment for the project obtained from a lending agency, the site is ready for actual dis- position to the sponsor. Disposition involves two key ele- ments: land re-use price and the contractual conditions under which the transfer of title is made. Section 107 of Title I requires that disposition of urban renewal land for the provision of new or rehabilitated housing must be for fair value for use by a purchaser or lessee who is: "( 1 ) a limited dividend corporation, nonprofit cor- poration or association, cooperative or public body or agency, or other approved purchaser or lessee, or (2) a purchaser or lessee who would be eligible for a mortgage insured under Section 221(d)(3) or (d)(4), Section 221 (h)(1). Section 235(i)(l), or Section 236 of the National Housing Act." The determination of fair value by appraisals under- taken by the LPA must be satisfactory to both RAA, which provides a portion (depending on the program utilized) of the difference between the acquisition cost and disposition price, and to the lending or mortgage insuring agency (e.g., FHA) which must include the re-use price in the mortgage loan as a project cost. The disposition agreement, after re-use price has been determined, spells out in detail the conditions under which the site is to be redeveloped by the sponsor. Such items as mortgage financing, zoning and design conditions, apart- ment distribution, community space, equal employment opportunity, tax exemption, public housing leasing, etc., are clearly set forth in a legally binding document. This agreement is usually executed several months in advance of the initial mortgage closing after HUD approval has been obtained. At the same time, of course, the deed to the site is executed, and title is formally transferred to the sponsor. Construction is begun shortly thereafter. STATE AND LOCAL PROGRAMS 18-16. In some States the expansion of housing produc- tion programs on the Federal level has been paralleled by similar programs enacted by State and local legislatures. In some instances these programs are capable of assisting housing production independently of the Federal programs heretofore described. However, in most cases they are complementary tools to be coordinated with Federal plan- ning, slum clearance, mortgage and subsidy programs. These programs differ in each State and municipality and consequently are too numerous to be discussed in detail in this study. Accordingly, in the analysis of State and local programs, this report groups types of assistance found in typical State and local programs as a general guideline. It will require checking the laws of the individual State or locality to determine which of these programs are avail- 105 able for the development of housing in any particular local area. The States which have the most highly developed pro- grams at the time of this study are Connecticut, Illinois, Massachusetts, Michigan, Pennsylvania, New Jersey, and New York. The State with the most advanced and numer- ous programs is New York, and New York City has more local statutes in the field than any other municipality. Real Property Tax Abatement 18-17. Local real estate property taxes account for be- tween 15 and 30 percent of the rents paid by occupants of government-assisted middle- or moderate-income hous- ing. Thus, where local statutes are available to abate the normal local property taxes, a considerable reduction in the rent or carrying charge can be effected. This reduction can, in some cases, be sufficient to bring the rental or carrying charge level down to a low-enough figure to avoid the necessity for other government subsidies. It also can be used jointly with other Federal, State, or local financ- ing and subsidy programs to bring the project within mortgage and rent limits fixed in these other programs. These tax abatement statutes are usually accompanied by limitations on tenant rent and return on equity on the project. They are generally supervised by an administra- tive agency created locally under the provisions of the statute granting tax abatement. Frequently both new construction and rehabilitation projects are eligible for tax abatements, and commercial and community space can be included in the project if limited to the ground floor and basement. The formula for tax abatement can be either on the basis of a perecntage of taxes which would otherwise be assessed against the property or on the basis of a factor of gross rents earned by the property. These abatements can be fixed either by statute or by contract with the taxing authority. The exemp- tion is usually provided on both State and municipal taxes on land and improvements. The exemption generally is fixed for a specific period of years. The rent limitations provided in such statutes are usually similar to those in effect in public housing projects except that the formula, which is usually a percentage of maximum family income, varies depending on the rent level at which the project is aimed. In some jurisdictions tax abatement is also made avail- able to permit the development of industrial projects to assist in creating jobs in the locality. Where Federally assisted public housing is involved, communities are required to abate real estate taxes on the project, although payments of approximately 10 per- cent of the rentals of the project are allowed in lieu of taxes. The differential between full taxes and the reduced amount can be made up either by the municipality itself or by State payments to make up the difference between taxes paid by public housing and the normal taxes charged to the property. Tax abatement in most jurisdictions where it exists is available for both new construction and rehabilitation of existing dwellings. In all instances where tax abatement is granted, the sponsorship of the project is required to be on a nonprofit or limited-profit basis. Land Acquisition and Write-Down 18-18. As a supplement to the Federal urban renewal proc- ess (Title I of the National Housing Act of 1949, as amended) many States have provision for the exercise of the power of eminent domain in the assemblage of sites suitable for development with low-, middle-, or moderate- income housing. This power of condemnation under most of the State statutes may be exercised either by the munici- pality itself or by the housing company created under the provisions of the statute authorizing the condemnation. These programs generally are limited to nonprofit or limited- profit sponsors. In addition, provision is made in some juris- dictions for a direct contribution by the State or locality to the cost of acquisition of the land, which is tantamount to the land cost write-down available under the Federal Title I urban renewal procedure. Where such State programs are available, they are preferable to the Federal urban renewal procedure. This is because the assemblage and acquisition of the land can occur much more rapidly under State pro- grams than in the long and cumbersome processes under the Federal urban renewal procedure. Some programs involve the acquisition and ownership of the land by the municipality with a leasing arrangement to a developer at favorable terms. These leasing arrangements free the developer from investing substantial capital in the land and substitute an annual rent on the lease which be- comes a deductible operating expense of the project. This is particularly attractive for cooperative and condominiur projects, where the lease arrangement would lower the cost of purchasing the housing although it would increase the carrying charges. These leasing arrangements can be aidec in many localities by the issuance of State guaranteed tax exempt bonds which are repaid from rent receipts under the terms of the lease of the land. In many jurisdictions there are a number of differen statutes under which land acquisition and write-down pro visions are available, and a selection must be made of the program most suitable for the particular project. Seed Money and Technical Assistance 18-19. Statutes in some jurisdictions provide a nonprofi housing project with an interim source of seed money tc defray project expenses incurred prior to the initial dis bursement of mortgage proceeds. A housing developmen fund is established for the purpose of loaning seed money te eligible housing companies. To be eligible for seed monej under these programs, the project must be nonprofit anc be financed by a government aided mortgage. Usually then is a requirement in these statutes that it may be "reason ably anticipated" that a mortgage loan will be granted b] the appropriate government authority and the advance wil be repaid at the initial mortgage closing enabling the fune to revolve and be utilized for other projects. The loans ar set up on the basis of covering expenditures for preliminar architectural fees, engineering fees, site options, tenant sur veys, market analyses, and legal and organizational expenses all of which would usually be recoverable from the proceed of the mortgage at initial mortgage closing. These loca seed-money programs are similar to the seed-money provi sion made in the Housing and Urban Development Act o 1968. In some instances there are programs which create non recoverable grants rather than recoverable seed-money loan; These grants may be available through funds created fo that purpose by the locality or as a result of foundatioi grants. In many areas provisions can be made for granting tech nical assistance needed in the development of the projec This assistance is generally furnished by the local govern ment agency set up for that purpose. However, it is some times available through private sources such as foundation; local Urban Coalition, or organizations such as the NAAC or the Urban League. In some cases, seed-money loans an technical assistance are made available to limited-prof housing sponsors as well as to nonprofit housing sponsor; 106 Below-Market Interest Rate Mortgage Loans 18-20. Several States have now set up mortgage loan pro- grams on the basis of borrowing through the issuance of tax-exempt bonds at low interest rates. These are usually long-term mortgages (ranging from 40 to 50 years) and consequently carry a lower debt service retirement factor than conventional financing would call for. These programs are generally available to nonprofit or limited-profit housing developers and require income limitations. Usually they are combined with provisions for tax abatement in order to assist in bringing the rents down to low- and moderate- income levels. Frequently construction loans are made available as well as long-term mortgage loans, both of which are floated at a below-market interest rate on liberal credit terms. A su- pervising agency fee is usually charged for this type of loan which is similar in many respects to the mortgage insurance premium of the FHA loan. These fees cover the cost of operation of the program and provide reserves against mort- gage defaults. Under a provision of the Housing and Urban Develop- ment Act of 1968, projects of this sort are eligible for interest reduction payments under Section 236 of the Na- tional Housing Act. There is usually provided a requirement for a limitation of tenant's income with provisions that when the tenant's income exceeds a fixed ratio, the tenant is required to pay a surcharge. As a rule, there are also restrictions on the sale of projects financed under these programs. This type of financing is used frequently in combination with available Federal programs, particularly with land cost write-down and acquisition assistance provided for by the Federal Title I, Model Cities, or Neighborhood Development Programs. Rehabilitation Process 18-21. This is a program where a State or municipality makes loans io private owners for the purpose of permitting the rehabilitation of single or multiple dwellings for occu- pancy by low-income families. The program is sometimes called the Municipal Loan Program. Before the loan can be made the property must be inade- quate, unsafe, and unsanitary. Both rental and cooperative projects are eligible. There is no restriction on the number of dwelling units, but the building must be a multiple dwell- ing within the boundaries of the municipality or the State and in an area where private rehabilitation loans are not available. The loan is made directly to the mortgagor by the municipality. The mortgagor may be a corporation, partner- ship, syndicate, trust, or individual. Usually the mortgage loan does not exceed 90 percent of the property value as ap- praised by the supervising agency after rehabilitation. These loans sometimes are subordinated to prior privately-held indebetness, and second mortgages are permitted. The loans are generally financed from tax-exempt bonds of the municipality, which are usually charged against the municipality's housing debt limit. They are usually amor- tized for a period which cannot exceed 30 years or for the estimated life of the property, whichever is less. The interest rate is the same rate as that paid by the municipality on its bonds. These loans are eligible for interest reduction pay- ments under Section 236 of the Housing and Urban De- velopment Act of 1968. Rents are controlled by the supervising agency as are the income limits of tenants eligible for occupancy in the projects. These programs are usually accompanied by some form of exception from local real property taxes, which in many cases amounts to 100-percent exemption for a fixed period of years. Housing Development Corporations 18-22. Some States have initiated programs for the creation of nonprofit housing development corporations which would serve as sponsor or developer of the project in the absence of a local group which could serve as the sponsor. 12 These corporations are calculated to furnish the high-risk seed or front money that is required to make development projects feasible in their early stages. Some are supported by private foundation money and some by direct contribu- tion of public funds. These corporations act in close co- operation with local public and private groups. Special Assistance Program 18-23. Some States have adopted programs to subsidize the rent or carrying charge which otherwise would be re- quired of tenants in government aided low- and middle- income projects. These programs, sometimes called capital grant programs, are similar to the Federal Rent Supplement Program in which a rent payment is made on behalf of the tenant, but the mechanism in the State programs for reduc- ing the rent paid by the tenants is somewhat different. The administering authority is authorized to purchase or rent a certain percentage of the dwelling units in the project and then to sublet them to eligible tenants at less than the rental required to be paid for the unit. The difference is financed from State funds appropriated by the State legislature for this purpose. Tenants receiving such assistance are required to meet specific income limits and are regulated by the supervising agency. The payment of rent or carrying charges is made directly to the housing company, and the rent is collected by the supervising government agency directly from the tenant. Another illustration of the type of program States have enacted to assist low- and middle-income housing is the loan program for the purpose of assisting middle-income families to meet the equity down payment of cooperative projects. This assistance is made available to families who can afford the carrying charges of cooperatives, but who do not have available the resources to pay the down payment for the apartments. The loan usually bears interest at a below- market interest rate based on the cost of borrowing by the supervising agency and runs for a limited period of years with the requirement that the purchaser pay a minimum down payment for the apartment. OPPORTUNITY FOR LOCAL CONTRACTORS 18-24. A number of related areas for economic development can follow from the development of housing projects. There are opportunities for local or minority general contractors and subcontractors to participate in these programs along with architects, labor unions, mortgage banking firms, legal and insurance groups, and management and maintenance outfits. These opportunities can become available to local groups as a result of the development of housing projects depending upon the location of the project, its sponsorship, and the government-aided programs under which it is devel- oped. In all instances, however, there are opportunities for participation by local and community groups. 12 A feasibility survey of the setting up of a Housing Development Corporation in Houston, Texas, prepared by the Non-Profit Housing Center of Urban America, Inc., should be examined by LEDCs interested in this approach. 107 Legislative and Other Support 18-25. Section 3 of the Housing and Urban Development Act of 1968 states: "Sec. 3. In the administration of the programs author- ized by sections 235 and 236 of the National Housing Act, the below-market interest rate program under section 221(d)(3) of such Act, the low-rent public housing program under the United States Housing Act of 1937, and the rent supplement program under section 101 of the Housing and Urban Development Act of 1965, the Secretary of Housing and Urban Development shall — "(1) require, in consultation with the Secretary of Labor, that to the greatest extent feasible opportunities for training and employment arising in connection with the planning, construction, rehabilitation, and operation of hous- ing assisted under such programs be given to lower income persons residing in the area of such housing; and "(2) require, in consultation with the Administrator of the Small Business Administration, that to the greatest extent feasible contracts for work to be performed pursuant to such programs shall, where appropriate, be awarded to business concerns, including but not limited to individuals or firms doing business in the fields of design, architecture, building construction, rehabilitation, maintenance, or repair, located in or owned in substantial part by persons residing in the area of such housing." The HUD handbook for the Section 236 program states, in paragraphs 14 and 15: "14. Employment Opportunities. Lower income resi- dents of the community shall be given, to the greatest extent feasible, opportunities to be employed in the construction or rehabilitation of housing produced under Section 236. Often, lower income residents will require training to par- ticipate effectively in the employment opportunities created by the construction, rehabilitation, and management of proj- ects. Insuring offices should assist sponsors in developing such employment and training programs. "15. Contract Opportunities for Area Businesses. Busi- ness concerns or individuals located in or owned by residents of the area in which Section 236 housing is to be built or rehabilitated should, to the greatest extent feasible, be given the opportunity to bid on contracts for planning, design, construction, material supply, maintenance, repair, and man- agement of Section 236 projects. Often neighborhood sup- plies and contractors will lack the experience to undertake such work and the financial capacity to meet bonding re- quirements. The insuring office director should explore with the sponsor ways to utilize neighborhood contractors, sup- pliers, and other firms. In this connection every effort should be made to encourage larger, more experienced construction, materials, and management organizations to enter into joint ventures with neighborhood firms." The most important thing which an LEDC can do at present in connection with construction, operation, manage- ment, and maintenance is to locate and identify local con- tractors and subcontractors and potential managers and superintendents. The Davis-Bacon Act (40 USCA 736a) requires that wage rates prevailing in the area must be applied in all work under government contract. The Act is applied to all of the Federal programs previ- ously described in this chapter. National Housing Act, Section 212, 12 USCA 1715 C. See the regulations to the various Sections (24 CFR 200.1 et seq.). The regulations to the Davis-Bacon appear at 29 CFR 5.1 et seq. The effect of the Department of Labor application, according to contrac- tors interviewed by the editors, is to require employment of members of the various construction unions. The Labor Department on June 27, 1969, issued an order describing a plan requiring the employment of minority group workers in all Federal and federally assisted construc- tion contracts exceeding $500,000 in a five-county area of Pennsylvania. The Department stated that they planned to set up similar plans in other major cities. The order, after referring to findings of fact regarding exclusionary practices of labor unions in the affected area, prescribes a procedure under which future contract low bidders must submit an "affirmative action program" indi- cating that minority manpower utilization standards have been met in the following trades: ironworkers, plumbers pipefitters, and steamfitters, sheetmetal workers, electrical workers, roofers and waterproofers, and elevator construe tion workers. The standards are to be determined by the Office of Federal Contract Compliance on the basis of th< following factors: ( 1 ) The current extent of minority group participatioi in the trade; (2) The availability of minority group persons foi employment in such trade; (3) The need for training programs in the area and/oi the need to assure demand for those in or from existing training programs; (4) The impact of the program upon the existing labo: force. Bonding Programs 18-26. One of the obstacles to significant participation ii housing construction which minority group contractors havi faced has been their inability to obtain surety bonds. J program for getting technical and managerial support t< satisfy surety companies that contractors will be able t( carry through a project has been developed by the Fon Foundation. A demonstration project set up under thi program, the General and Specialty Contractors Associatioi in Oakland, California, operates as follows: (a) A foundation grant provides a revolving fund b supply working capital, plus administrative expenses for i program manager and staff of four. (b) The program manager and staff are men with Ion experience in the construction field, who assist the membe contractors in joining together to take over the big jobs, b providing expert support and constant supervision as well a training. For complete information on this program, obtain copy of "Minority Contractor Bonding Program — A Manua of Organizational Steps and Procedures," by writing to: Office of Reports Ford Foundation 320 East 43rd Street New York, N.Y. 10017 The LEDC can help the expansion of opportunities fc minority contractors by actively encouraging the establisl ment and operation of a locally based and representativ organization of minority contractors in the area. One such organization, the Association of United Coi tractors of America (AUCOA) has a membership of aboi 60 minority group contractors' organizations engaged i various types of work, ranging from minor renovatio through major construction and demolition jobs. Its addrei is 271 Lenox Avenue, New York, N.Y. 10027. On projects growing out of the LEDC's activities, priorit can be given to the use of qualified minority contractors b channeling requests for the names of interested contracto through such a trade association. The association coul provide the initial screening to insure that applicants ai properly qualified, as is done by AUCOA. 108 IBLIOGRAPHY 8-27. The following reference materials provide additional information i housing projects. Clurman, David, and Edna L. Hebard. Condominiums and Coopera- tes, John Wiley & Sons. Inc.. 1970. Discusses requisite considerations :fore attempting to establish a condominium or cooperative. Elabo- ites on New York regulations and FHA forms. Agenda jor Positive Action: State Programs in Housing and Corn- unity Development, Urban Coalition, 1819 H Street, NW., Washing- m, D.C. 20036. Basic Law and Authorities on Housing and Urban Development. smpiled for Senate Banking and Currency Committee, U.S. Govern- lent Printing Office, Washington, D.C. 20402. Building the American City, report of the National Commission on rban Problems (Douglas Commission), 91st Congress, 1st Session, ^ouse Document No. 91-34, U.S. Government Printing Office, Wash- igton, D.C. 20402. December 1968. ($4.50). Guide to Federal Low- and Moderate-Income Housing and Develop- ment Programs, Urban Coalition, 1819 H Street, NW., Washington, I.C. 20036. Public Housing, Rural Housing Alliance, 1346 Connecticut Avenue, Washington, D.C. 20036. Publications of the Department of Housing and Urban Development HUD MD-36), U.S. Department of Housing and Urban Develop- tent, Washington, D.C. 20410. "Symposium on Housing: Problems and Prospects in the 70's," art I. 2 Urban Lawyer Winter 1970. A. Sections 235 and 236: The irst Year, p. 14. Explanation of both programs in light of the con- ressional goal, a review of the first year experiences, as well as the ramifications of the 1969 Housing and Urban Development Act. B. Citizens' Participation: A Challenge to HUD and the Community, p. 29. Discusses community participation thus far and urges develop- ment of mechanisms to assure effective participation and representa- tion. "Symposium on Housing: Problems and Prospects in the 70's," Part II. 2 Urban Lawyer Spring 1970. A. A Lawyer's View of Opera- tion Breakthrough, p. 137. Focuses on problems a lawyer faces in government contracting. Operation Breakthrough is directed at gov- ernmental and private constraints affecting the quantity and quality of housing production. B. Low Cost Housing Systems, p. 146. New ideas for providing low and moderate income housing. C. The Function of the Private Builder, Manager, and Owner in the Evalu- ation of the Low-Rent Housing Program, p. 175. Discussion of the turnkey programs. D. Abandoned Buildings and the In Fill Program, p. 186. "Summary of Tax Reform Act of 1969," 25 Bus. Law. 973, p. 998. A. Items 13 and 15 under Miscellaneous: "Cooperative per-unit retain allocations paid in cash," and "Cooperative Housing Corpora- tions," respectively. "Rebuilding the Ghetto from Within," 2 Manpower 7. June 1970. Relates Clifton Terrace experience in terms of using black construc- tion workers and community participation. "Citizen Participation in Urban Renewal," 66 Colum. Law Rev. 485. 1966. Handbook on Housing Law, National Housing and Development Law Project, Earl Warren Legal Institute, Berkeley, California, 1969. Rohan and Reskin. Condominium Law and Practice Forms. Matthew Bender, 1967. Rohan and Reskin. Cooperative Housing Law & Practice, Matthew Bender, 1969. 109 Section 19 INDUSTRIAL PROJECTS INVOLVING OUTSIDE CORPORATIONS ROLE OF THE LEDC 19-1. Selective industrial development, sponsored or stimu- lated by a Local Economic Development Company, can make maximum use of a depressed area's major resource — its resident labor force — and have a multiplier effect on the community's overall economy. However, technical, man- agerial, and financial resources are essential to enable such enterprises to utilize local human resources effectively and to compete successfully in the marketplace. A large industrial corporation (IC) occupies one of the best economic positions from which to make a contribution toward economic development of a low-income community. At present, few economic advantages or incentives exist to entice an IC into a ghetto or underdeveloped rural area. In fact, initial costs for ventures within the urban core are normally higher than for those in suburban areas. Neverthe- less, some large concerns do parpticipate in programs to alleviate minority unemployment; toward this goal, some ICs have expanded their inner-city operations. In addition, several companies have begun to assist new inner-city ven- tures in such areas as financing, managerial consulting, operational advice, and customer patronage, in order to aid in developing managerial and entrepreneurial skills in de- pressed communities. A Local Economic Development Company (LEDC) or similar organization could have a large role in the planning and coordination of projects involving ICs. An LEDC could render invaluable assistance to the venture — by contacting potential corporate and community participants and by lend- ing its knowledge of the economic potential of the area to the planning and execution of the project. The LEDC may also be able to contribute to the capital and manpower needs of the venture and to participate on a continuing basis. Therefore, the LEDC, as well as the IC and minority entrepreneur, should be familiar with major legal problems incident to an ICs involvement in the ghetto. Projects May Take Several Forms 1 19-2. The extent and form of the ICs arrangements with the local entrepreneur and LEDC should be governed by the goals of the venture and by the legal and business con- sequences that will flow from the choice of organizational forms available to the parties. Among other factors that should be considered by the parties in determining the form that the venture should take are the following: (1) Is the business that will be conducted by the venture sufficiently defined to justify operation as a separate business entity, or should it be integrated with exist- ing facilities of the IC? (2) Which form of venture can be operated most economically and efficiently? (3) What busi- ness relationship, if any, will exist between the IC and the venture? (4) Do sufficient markets exist so that the venture could eventually be operated profitably without support from the IC? (5) Are resources, such as management and produc- tion skills, access to financing, etc., available to the ventu separate from the ICs resources? (6) Perhaps most portant, what is the expectation of each party with respc to its appropriate share of equity in the venture? Depending on the above factors, the parties have a bro range of organizational structures to choose from. At o extreme, the venture could be established as a division subsidiary owned 100 percent by the IC. In some cases joint venture with ownership and control divided betwe the parties may be advisable. At the other extreme, it m be in the best interests of the parties to provide for si stantial or complete ownership by the local entrepreneurs the LEDC, or both of them together, with the IC providi assistance primarily as a lender, advisor, customer, etc. It may also be that, even though present factors dictat( large degree of ownership and control by the IC, its r could be diminished once the venture is able to stand its own. In this case, any of the above approaches in wh the IC takes an equity interest could be initially utilized conjunction with an eventual plan for divestiture or dimii tion of the ICs position of ownership. SUBSIDIARY OR DIVISION APPROACH 2 19-3. Probably the simplest approach in terms of both or nization and operation is the establishment of a vent within the central city that would hire minority labor to p duce goods, materials, or services used in the operation of ICs business. The venture could be organized as a separ; wholly owned subsidiary of the IC or as an integra division of the IC. The IC will theoretically be confron with problems identical to those arising at any time exj sion is undertaken, and a venture originally set up a division could later be incorporated. Organization 19-4. Organization of a subsidiary requires certain forr ties. For example, the corporate charter must be filed in State of incorporation, by-laws must be adopted, stock issi minutes of meetings kept, accounting records set up, In other words, all formal requirements of establishin| corporation held by individual stockholders must be served by the parent. Since the parent is the sole stockhol| however, certain short cuts may be followed once the er is established. For example, many States allow a whl owned corporation to be managed by one director or by[ stockholder. The organization of a division requires few formali since a division is not a separate business entity. Qualification 19-5. If the IC is not already subject to the jurisdiction the State where the venture will have its operations, usl 1 See suggested reference materials in Section 19-30. - Sec suggested reference materials in Section 19-30. 110 a subsidiary might preserve the IC's insulation from that State's reach. Although the subsidiary must qualify in the State (unless it is incorporated there), such qualification will not subject the parent to the State's jurisdiction. Use of a division would clearly require qualification by the IC in the State where the division is located, rendering the IC subject to the State's jurisdiction for most purposes. Minority Representation 19-6. Assuming a role is to be played by a minority entrepreneur or an LEDC, a subsidiary lends itself to participation by such parties. Minority participation could be accomplished by minority representation on the board of directors of the subsidiary or by appointing LEDC or minority representatives to executive offices of the subsidiary. If eventual divestiture of the IC's interest is contemplated, the IC could establish a separate subsidiary, the stock of which could later be transferred to a minority entrepreneur. If a division is set up, minority participation could be accomplished by the creation of divisional offices. Eventual divestiture of a division, although perhaps somewhat more difficult than divestiture of a subsidiary, could also be accomplished. employees with the required skills for jobs at production levels. 3 Liability of Parent for Subisidary's Obligations 19-10. A major consideration at this stage may be the IC's desire for limited liability. Notwithstanding enthusiasm for the venture, the parent corporation is probably willing to risk only a fixed amount of its assets in the venture. This factor alone may dictate that the venture take the form of a subsidiary rather than of a division. To prevent the possi- bility that the corporate veil could be pierced (that is, that the separate entity of the subsidiary would be disregarded and the parent held liable for the subsidiary's acts or obligations) the following steps should be taken: ( 1 ) A separate financial unit should be set up and maintained. That unit should be sufficiently financed so as to carry the normal demands made upon it. (2) The day-to-day business of the two units should be kept separate. (3) The formal barriers between the two management structures should be maintained. (4) The two units should not be represented as being one unit. Taxation 19-7. The tax consequences from use of a subsidiary differ somewhat from those of a division. Transfers of property to a subsidiary or division would not normally be taxable. If the subsidiary is initially unprofitable, the IC would not gain the full and immediate benefit of losses as it would with an unprofitable division, unless a consolidated return covering both the IC and the subsidiary were filed. If the subsidiary shows income, it would itself be taxable at normal corporate rates. Of the dividends paid by the sub- sidiary to the IC, 85 percent normally would be exempt from tax. If the IC meets certain requirements, including Dwnership of securities representing at least 80 percent of the voting power of the subsidiary and at least 80 percent of each class of nonvoting stock of the subsidiary, the IC may elect to receive dividends tax free. Outside Financing 19-8. If needed, outside financing of the division or sub- sidiary may be accomplished by traditional means, such as public offerings of debt securities, lease financings, industrial revenue bonds, etc., as well as by utilizing any of several government programs. Small Business Administration funds probably would be unavailable in this approach, but Man- power Training grants and grants through the Economic Development Administration and Office of Economic Oppor- tunity might be obtained. In addition, banks, foundations, churches, and other institutions are making more funds available for this type of venture; they usually require as a prerequisite seed grants from other organizations, including presumably the IC. (See generally Part III of this book.) Management 19-9. An IC using the subsidiary or division approach is likely to find that entrepreneurial skills needed to staff the enterprise completely at the management level are not immediately available in the community. However, individ- uals could be brought in at the executive or managerial level for training. (A potential source is within the IC itself.) rhe parent should also consider lending experienced person- nel with pertinent and essential backgrounds for guidance at the start of the operation; this can often make the difference between success and failure. The IC will probably need to set up training programs to provide the new subsidiary's JOINT VENTURES 4 19-11. Ownership and control can be divided between the IC and the minority entrepreneur, with possible participation by the LEDC. The main problems in forming such a rela- tionship will be choosing the business structure to be estab- lished and providing for division of interests and respon- sibilities. It is not possible to anticipate all the varying interests and objectives which could be represented by the parties to the venture. However, for purposes of this section, it is assumed that the IC will furnish capital to the venture in the form of equity or debt or both. It will probably also be looked to for its expertise and general business experience as well as for its contacts with financing sources, potential customers, and the business community in general. The minority entrepreneur presumably will not supply initial capital to the business. However, he will provide services, ideas, and some degree of expertise. The LEDC will have an important role in analyzing the feasibility of the venture from the community's standpoint and in bringing the parties together. It may also stand ready to supply funds or credit and beneficial contacts. The various objectives of parties to the venture may be roughly predicted. The IC's first interest will be effective use of its investment. Inherent in this objective should be a desire to have some control over the operation or business to assure efficiency and economy. The IC will also wish to control the quality of products or services of the enterprise, especially if a business relationship is to exist between the IC and the enterprise. The minority entrepreneur will want fair compensation for his contribution, in terms of both present compensation and future participation in profits of the enterprise. He, like the IC, should also be especially interested in efficient operation of the business and quality of the goods or services produced. An LEDC should be interested in receiving compensation for the services it may have already provided as well as a return on any funds invested in the enterprise. Both the corporate and unincorporated forms can be structured to reflect the desires of the participants with 3 See "White Help for Black Business," Special Report, Harvard Bus. Review 4. May-June 1970. Research survey of attitudes and activities of large corporations in supporting minority ventures, with list of businesses. 4 See suggested reference materials in Section 19-30. Ill respect to allocation of ownership, profit-participation, and control. Before a choice can be made as to the form, however, a number of factors should be considered. Some of them follow: (1) Formalities of organization of the form of business. (2) Importance of limiting each participant's liability to the amount of capital contributed. (3) Importance of providing continuity and perma- nence of the enterprise. (4) Desirability of maintaining or restricting free trans- ferability of interests in the enterprise. (5) Effect of form on the availability of financing, both public and private. (6) Desired allocation of ownership and control of the enterprise. (7) Tax consequences, both immediate and continuing, flowing from the choice of business form. Organizational Formalities 19-12. Organization of a corporation requires more formal steps than does organization of a partnership. In nearly all States the corporate charter must be filed and recorded with a public agency. In addition, the incorporators or directors must adopt by-laws, hold an organizational meeting, issue stock certificates, and preserve minutes of meetings. Organizing a general partnership usually requires no public filing unless State law requires filing under a fictitious or assumed name statute. Often an agreement is not necessary to establish a partnership, although it is rarely advisable not to have one. The creation of a limited partnership is a public and formal proceeding which must follow statutory require- ments. A detailed certificate much like a corporate charter must usually be filed. There is little difference between corporation and partner- ship organizational costs. Corporations and limited partner- ships must pay nominal filing fees not required for general partnerships. Attorney's fees for the setting up of either type of business form should not vary substantially. The local franchise or capitalization taxes should be examined to determine which form of organization pays higher taxes. State laws usually place a larger burden on corporations than on partnerships with respect to taxes, fees, and annual reports. A corporation, unlike a partnership, is required by many States to have a minimum amount of capital paid in before it can commence operation. The sum required, how- ever, is usually far less than the initial capital needs for an operating company, so this factor is largely irrelevant. State law with respect to the nature and valuation of consideration for shares of stock of a corporation must be complied with, and corporations are required to qualify in each State in which they do business outside of the State of incorporation. Partnerships are generally exempt from such qualifications. A further problem for consideration is the view held by some courts in the past that a corporation exceeds its cor- porate powers when it becomes a partner. This view was based upon the rationale that the authority of partners to manage their joint affairs and bind each other is incom- patible with the statutory mandate that a corporation be managed by its board of directors. Several States, however, have expressly granted corporations the power to enter partnerships. In States where corporations are not permitted to be partners, certain courts have held that corporations may nonetheless enter joint ventures; the distinction is made in these cases that a joint venture involves less delegation of managerial authority of the board of directors. A joint venture is a business association distinguishable from a partnership (if at all) only by narrowness of purpose and scope, it commonly being organized for a single under- taking or a series of related undertakings. Whether a joinl venture is considered a partnership or merely compared to one, the venturers are governed by the rules applicable tc partners and are subject to the same formalities of organiza tion. Limitation of Liability 19-13. In general, a stockholder of a corporation will no be liable to creditors of the corporation in an amoun exceeding his capital contributions. He also stands in th< same position as a third-party creditor for any sums len in good faith to the corporation and not subordinated t< other claims. The same principles hold for limited partners but not with respect to general partners, who are personallj liable for all obligations of the business. Limited liability may be of most importance to the K which, presumably being the more solvent party to th< transaction, is more likely to be looked to than the minoritj entrepreneur for the satisfaction of liabilities of the business However, even if the corporate form is used, lenders ma] initially ask for a guaranty by the IC of certain indebtednes of the venture, thus diluting the advantage of limited liability If the original capitalization is sufficient in the eyes o lenders and other creditors or, at a later stage, if the busines is expanding and prospering, the IC may not be called upoi to extend a guaranty. Moreover, even though a guarant may be required with respect to particular items of indebted ness, the corporate form normally will prevent individua liability on loans and contracts not separately guaranteed, a well as liability arising out of unauthorized contracts o nonventure-related liabilities of other parties. Circumstances may be such that a limited partnershi form could be used to accomplish insulation from liability If, for example, the IC's participation is intended to b limited to financial support, with no management role, th IC could act as a limited partner. The LEDC might also ac in that capacity. It must be kept in mind, however, that th limited partner will forfeit his limited liability by takin part in the control or management of the business. Anc of course, general partners do not have the benefit of limite liability. Continuity and Permanence of Enterprise 19-14. The corporate form is also the only form insurin the continuity of the enterprise. Unlike partnerships agencies, which, unless otherwise provided by agreemen automatically undergo a technical dissolution upon th happening of any one of several events, the corporation ca be organized to continue until affirmative action is take toward its dissolution. In some cases the identity of th parties would be considered of such importance that dissoh tion or liquidation would be desired, for example, upon th death or departure of any party. The parties can control the question of continuity b agreement either, in the corporate form, by limiting th venture's duration by charter or, in the partnership, b providing for the continuation of the business notwithstanc ing the occurrence of events which would otherwise caus dissolution. The matter of providing for dissolution < liquidation upon disagreement or deadlock of the parties discussed below. Transferability of Interests 19-15. It is normally more difficult for one to dispose c his interest in a partnership than in a corporation. Owne ship of an intangible claim in the residual assets of a co 112 poration is normally freely transferred 'oy transfer of the stock certificates representing that claim. Unless otherwise agreed, the consent of other stockholders is unnecessary. Transfer of a partnership usually not only requires the consent of other owners, but may technically be a dissolu- tion of the partnership. It is likely that, in most ventures that are the subject of this book, the parties would desire to initially restrict the transferability of interest. It does not automatically follow, however, that a partnership form should be used to accom- plish this purpose. The corporate form could accomplish the same goals by providing by agreement for the restriction of transfer of shares of stock or by granting various pur- chase or first-refusal rights to the other stockholders. In this way, once it is decided that transfer would be desirable and any restrictions are removed, transfer could be accom- plished more easily than in the case of a partnership interest. If such an approach is followed, care must be taken to insure that any restrictions on transferability of interest are reasonable and that stock certificates are clearly noted with a legend setting forth the restrictions in order to put third- party purchasers on notice. Availability of Financing 19-16. The corporate form of business generally has an advantage in obtaining funds, partially because of the broad range of equity and debt securities (or combinations thereof) it may offer. A corporation with competent management and a good earnings record can raise capital by public offerings; and, where a large amount of capital is required, the public securities market has it most readily available. Of course, public offerings will be somewhere in the indefinite future for most ventures that are the subject of this book. The availability of private financing does not depend on the form of the business. Private and institutional investors tend to be more concerned with the quality of the business and its management. Also, as mentioned above, whether the organization is a corporation or a partnership will make little difference if individuals are to be looked to for guar- anties of loans. The form of the transaction may have a bearing on the availability of certain government funds. (See Part III of this book.) Ownership and Control 19-17. This is, of course, the most sensitive area of the relationship between the parties, perhaps more so in this context than would be true in customary commercial ven- tures. For this reason the parties should not expect to settle ill questions with ease. (1) Allocation of Ownership Interests. Both the corporate ind the partnership form can be structured to achieve the desired allocation of ownership and control of the venture. In the corporate form respective ownership and profit par- icipation interests can be easily represented by the type and imount of securities issued to the parties. If initial revenues vill be needed for expansion, the corporation obviously should not issue preferred stock or debt securities bearing ixed dividend or interest rates if it can be avoided. Multiple :lasses of common stock, bearing various rights, or a single :lass of common stock can be issued in proportions reflecting he negotiated interests. If ultimate withdrawal of one or nore parties from the venture is contemplated, option or mrchase agreements can be adopted. For example, the IC :ould receive a majority of the stock initially issued and >rovide by agreement for the transfer of all or part of its tock to the minority entrepreneur or the LEDC upon ex- •iration of a certain period or the happening of specified events. Alternatively, provision could be made for the issuance to the IC of a Class A common stock bearing liquidation and dividend preferences over a Class B common stock for a specified or ascertainable period of time. A non- cumulative preferred stock could accomplish the same ob- jective as the Class A stock. Allocation of ownership of a partnership is not as readily accomplished. For one thing, "ownership" is measured by the right to share profits and the obligation to share losses as well as by the respective partnership interest; these inci- dents can be avoided in the corporate form. A presumption exists that partners will share both profits and losses equally unless otherwise specified by agreement; however, the agree- ment could include provision for the gradual withdrawal of the IC and increased ownership by the minority entrepreneur. (2) Allocation of Management Control. The corporate form also lends itself to natural distribution of management control in any of several ways. An even number of directors, with half of the board being elected by each interest, would assure that each side retained a veto power over the other. This may also be provided by classification of shares, each class being entitled to elect an equal number of directors. This equilibrium could be maintained through a shareholder agreement or through the rights borne by the shares them- selves, providing that each interest is entitled to elect an equal number of directors. A problem would arise in the case of a vacancy, but a solution would be to provide in the agreement for filling the vacancy by the class of shareholders who originally elected the director to the now vacant seat. To prevent the loss of equilibrium in the case of absence of a director, any of the above types of provisions should be coupled with a requirement that action may be taken only by a majority of the whole board of directors or by a majority of those present, provided that at least one director of each class votes in favor of the action. It may be that in most cases the interests of the LEDC (if one is present in the venture) and the minority entre- preneur would predictably be more closely aligned than any other combination of interests. If so, it may be advantageous to provide that half of the directorships be divided between the LEDC and the minority entrepreneur. Equilibrium may also be accomplished in the use of the partnership form. Each partner has traditionally had one vote without regard to his proportionate ownership of the venture. If only the IC and minority entrepreneur were involved in the venture, veto power would result naturally from the partnership form. If an LEDC is involved, how- ever, veto power could be maintained only if two of the parties pool their rights — for example, by appointing a managing partner representing their joint interests to serve with a managing partner from the other party. If equilibrium is not initially desired, it is a simple matter in the corporate form to vest one interest with absolute power by issung to that interest stock of a class or quantity entitled to elect a majority of directors. If stock is dis- tributed equally, one interest can be vested with initial power through a voting trust, voting agreement, or proxy. Some State statutes allow for the operation of the corporation by shareholders instead of directors, or by a sole director. In the partnership form, a managing partner can be appointed to act with full authority. (3) Anticipatory Provisions Covering Divestiture or Dis- sension. If it is intended that the IC will eventually withdraw from the venture, recognition should be given to this fact in the control provisions. In this case the agreement specifying representation on the board and appointment of officers should provide for a gradual phasing out of representation of the IC and an increase in the proportionate representa- tion of the minority entrepreneur. One approach to this 113 might be to link the transfer of control to the transfer of equity or profit participation. Whatever the allocation of control, it will be necessary to anticipate dissension between the respective parties. In all commercial ventures the parties are well advised to recog- nize that, despite optimism and mutual goodwill at the outset, there will be occasions in the future when the rela- tionship may be inharmonious. The laws governing all forms of commercial relationships contemplate the possible neces- sity for divorce, but such a course followed automatically by operation of law, or after protracted litigation, seldom provides as satisfactory a solution as can be achieved by an agreement which anticipates disputes before they arise. The objectives of such an agreement are several, (a) Each participant's measure of control, responsibility, and authority to act should be clearly delineated in advance. A formal understanding of respective roles will prevent many disputes from arising and provide a ready answer to many that do. An outline of roles should be sufficiently flexible to allow for the smooth function of normal operations and should be revised as circumstances warrant, (b) Because disputes will arise over matters going beyond jurisdictional questions, means for managing the business pending resolution of such disputes should be agreed to. (c) Effective provisions should be made for resolving the conflicts by inserting a dis- interested viewpoint. Various types of deadlock-breaking provisions include the appointment of a distinterested direc- tor to serve either on a permanent basis or to be appointed when serious disputes arise, delegation of broad authority to stockholders or management committees, and provisions for arbitration of disputes under specified circumstances, (d) In case a conflict not capable of resolution arises, pro- vision should be made for the orderly exit of one or all of the participants on fair terms. The above provisions should also be considered in the context of the likelihood that eventual voluntary divestiture of one party's interest is intended from the beginning. In such a case, a deadlock provision should take the form of some sort of buy-out provision running to the local entre- preneur of the LEDC, rather than its being a dissolution provision. The provision could be drafted so as to merely accelerate the effectiveness of whatever normal withdrawal provisions have been agreed to, with the terms appropriately adjusted to reflect the circumstances. Of course, alternate provisions should be made in case the continuing party is unable to provide adequate capital or value for the IC's interest. If the parties are unable to agree to a private resolution of their difficulties, procedures are usually available under State law. Both New York and Delaware corporate laws, for example, provide for judicial action to resolve deadlocks. The Delaware law contains a procedure for continuing the business during disputes as well as a procedure for dissolu- tion. Tax Considerations 19-18. The varying tax consequences resulting from the choice between the corporate form and the partnership form (whether general or limited) can be significant. (1) Rates. The rates paid on taxable income differ sub- stantially between forms. Because the earnings of a partner- ship are passed through to its partners, the rates vary according to each partner's individual tax status and could range from 14 percent to 70 percent of his ordinary income. A corporation, on the other hand, pays taxes on its ordi- nary income at rates of 22 percent on the first $25,000 of taxable income and 48 percent on income above that amount. In addition, shareholders are taxed on any distribution o earnings of the corporation, and the corporation has nc deduction for such distribution. Payments of reasonablf compensation to one or more of the parties would b< allowed as deductions to the corporation and would b< taxed to the recipient at the ordinary rates. A partner whc receives reasonable compensation for services rendered t( the partnership by means of a guaranteed payment wil realize ordinary income in the amount of the payment. I the partnership is operating at a loss, each partner will havi distributive share of the loss increased by his distributiv share of any guaranteed payment. If the partnership is oper ating at a profit, each partner will have his distributive shar< of the profit decreased by his distributive share of an guaranteed payment. (2) Subchapter S. The Subchapter S election, which make a corporation's distributable income taxable to its share holders rather than to the corporation, cannot be used i the IC is to be a shareholder, because corporations wit corporate shareholders cannot elect to be taxed unde Subchapter S. Subchapter S treatment would generally be available if th corporation does not (1) have more than 10 shareholders (2) have a shareholder (other than an estate) who is not a individual; (3) have more than one class of stock; or (4 derive more than 20 percent of its gross receipts fror royalties, rents, dividends, interest, annuities, and sales o exchanges of stock or securities (gross receipts from sue sales or exchanges being taken into account only to th extent of the gains therefrom). (3) Debt or Equity. If Subchapter S treatment is sough it will obviously be required that the minority entrepreneu be in a position to provide or obtain equity financing (froi the IC or others) in order that he may receive all of th stock of the corporation, with the IC being called on by th corporation for a loan only. In this case, as in the case any loan to the corporation, the possibility that the IC advance could be classified as equity must be avoided b< cause, if the obligations the IC holds were considered t constitute preferred stock, the result would be to nullify th Subchapter S election. 5 Moreover, whether or not Subchapter S treatment hi been elected, if the obligations to the IC are classified < stock, payments characterized by the parties as "interest would be considered dividends, taxable to the "lender" an not deductible by the corporation. Repayment of all or pa of the "principal" might also be taxed as income of the I( The presence of the following factors would indicate th. a particular advance should be considered debt rather tha equity: (a) There is a written unconditional promise to pi on demand or on a specified date a sum certain, and to pa a fixed rate of interest thereon; (b) the right to repaymei of principal is not subordinated to the rights of gener creditors; (c) the corporation does not have an excessh amount of debt as compared with the equity investmen (d) the debt is not convertible into stock of the corporatio (e) there is not a pro rata relationship between holdings stock in the corporation and holdings of the debt obligation (f ) the degree of risk that the principal and interest will n be repaid is minor; (g) remedies are not restricted in tl event of nonpayment of principal or interest; (h) paymen of principal and interest are not limited to a special sour such as earned surplus; (i) the instrument does not convi a right to share in the profits; (j) the holder of the instr 6 "The Subchapter S Corporation," 58 ///. B.J. 542, March 19' Analyzes the Subchapter S Corporation in operation and upon tern nation in light of Federal statutes. Also includes recent judic decisions and the 1969 Tax Reform Act. 114 lent is not given voting rights; (k) a third party acting at rm's length would have made the loan. (4) Reasons for Organizing the Business as Partnership luring Initial Stage. For purposes of this discussion we ssume that the ghetto entrepreneur's contribution will be in le form of services, that the IC will provide most of the isk capital for the venture, and that Subchapter S is not vailable. (a) Losses: On these assumptions the partnership form rould be preferable to the corporate form from a tax stand- oint if losses are expected in the initial stage of the business nd the requirements for filing a consolidated return cannot e met. Use of the partnership form will allow the IC to educt its share of such losses from its income from other Durces. Subchapter S aside, if a corporation incurs losses, ley may be set off only against its past and future income; hareholders cannot deduct losses incurred by a corporation /hich is not taxed under Subchapter S. Thus, organization f the business as a partnership would give the IC substantial ix relief during the initial stage of the business. The linority entrepreneur will also have loss deductions equal d the larger of: (1) the amount of his share of partnership Dsses; (2) the capital he has invested in the partnership, lowever, he will not be able to benefit from such deduc- ions except to the extent that he has income against which ie can offset them in the year they are incurred or in the preceding or 5 succeeding taxable years to which losses an be carried back or forward. A possible disadvantage of the partnership form is the mavailability of the ordinary loss deduction that an inves- or in a small business corporation may have if he sells at . loss stock that was issued to him. The requirements that nust be met to qualify for this deduction are discussed in lection 19-18(7). (b) Service Contributor's Income: If the minority entre- ireneur, in exchange for services rendered or to be rendered, s given a stock interest in a corporation set up to carry >ut the venture, he will be considered to have received :ompensation in an amount equal to the fair market value )f the stock. In that event, the minority entrepreneur, who las not yet received any funds from the venture, will have o pay a tax imposed at the ordinary rate on the fair market 'alue of the stock he has received. A minority entrepreneur, vho receives stock in exchange for property and services, vill be taxed at ordinary rates on the fair market value of )nly the portion of the stock he received for services. The minority entrepreneur will not receive compensation ncome if he is given a profit interest in a partnership. Bowever, if in exchange for services the minority entre- preneur is given a capital interest in the partnership, he will 'ealize compensation income in an amount equal to the :apital interest's fair market value. The time of realization ind valuation will depend on: (1) when the services are )erformed; (2) when substantial restrictions on the dis- Dosability of the capital interest cease. (c) Transfer of Property to Venture: The IC, if it intends o contribute appreciated property to the venture as part of ts investment, must be wary if the corporate form is used it the inception of the business. If, pursuant to an integrated ncorporation plan, the minority entrepreneur receives in the iggregate more than 20 percent of the new corporation's tock in exchange for services rendered or to be rendered, he IC will have to recognize gain when it transfers the >roperty to the new corporation. The Internal Revenue 'ode (Code) allows tax-free transfers of property to a orporation only if, immediately after the transfer, the ransferors of property own stock with 80 percent or more )f the voting power in the transferee corporation and at east 80 percent of the total number of shares of all other classes of stock of such corporation. A minority entre- preneur who receives stock in exchange for a substantial amount of property and services qualifies as a transferor of property. (5) Incorporation of Profitable Venture. Although the venture commences as a partnership, if the business begins to earn money it will probably be desirable to change its organization form to that of a corporation. The main reason for changing to a corporate form is to generate capital that can be used in expanding the business. If the venture is going well, it is likely that the entre- preneur's top income-tax bracket will exceed the rate that would be payable by a corporation conducting the business. Thus, by utilizing the corporate form, dollars that would otherwise be used by the partners to pay taxes can be retained in the corporation for use in the business. Another tax advantage of the corporate form is that a corporation may obtain tax deductions for certain fringe benefits for its employees, the value of which is either not taxed to the employees or the tax on which is deferred. Partners either are not eligible for these benefits or are not eligible to the same extent as shareholder employees. There are, however, tax disadvantages to a change from the partnership to the corporate form. For example, the partnership, if reporting on the cash basis, may recognize gain upon the transfer of accounts receivable, if any, to the corporation. The partnership may also recognize gain with respect to any reserve for bad debts should the debts for which the reserve was established be transferred to the corporation. In addition, the corporation will be denied the right to take the accelerated depreciation on property trans- ferred to it by the partnership, even though the partnership was entitled to do so. (6) Pui chase and Sale Agreements. The IC and the minority entrepreneur may wish to enter into an agreement that will eventually enable the entrepreneur to buy out the IC. This goal can presumably be accomplished more easily if the business is conducted in corporate form, the corpora- tion contracts with the IC to buy its stockholdings, and the entrepreneur has never so contracted. This is so because the corporation's lower tax rate will enable it to accumulate the funds needed for the buyout more quickly than they could be accumulated by the entrepreneur as a member of a partnership. Generally, the IC will only be taxed at capital gains rates on any gain from the redemption of its stockholdings in the corporation. (An exception to this rule may occur if the corporation is a collapsible corporation — one organized to convert ordinary income into capital gains. A shareholder's gain on a redemption of his stock by such corporation may be taxed at ordinary rates.) Assuming that appreciated prop- erty is not used for the purpose of the redemption, the corporation will not recognize any gain when it redeems the shares held by the IC, and the minority entrepreneur will not realize any income from the transaction unless he has entered into an agreement to purchase the IC's stock. If this is the case, the corporation's payments in the redemption of the IC's stock could be found to be income to the entre- preneur, the argument being that this payment relieves him of a binding obligation to purchase the stock. The accumulated earnings tax raises problems that may counterbalance the favorable tax treatment of the plan de- scribed above. In general, the Internal Revenue Service takes the position that earnings accumulated for a proper business purpose of the corporation are not subject to the accumulated earnings tax but that a corporation unreason- ably accumulates earnings if it retains them for a share- holder purpose. 115 It has been suggested that if the corporation, at the time of its organization, is given an option rather than a binding commitment to redeem the IC's stock, the accumulated earnings tax may be avoided, at least in part. In this way the corporation would not be forced to accumulate earnings in excess of those needed for proper business purposes and the accumulated earnings tax would therefore be avoided in the years prior to the year of stock redemption. (It should be noted, though, that the use of the accumulation to buy out the IC might cast doubt on the corporation's purported reason for accumulating earnings.) To exercise its option the corporation would probably have to issue debt securities. It is debatable whether earn- ings accumulations made for the purpose of paying off debt incurred to buy out a stockholder are made for a reasonable business purpose. The situation would be different if cor- porate assets or their proceeds were used to buy the IC's holdings of the corporation's stock. Accumulations made to restore assets depleted in that way would seem to be made for a reasonable business purpose. The tax law governing accumulations and redemptions is very complex, and no steps should be taken without the advice of tax counsel. (7) Deduction From Ordinary Income Allowed Where Stockholdings Sold at a Loss. Section 1244 of the Code allows an individual investor to deduct from his ordinary income for a taxable year up to $25,000 of the losses he incurs during such year from sales or exchanges of stock issued to him in consonance with the requirements of that section. (If a husband and wife file a joint return, the allow- able deduction is increased to $50,000.) The statute provides that if a stock is to qualify for Sec- tion 1244 treatment it must be issued by a "small business corporation" pursuant to a plan to issue stock within a period ending not later than 2 years after the date of adop- tion of the plan. A corporation qualifies as a small business corporation if at the time of adoption of the plan (1) the dollar amount of the stock to be offered under the plan (plus the value for tax purposes, at the time of receipt by the corporation of the money and other property transferred to the corporation for stock, as contributions to capital and as paid-in surplus) is $500,000 or less; and (2) the dollar amount of the stock to be offered under the plan (plus the value for tax purposes of the money and other property held by the corporation minus indebtedness to third parties) is not more than $1,000,000. The other statutory requirements that must be met in order to qualify the stock for Section 1244 treatment are: (1) No portion of a prior offering may be outstanding at the time of adoption of the plan. (2) The stock issued pur- suant to the plan must be paid for by money or property other than stock and securities. (3) During the 5-year period (or, if shorter, the corporation's period of existence) prior to the date the loss is suffered, the corporation must not derive more than 50 percent of its gross receipts from royal- ties, rents, dividends, interest, annuities, and sales or ex- changes of stock and securities (gross receipts from such sales or exchanges being taken into account only to the ex- tent of gains therefrom). The benefits of this provision are very important. How- ever, they can only be obtained if a written plan that com- plies with the statute is adopted by the corporation before the stock is offered. Failure to meet this requirement can- not be corrected by later action. CONTRACT APPROACH" 19-19. The LEDC should also consider another approach, that of persuading an IC to sponsor ventures to be conducted by minority entrepreneurs by means of various contractua relationships. Most contractual arrangements would involv< the IC providing the venture with business contracts or ar rangements that might not otherwise be available to venture in a competitive market. th< K th K it (a Guaranteed Market 19-20. One of the most beneficial arrangements that coul be entered into through this approach would be for the to guarantee a market for the products or services of venture. One possible arrangement could be an agreemen to purchase a specific amount of the venture's productio for a certain period of time. Another would be for the to enter into a requirements contract (an agreement by buyer to purchase all of its needs of a particular commod or service from one seller) or an output contract agreement by a buyer to purchase the total output of seller) with the new venture. Through such agreements th venture is provided a market for its production while bein insulated from competition with established businesses. Th IC is also in a position to evaluate and influence the qualit of the venture's product or service as well as its prospec for success. The formation and execution of these contracts will, course, be governed by the general principles of contra< law applicable to all such agreements. If the contract volves the sale of goods. Article 2 of the Uniform Con mercial Code will be applicable. In addition, requiremen contracts and output contracts involve unique problems nc present in more common forms of sales agreements, and which the parties ought to be aware. (1) Quantity to be Purchased. In both a requiremen contract and an output contract the quantity to be purchas is often left open. This can lead to unexpected results. Fc example, the buyer might be required to purchase moi than he thought the seller was capable of producing, or tl seller may find that the buyer's requirements are less tha expected. Section 2-306(1) of the UCC establishes a standard reasonableness, based on the history of the party's produ tion or requirements, which would be applicable when tl quantity to be purchased under the contract is left open estimated. However, a court may still, in construing an op< quantity term, place greater or lesser limitations upon tl quantity than was contemplated by the parties. Therefor the parties to such an agreement may wish to include in tl contract a provision setting the maximum and minimu amounts that may be required or tendered. (2) Price of Goods or Services Sold. Another proble deals with the price of the goods or services sold under su< agreements. Typically, these contracts extend over consi erable time, and substantial variations in the market vali of the goods or services or the costs of production are like to occur. Thus, a flexible pricing provision in the contra may be preferable to a fixed price. Such a provision mig provide for the price to be determined by reference to t market price or cost of supply at the time of each trar action. The parties could provide that the price be dete mined by agreement within a certain time before the delive date, with provision for arbitration in case of failure agree. The price could also be made contingent on I amount of goods sold. (3) Assignment or Termination of the Contract. T parties may also desire to provide for problems of assig ment and termination of the contract. The seller may wa to be able to assign accounts receivable or the duties performance under certain circumstances or to be able 11 See suggested reference material in Section 19-30. 116 erminate the contract in the event of certain contingencies. 3n the other hand, the buyer may want to sell his business. rhis raises the problems of whether he will still be liable )n the contract and whether he can assign his contract rights O the new owner. There is much judicial uncertainty re- garding these issues where no provision is made for them n the contract, and thus there is a special need to settle hese points by express contractual provision. The parties should also consider defining events of default: : or example, the refusal of the buyer to take up all of the seller's output or the inability of the seller to produce the juyer's requirements. Section 2-306(1) of the UCC provides hat unless otherwise agreed there is an obligation by the seller to use best efforts to promote sales. Remedies upon lefault should also be provided. However, in many situations ;ontemplated by this book, the parties probably should not )e too strict in defining the standard of performance. Neither should they provide overly harsh remedies upon default. (4) Status Under Antitrust Laws. A final problem con- :erns the legality of requirements and output contracts under he antitrust laws. Such agreements would be illegal and, n most cases, unenforcible under the Sherman Act if they inreasonably restrain competition or if they are intended o create a monopoly or to have that effect. The principal 'actors to be examined in determining reasonableness are he scope, business purpose, duration of the contract, and he economic power of the parties to the agreement com- pared with others in their fields. The larger the transactions with respect to the relevant market, the greater the proba- bility that the restraint will be unreasonable and illegal. A requirements or output contract may also fall within he prohibition of Section 3 of the Clayton Act, which for- bids the making of contracts for the sale of goods on the ;ondition, agreement, or understanding that the purchaser shall not use or deal in goods of a competitor of the seller where the effect of such sale or understanding may be to substantially lessen competition or to tend to create a mo- lopoly in any line of commerce. Finally, such agreements could be held illegal under Sec- :ion 5 of the Federal Trade Commission Act, which pro- libits unfair practices in interstate commerce. Although the possibility of antitrust violations does exist when require- ments and output contracts are involved, it is unlikely that he transactions contemplated in this book will initially be such that these laws should be of great concern. Subcontracts 19-21. The IC may also be in a position to award sub- :ontracts to the venture. The subcontracts will again present problems of general contract law, varying according to the nature of the transaction. If the sale of goods is involved, Article 2 of the Uniform Commercial Code comes into play. If the IC is involved substantially in Government or de- fense procurement contracts, factors unique to the Govern- ment-prime contractor-subcontractor relationship will be present. A Government subcontractor is subject to regulation not applicable to nongovernment contracts. The Government has a continuing and substantial interest in the terms and conditions of subcontracts awarded by prime contractors, even though there is no direct contractual relationship be- tween the Government and the subcontractor. Thus, a sub- contractor is often required to furnish the Government with :ost and pricing data or to allow the Government to audit its books. Similarly, approval by a Government contracting Dfficer of the terms of a particular subcontract or the sub- :ontracting procedures used is often required before a prime :ontractor can award a subcontract to a particular subcon- xactor. The prime contractor usually desires to pass on to his subcontractor those contract provisions to which he must conform which are derived from Government specifications, legislation, regulations, and contract clauses contained in Government procurement regulations. Some of the major provisions which a prime contractor seeks to pass on to the subcontractor involve rights to proprietary data; provisions for termination for convenience; military security require- ments; changes; restrictions on establishing price, profit, or fee; inspection requirements; examination of records; labor laws and regulations; liquidated damages; and delivery. Other conditions which a prime contractor often seeks to impose on a subcontractor might include broad and compre- hensive warranties, patent indemnity, consequential damage provisions, exculpatory provisions, reproduction rights to proprietary data, payment and performance bonds, and re- strictions upon assignment of the contract bonds. Since the purpose of granting a subcontract to a new venture is to help it get started, the conditions in the subcontract should not be unduly restrictive. However, reasonable safeguards will be needed for the IC's protection. The procedural and remedial aspects of a Government contract, at least as between the private parties to the con- tract, are usually governed by State commercial and conract law. However, several cases indicate that Federal contract law may apply when a substantial Government interest is involved. For example, the subcontractor may be required to exhaust the administrative remedies under the prime con- tract before commencing litigation against the prime con- tractor to enforce rights under the subcontract. An issue may also arise as to whether the subcontractor is bound by an adverse determination against the prime contractor in liti- gation between the Government and the prime contractor. Rendering Managerial, Marketing, Financial, or Technical Assistance 19-22. Corporate sponsorship of ghetto enterprises may take the form of technical assistance in various areas, either with or without compensation. If advice is given for a fee, a written agreement will probably be desirable. In such a case, a management corporation might be formed. Such a corporation is normally involved exclusively in the business of providing management know-how for a fee, usually pay- able out of revenues of the venture. This approach could be especially meaningful if the IC is involved in more than one ghetto business, or if two ICs pool resources in coordinated projects. The obligations of the corporation and the ghetto business could be spelled out specifically in a contract be- tween the parties. If the advice is gratuitous, a formal contract may not be desired. However, it is conceivable that the IC may be held liable in case of nonperformance on informal, oral promises to give aid, if the promisee detrimentally relied on the ex- pectation of free assistance. Problems relating to the doctrine of respondent superior might arise if torts occur while em- ployees of the corporation are rendering aid to the new enterprise. The corporation's liability for negligent advice might also become an issue. Thus, it might be advisable to put agreements to render gratuitous aid in writing to clarify the parties' understanding. (See Section 4.) Loans and Guarantees 19-23. Although the IC presumably will not have as its principal business the making of loans to unaffiliated com- panies or extending of guaranties on credit of such compa- nies, it may be able to provide assistance in this area to new ghetto ventures. This is especially true if another business relationship, such as contractor-subcontractor, exists between the IC and the new venture. There is little doubt as to the IC's power to lend money to any third party, so long as there exists a business purpose 117 in doing so. A reasonable rate of return on the loan, or the development of new markets for needed products or serv- ices, would seem to support loans to the venture. As in the case of loans to subsidiaries, however, steps should be taken to prevent the loan's classification as a capital contribution. The IC also appears to have power to guarantee other loans of the venture. Ordinarily, in the absence of express authority, a corporate manager cannot bind its corporation as surety or guarantor and thus lend its credit to a third party solely for his accommodation or benefit. However, where some benefit is expected by the guaranteeing corpora- tion, the requisite authority is usually present. If the ghetto venture provides an important product or service to the IC, its business interest should be apparent. As in other areas of business judgment, the decisions of the directors and offi- cers of the IC should be controlling. (See Section 30.) ADDITIONAL CONSIDERATIONS 7 19-24. Apart from questions relating to the type of projects in which an IC could become involved, a number of other considerations — that are present no matter what approach is chosen — should be focused upon before the project is begun. Ultra Vires and Corporate Waste 19-25. No serious legal impediments to the IC's involve- ment in these projects are believed to be present, so long as the activity reflects business objectives. The ancient problem of ultra vires (or limitations on the scope of corporate power) is no longer a matter of vital concern. Today cor- porate authority to act appears to be reasonably clear, in- sofar as expenditures may be properly classified as "chari- table, scientific, or educational" or "public welfare." Another question has do do with the IC's obligation to its shareholders to preserve corporate assets. Although there is much philosophical discussion of the responsibilities of the corporation to a number of "constituencies" in addition to the shareholders — employees, creditors, suppliers, cus- tomers, and the community generally — the cases do not appear to support this view, and the management's obliga- tion to the shareholders remains as the legal standard. Al- though this traditionally has been stated in terms of a duty of corporate managers to maximize profits, it obviously can- not be taken to mean that management must conduct the corporation's business so as to maximize each short-run opportunity for profit without regard to more fundamental implications for the business' future. Profit maximization thus may mean long-term profit maximization, or concern with future growth. In substance, then, the test for the validity of corporate activity rests on the business orientation of the program and the existence of some reasonable relationship between the program and the long-term goals of the business. Under current attitudes, if the program is the product of business considerations, it is difficult to see how either ultra vires or any concern with "corporate waste" can override the rea- sonable business judgment of the management. Restrictions in Corporate Legal Documents 19-26. Another factor to be determined is whether the IC may have restricted itself from a given activity. For instance, a narrow purpose clause in the charter might prove an im- pediment. Obstacles are more likely to be unearthed in loan agreements, indentures, or other financing arrangements to which the IC is a party. Such documents would probably not specifically prohibit this type of activity but may indi- rectly restrict the use of one or more of the particular forms of relationships with minority entrepreneurs or LEDCs dis- cussed above. Labor Relations Problems 19-27. The IC involved in a project of this nature may find itself in potential conflict with a union asserting rights under its collective bargaining contract. To management, hiring minority group members and upgrading their jobs is a means of tapping a substantial labor pool and makes good business sense. To present jobholders and their unions, however, the demands of minority group members may represent a threat to seniority, job security, and work opportunities built up over years. Collective bargaining agreements with an employer com- monly prohibit the performance of bargaining unit work by employees who are not members of the bargaining unit. Often an employer is prohibited by contract from bringing in new employees until after he has exhausted the list of those on layoff or on union referral lists. The IC, in under taking a community business development project or in at tempting to protect Government contracts and comply with Federal "affirmative action" programs designed to curb dis crimination in hiring, faces the threat of organized union work stoppages or wildcat strikes. It seems clear that a union will not be able to hindei programs designed to comply with Federal antidiscrimina- tion requirements. Companies who wish to participate volun- tarily with minority group organizations in training anc apprenticeship programs will have more difficulty. The man datory bargaining provisions of Section 8(a)(5) of the National Labor Relations Act require that an employer notify a certified or majority union in advance and give i) an opportunity to discuss and bargain with respect to the proposed implementation of such programs and with respec to such ordinary business decisions as relocation of a plant opening of a new facility in a ghetto area, and transfer oi employees to staff such facilities. Unions often contend that their contracts covering exist ing plant operations automatically extend to later-acquirec or newly opened facilities. Ambiguous, broad bargaining unit descriptions and the union's geographical jurisdictioi may provide the basis for such claims. Whether or not union will be successful in its arguments, however, wil depend to a substantial degree upon how management set; up and operates the new facility. The existing union con tract will apply to the new facility and its employees when (1) the new facility is found to be "an accretion" to th< existing operation or (2) where the union succeeds ir signing up a majority of the employees at the new location Whether or not a new operation will constitute "an accre tion'" depends on many factors within the control of man agement. These include integration of operations, transfe and interchange of en.ployees, common control over day to-day business operations and decisions, geographical prox imity, and centralized bookkeeping, payroll, and administra tive procedures. The key question is whether the new opera tion is merely another part of the old operation and is sc thoroughly integrated with it in every respect so as not t( constitute a separate entity. Reverse Discrimination 19-28. Reverse discrimination, that is, hiring minority-grou] members in order to eliminate racial imbalance, raise unique problems. The existence of hiring systems based oi racial quotas, coupled with the reduction or elimination o skill standards, in an attempt to employ the hard-core un employed, may create problems as serious as the origina discriminatory practices the business is seeking to overcome The language of Federal, State, and local civil right statutes generally makes such conduct equally as imprope Sec suggested reference materials in Section 19-30. 118 is direct discrimination, although certain legislative pro- ;rams designed to aid urban economic development im- ilicitly approve reverse discrimination by allowing or re- hiring that, to the extent possible, employees hired in :onnection with the project be enlisted from the com- nunity. The "Philadelphia Plan," proposed under Execu- ive Order 11246, calls for compensatory hiring by Federal :ontractors and subcontractors. New York recently amended ts State Human Rights Law to expressly permit reverse liscrimination pursuant to written agreements with the State Division of Human Rights, where such activity is intended o relieve the disproportionately high unemployment of cer- ain minority groups. 'roperry Acquisition 9-29. It is likely that, whatever form the venture takes, the mrchase or lease of real estate, improved or unimproved, vill be required. The principal may be the IC, an LEDC, >r a private developer brought into the transaction for this mrpose. No matter which of these is the principal, the legal ispects will be more complicated in acquiring property vithin the urban center than they would be if more re- notely located, undeveloped property were sought. Ques- ions such as existing zoning restrictions, condemnation of listing facilities, and determination of the quality of title vill all be present. Acquisition of property in the urban center also presents conomic problems not present in the acquisition of un- mproved properties. Unless existing facilities can be reno- f ated and utilized by the IC, the cost of clearing the >roperty for improvement must be undertaken. In addition, he price of the property and the taxes imposed on it are ypically higher within the city than outside. On the other land, sewage, power, transporation, and other facilities are lsually already present, although possibly in need of upgrading. In this connection, consideration should be given to the easibility of using an industrial park or planned industrial listrict approach. An industrial park or industrial district s a planned subdivision in which a number of concerns ocate industrial facilities. The properties are managed and ervices provided by a central managing body. Normally, uch a district is planned, developed, and marketed by a leveloper who, in addition to creating the district, may :ontinue in a proprietary position to maintain the proper- ies and services and to supervise observance of any re- ;trictive covenants. Although such a project does not iliminate the problems discussed above, it does consolidate ittempts at their solution. In addition, the industrial park nay provide the highest potential for large economic im- >act on the community. An LEDC may be well situated to act as sponsor or leveloper of an industrial park or district. Not only might t provide the essential functions of planning, property icquisition, negotiation with municipalities on zoning, con- lemnation, etc., but it also has the power to acquire financ- ng from both governmental and private sources. In addi- ion, the LEDC could insure continuity to the completed project by providing management of the properties. BIBLIOGRAPHY 19-30. The following reference sources provide information on forms vhich the project may take, including the subsidiary or division approach, and the contract approach. Also included in the bibliography are references dealing with labor difficulties and reverse discrimina- tion, property acquisition, and industrial districts: Forms Which (he Project May Take (1) A fundamental decision must be made as to whether the ven- ture involving the IC's participation should be conducted in corporate form or through an unincorporated entity such as a partnership or joint venture. The reader should consult any of several standard treatises dealing with fundamental corporate, partnership, and joint venture law. The following texts should be useful: Ballantine, Corporations (1946); Crane and Bromberg, Partnerships (1968) (in- cludes forms of general and limited partnership agreements as well as helpful discussion of factors involved in choosing between corporate and partnership forms); Fletcher, Cyclopedia of Corporations (Perm, ed., 1959) (including extensive forms); Israels, Corporate Practice (1969) (including forms of charter and by-laws); Mulder, Volz & Berger, The Drafting of Partnership Agreements (5th ed., 1967) (including forms); O'Neal, Close Corporations (1958) (including extensive forms); Pantzer & Deer, The Drafting of Corporate Charters and By-Laws (1968) (including forms); Rohrlich, Organizing Cor- porate and Other Business Enterprises (1967); Practising Law Insti- tute, A New Look at Corporate Planning. (1970). Subsidiary or Division Approach (2) In addition to sources dealing with general corporate law cited in (1), see Cataldo, "Limited Liability with One-Man Companies and Subsidiary Corporations," 18 Law & Contemp. Prob. 473 (1953); Douglas & Shanks, "Insulation from Liability Through Subsidiary Corporations," 39 Yale L.J. 193 (1929). Joint Ventures (3) In addition to the sources cited in (1), see Broden & Scalas, "The Legal Status of Joint Venture Corporations," 11 Vand. L. Rev. 673 (1958); Note, "Joint Venture Corporations: Drafting the Cor- porate Papers," 78 Harv. L. E. 393 (1965) Crane & Bromberg, op. cit. (1) supra and O'Neal, op. cit. (1) supra are particularly use- ful here. With respect to the discussion of tax considerations, see Bitker & Eustice, Federal Income Taxation of Corporations and Share- holders (2d ed. 1966); and Aronsohn, Partnerships (1961); CCH 1968 Stand. Fed. Tax. Rep.; and Mertens, Law of Federal Income Taxation (1969). In addition, the Tax Management Portfolio, a comprehensive set of booklets published by Tax Management, Inc., a division of the Bureau of National Affairs, may be extremely helpful in analyzing and planning certain aspects of the transaction. Contract Approach (4) In addition to standard texts on contract law such as Corbin on Contracts (1963) and Williston on Contracts (3rd ed., 1957), the following may be helpful with respect to specific aspects of this sec- tion: Paul, United States Government Contracts and Subcontracts (1964); Von Baur, "Differences Between Commercial Contracts and Government Contracts," 1 Pub. Contract L. J. (1968); and Note, "Requirements Contracts; Problems of Drafting and Construction," 78 Harv. L. Rev. 1212 (1965). Additional Considerations (5) With respect to the problems of labor difficulties and reverse discrimination, see Kaplan, "Equal Justice in an Unequal World — The Problem of Special Treatment," 61 Nw. U. L. Rev. 363 (1966); T. Kheel, Guide to Fair Employment Practices (1964); J. Kroner, Labor and the Emancipation Proclamation (1965); R. Miller, Civ;7 Rights and Fair Employment Practices (1965); National Industrial Conference Board, Company Experience With Negro Employment (Studies in Personnel Policy No. 1966); and New York School of Industrial Relations, Business, Labor, and Jobs in the Ghetto — Issues in Industrial Labor Relations (vol. 1, 1969). With respect to the discussion on Property Acquisition and Indus- trial Districts, see Kinnard, Industrial Real Estate (1967). In addition, the Urban Land Institute has published two technical bulletins dealing with planning and development of industrial districts, both written by Robert E. Boley. They are Industrial Districts Restudied — An Analysis of Characteristics (Technical Bulletin 41 1961) and Industrial Districts — Principles in Practice (Technical Bulletin 44 1962, reprinted 1967). Both contain extensive forms and provisions for sale and lease agreements. The Bulletins may be obtained by writing the Urban Land Institute, 1200 18th Street, N.W., Wash- ington, D.C. 20036. 119 Section 20 PLAN FOR EMPLOYEE PARTICIPATION IN OWNERSHIP OF A LARGE CORPORATION THE LEDC AS SPONSOR OF THE PLAN 20-1. A Local Economic Development Company may wish to encourage a large corporation in the community to establish an employee benefit plan that involves employee participation in ownership of the company. The same goal may be sought by a group of employees in a company that has a large work force from ghetto or poverty areas. The LEDC, as prospective sponsor for one or more such plans, should consider the legal and practical procedures for achieving employee stock ownership in both new and established companies. This discussion examines practical alternatives for such a plan from the point of view of a prospective sponsor. A model plan is shown in Appendix 20-A. Assumptions 20-2. In discussing alternatives for an employee stock ownership plan, it is assumed that: (1) many employees of the subject company are members of minority groups; (2) the company is sympathetic to the general goal of im- proving the economic status of disadvantaged groups; (3) stock ownership by company employees who are members of disadvantaged groups will improve the economic status of such groups; and (4) the company is a profitable corpora- tion; thus, in view of its obligations to its stockholders and to others, it cannot transfer a major share of ownership in the company without receiving some kind of value in return. Benefits to the Employer 20-3. The sponsor must structure a plan for employee stock ownership so as to balance potential employer and em- ployee benefits. Potential benefits to the employer can be classified in three major groups. In promoting employee ownership, the employer will be seeking to improve employee motivation. Participation in profits obviously increases interest in the productivity and profits of the company. An attractive plan may also be a powerful inducement to employees to continue their employment, and it may in this way alleviate rapid employee turnover, a chronic problem for employers of disadvantaged or untrained personnel. It should also be recognized that the employer's contribu- tion of stock to the employees can replace other types of employee benefits. For a cash-poor company, distributing company stock may be an attractive, partial means of compensating employees. Recently, government and foundation support, through capital infusion at lower than market rates of return, has been offered to key employers in ghetto or poverty areas on condition that a share in the business be conferred on em- ployees. Variations and extensions of these precedents may occur in the future, and tax incentives may be offered for broadening ownership to include the poor. The sponsor should point out to a new company in a low-income con munity that a program for sharing ownership with en ployees can be a crucial factor in obtaining government foundation financial assistance for the company. Who Contributes to the Plan? 20-4. A plan designed to share capital and ownership wi employees in more than a token way must depend heavi on contributions from the employer. Thus, the sponsor of plan must motivate the employer to make very substantia regular contributions to the plan. It has already been su gested that capital may be advanced by public intere sources to support significant experiments in employee cap talism. Alternatively, efforts may be aimed at structuring plan which will maximize the employees' motivation to co tribute to the growth and profitability of the company exchange for a dynamic participation in its profits. Within the context of a ghetto or development enterpris a contributory formula based on the company's profits ■ a profit-sharing plan — • will probably be most useful. Tl company's contributions might also be proportionate to en ployee earnings or be on a fixed formula related to ear ings and seniority. However, if the company is commits to fixed amounts whether or not anticipated growth ar profits materialize, it is doubtful that the company's co tribution will be as large as they would be if the contrib tion were related to profits. In plans that require employee contributions, the co tribution of the employer is often based on that of tl employee; thus, the employer might contribute 50 cents f< each dollar put up by the employee. If employee contrib tions are considered feasible, a formula based on the contributions might be attempted. However, such a formu will produce the greatest benefits to those who contribu the most; it may work against the interest of employees the lowest wage scales who may not be able to set asi< significant savings through payroll deductions, or who m; fail to understand the long-run benefits of a savings pli where matching contributions are made by the employer. The Risk of Loss 20-5. It is imperative that the sponsor realistically evalua the risk of loss to the employees. Accumulating commc stock of the company may satisfy the goal of sharing owne ship; but this will be of little consequence if the stock b comes worthless. Even in a plan wherein all costs of acqu: ing the stock are bome by the employer, the companj contributions will necessarily be in lieu of some other for of employee compensation. The sponsor must be skeptical of apparent bargains the common stock of new enterprises or enterprises open ing under especially risky business conditions. Employ ownership of company stock may be of little value if tl stock is not publicly traded and cannot be sold. As a hed against the risk of loss, the sponsor may well be advised 120 consider a plan which would permit investment of em- ployer contributions in securities other than the company's common stock. However, employees from a minority group may have little interest in acquiring a tiny fraction of the stock of a large publicly held corporation. The employees might prefer — notwithstanding the greater risks of loss — to invest the employer's contributions in minority-owned businesses or in businesses in which their fund could attain voting control. The sponsor must decide on the advisability of suggesting a plan that requires contributions by employees as well as by the employer. The risk of loss is obviously more critical if the employees contribute part of their earnings to the plan, and this factor may militate against employee con- tributions for the purchase of stock in a new or risk-fraught business. If the employees are from low-income communi- ties, it is likely that wage scales will not permit systematic savings, and the financial background and discipline to forego present income for deferred savings may be lacking. For these reasons, it may be inadvisable to require employee contributions to the plan. Qualifying for Tax Advantages 20-6. A plan must be structured to take into account the tax requirements of the employer and of the trust fund itself. The employer will want the entire amount of his con- tribution to the plan to be a deductible expense for em- ployee compensation. The tax laws spell out conditions which must be satisfied to assure that the employer's con- tribution will be deductible to the employer in the year of the contribution even though the contribution will not be taxed to the employee as income. In general, contributions must be made to a plan qualified under Section 401(a) of the Internal Revenue Code and Regulations and must not exceed 15 percent of compensation otherwise paid to employees. It is crucial that the fund to which the employer con- tributes is a qualified trust fund under the tax laws. Most of the anticipated benefit of an employee benefit plan will come from the taxfree accumulation of dividends and inter- est and from investment and reinvestment of trust funds without tax liability. The trust must be for exclusive bene- fit of the employees, and allocation of benefits must be made so as not to discriminate in favor of management or supervisory personnel. To qualify under the tax laws the employer submits the proposed plan to the Internal Revenue Service for a ruling that the plan is qualified. When Are Benefits Vested and Distributed? 20-7. Most employee benefit plans provide savings and in- come to the employee upon his retirement. This fact poses a basic conflict with the goals of a plan seeking to extend ownership and control to the disadvantaged. The accumula- tion of stock held in a trust fund for participating em- ployees may fail to satisfy the demands of employees who do not participate in the plan. There are two reasons why distribution of benefits usu- ally is deferred until retirement. Tax treatment for the employee on the employer's contribution is more favorable when distribution is deferred until termination of his service. Also, employers usually wish to defer vesting of benefits to maximize the employee's incentive to remain on the job. Under the tax laws, when distribution is made in a lump sum upon termination of employment, the employee is taxed at long-term capital gains rates on amounts con- tributed by the employer plus the appreciation in value resulting from investment of employer and employee con- tributions. Deferral of distribution also permits accumula- tion and reinvestment without taxation of dividends *.. interest on the employee's allocable interest in the trust fund. By contrast, the employee's contribution would be taxed as ordinary income if distributed to him prior to the termination of his service. An employer usually wishes to delay vesting of the em- ployee's right to collect the employer's contribution. Typi- cally the employee's rights to the employer's contribution in any one year would vest in fractions over a period of 3 to 5 years following such contribution. Upon retirement, death, or disability, the employee's rights to all employer contributions would normally become fully vested. How- ever, termination of the employment of the employee by resignation or discharge would sever the rights of the em- ployee to unvested contributions of the employer. The em- ployer may also desire to prevent distribution of the em- ployee's account prior to normal retirement age even upon termination of service by discharge or resignation even after the benefits have vested; the employer may fear — legiti- mately under some circumstances — that an employee will quit his job for the sake of obtaining his vested interest in the plan. Owing to the compound effect of employer attitudes and of tax advantages to employees, a plan based on significant employer contributions will probably provide for deferred vesting, with accelerated immediate vesting and distribution upon termination of employment by reason of death, disa- bility, or retirement; such a plan may provide for deferral of distribution of vested benefits until the employee reaches normal retirement age if he resigns or is discharged earlier. Employee Participation in Plan Management 20-8. The employees' disappointment at their failure to re- ceive immediate benefits under a plan may be partially allayed if some control over the investment and voting of stock in the trust fund is conferred on the employees acting through a board or committee. Under a plan in which the employer's contribution is minor or in which his contribution is the granting of options to purchase stock, stock purchased through employee con- tributions would normally be distributed as the purchase price is paid or the options exercised. However, plans to encourage employee ownership of a business will probably fail to have a significant impact for low-wage, unskilled workers without substantial contributions from their employer. Employers may seek to defer vesting over an inordinately long period as a condition for a plan that provides for large employer contributions. By phased vesting over a very long period of perhaps 10 years, an employer may deter em- ployees from switching jobs, thus retaining valuable, trained employees. Phased vesting over a shorter period may make an important contribution to the training of disad- vantaged employees, but undue extension of the vesting period may unfairly penalize job switching and discourage newly trained employees from advancing themselves through other job opportunities. It would be an undesirable result if a lucrative employee benefit plan were structured so as to have the effect of indenturing employees to the employer. Who Manages the Plan? 20-9. When a plan is restricted to holding exclusively the stock of the employer, the problem of investment is purely administrative. In this case, it would be appropriate to retain a commercial bank to manage the plan for a fee. Consistent with the general goals of advancing minority business, efforts might be made to solicit the services of a 121 minority-owned bank. In some cities banks owned by minority groups have the staff and experience needed to handle a straightforward stock plan. If a plan permits investments in securities other than company stock, or if multiple plans require that decisions be made to allocate contributions among the several plans, the sponsor might propose that investment decisions or allocative decisions be controlled by the company, by the employees, or by both. It would probably be inadvisable for the employees to retain complete control of investment deci- sions, for in this area professional investment advice is extremely valuable and relatively available to an employee benefit plan. However, the employees may wish to retain a veto on the investment of funds to discourage investment in industries or firms for which the employees have no sympathy. While in industrial experience as a whole it is unusual for employees to retain any control over the principal invested in a plan, companies with a high percentage of employees from minority groups are likely to be sympathetic to the desires of employees to retain partial control of the invest- ment of such funds. An employee board for such purpose may help to communicate to the employees a sense of immediate participation in ownership and control even though stock is not distributed to individuals until termina- tion of employment. To further augment the employees' sense of participa- tion, a sponsor might seek to have one or more seats on the board of directors provided to the employees or their representatives. This might be especially appropriate for a new or developing company that depends on the goodwill and best efforts of workers from a single community. LEVERAGING BY AN EMPLOYEE PLAN 20-10. It may be possible to leverage the assets of an em- ployee benefit plan. The concept of leverage is discussed in Section 3-1. Recent writings and professional work by Louis O. Kelso and his associates 1 have drawn attention to the opportuni- ties implicit in leveraged investment by an employee plan. Kelso has suggested that a plan borrow funds from a com- mercial bank or other lender to buy stock in the company that established the plan. The company would guarantee repayment of the loan by the plan and would commit itself irrevocably to an annual contribution to the plan sufficient to pay the interest and amortize the principal of the loan. As additional security, the stock purchased with proceeds from the loan would be pledged to the commercial lender. This proposal permits the employees to obtain at the out- set a very substantial fund for investment through the plan. For this reason, the Kelso Second Income Plan Trust is responsive to one of the greatest problems with conven- tional employee benefit plans: the rate of capital accumula- tion by conventional plans is too small to give the bene- ficiaries a sense of meaningful participation in the ownership and profits of the company. If a company wants its em- ployees to acquire capital ownership rapidly, the company can use its corporate credit to guarantee a bank loan to obtain capital funds for this purpose; the loan would be repaid in pre-tax dollars through the company's pledged annual contribution to the employee trust fund. A profitable investment leveraged in this way would be a bonanza for participating employees. However, a slight decline in value of stock purchased with borrowed funds could completely eliminate the benefit to the employees of the company's accumulated contributions. The sponsor also should be alert to the danger that the company might be unable to sell the stock to other buyers at the price paid for it by the plan; a company might be willing to make a generous annual contribution to the plan, but if this con- tribution is used for the purchase of stock of the company at a price higher than fair market value, there may be no net benefit to employees. The Kelso Plan suggests that capital formation for the company is one of its major advantages. If the company sale of stock to the plan is at fair market value, however, the company would pre sumably be able to market such stock at that price by a private placement or public offering. Therefore, the sponsor cannot expect that the agreement for the plan to purchase the company's stock would induce the company to make any larger annual contribution to the employee plan than it would without such an agreement. When the company's' common stock is not publicly traded, it may be very difficult for the company to sell its stock to outside investors for a price fully reflecting the company's apparent assets, sales, and expected growth. Under these circumstances, employees might be more willing than other investors to assume a substantial position in the stock of their company even if the stock is not marketable at the time. Employee purchase of stock might appropri- ately be negotiated under the Kelso Plan. 2 If the company is newly established or does not have a strong financial record, it is far from certain that an em- ployee trust fund could borrow the purchase price of the stock against the company's irrevocable promise to con- tribute annually an amount sufficient to pay interest and amortize the loan, even if the company guarantees the loan and pledges the stock. 3 However if the company is a development enterprise acting on innovative principles, it is possible that government guarantees could be obtained to back the bank loan. CHOOSING THE PLAN 20-11. This section analyzes techniques for distributing stock or other benefits to employees. Such plans are nor- mally based on a written statement of the plan adopted by the company's board of directors; the company usually retains the right to amend the plan. Except for a stock option plan, contributions are usually made to a trust fund set up for the purpose. A trustee is appointed to act as a fiduciary in the investments and administration of the trust fund. The company usually appoints the trustee and re- serves discretionary authority to replace the trustee. A trust agreement between the company and the trustee gov- erns the function and conduct of the trustee. An annotated model plan appears in Appendix 20-A. The text of the plan provides for a profit-sharing plan funded by employer contributions in which all employees would be beneficiaries upon termination of service through retirement, death, disability, or resignation. Vesting over a 3-year period is accelerated upon termination by reason of death, disability, or attainment of normal retirement age. The plan provides for a 3-member board which has broad control over administration of the plan. Language is in- cluded which would be appropriate in the event that a l Two Factor Theory: The Economics of Reality, by Louis O. Kelso and Patricia Helter (Random House, 1968; paperback edition, Vintage Books, 1968). - Editor's note: This approach has been used in financing ownership of the Albina Corporation of Portland, Oregon, a profitmaking corpora- tion, through use of the Albina Investment Trust, established on behalf of its employees. The Trust purchased a majority of the corporation's stock, financed by a bank loan, with repayment guaran- teed by the corporation. The corporation has pledged annual contri- butions to the trust of 15 percent of the total annual compensation of each employee, which will be used for repayment of the outstanding bank loans. 8 An OEO guarantee was relied upon to secure the bank loans in the Albina situation. 122 parallel plan (as described below) was established for in- vestment in stock of the company, on the assumption that the trustee would be reluctant to invest a substantial part of the assets of the profit-sharing plan in company stock. In a stock bonus plan, company stock is the ordinary medium for investment of most of all of the trust fund. Alternative Plans for Distribution 20-12. If a company is willing to commit a substantial annual contribution for the benefit of its employees, but circumstances make it difficult to determine whether the employees would benefit most from accumulation of the company's common stock or from investment in other assets and securities, it is feasible to establish multiple employee benefit plans. Thus, a stock bonus plan could be established to which the greater part of the company's annual contribu- tion would be allocated if it were considered desirable to accumulate common stock. On the other hand, a profit- sharing plan would be a better means for investing in other securities if this were considered to be more prudent because of the high risks of devoting all assets accrued for the employees' benefit to the purchase of company stock. In general, under the tax laws minimum contributions would have to be made in each year to any existing plan. But after contributing the required minimums, the company's annual contribution could be apportioned between the dif- ferent plans. In at least one company, a board of repre- sentatives of the employer and employees allocates the company's annual contribution between alternative employee benefit plans. Stock Bonus Plan 20-13. If the employees wish to acquire shares of common stock in the company for which they work, a stock bonus plan would be appropriate. Distribution of benefits to em- ployees will be made by a stock bonus plan in company stock, and tax considerations ordinarily would make invest- ment of the entire trust fund in company stock the most desirable practice. No problem would be raised for the trustee of such a plan in investing the principal of the trust fund primarily or exclusively in the company's common stock, despite the risks involved in such investment. The company's contribution to the plan would be made either in company stock or in cash. If the company stock is not publicly traded, the company should agree to sell stock to the trustee at a price agreed upon or fixed by formula. The company's contributions are deductible under the tax laws only up to 15 percent of compensation otherwise paid to the employees; this establishes a practical ceiling on the employer contribution for all qualified employee benefit plans. As previously noted, the contribution could be based on profits, participants' earnings, participants' contributions, or any other nondiscriminatory standard. Allocation of the principal among participants in the plan can be made according to any formula that does not dis- criminate in favor of officers, shareholders, or supervisory personnel. In general, the formula would give weight both to the wages and length of service of each participant. The typical ghetto enterprise or development corporation may wish to weight the formula to favor service rather than wages so as to induce continuity of employment, and because most untrained employees of such a company would earn wages within a relatively narrow range, a formula weighted to increase an employee's share of the plan in proportion to years of service might yield more favorable results. The formula used in the model plan gives substantial weight to seniority. (See Appendix 20A.) If employees contribute to the plan, the company's con- tributions are ordinarily proportionate to the amount con- tributed by the participating employees. But, for reasons suggested earlier, it seems likely that a plan that primarily aims to encourage low-income employees to participate in ownership of company stock would be more successful if it did not require employee contributions. Administration of the stock bonus plan would be delegated to a trustee under terms of a trust agreement between the company and the trustee. Fees and expenses of the trustee usually would be paid by the company, and other expenses would be borne by the trust fund. Stock Option Plan 20-14. Recently a number of companies have begun the practice of making available to all employees options to purchase stock of the company. At a particular date the company awards to each employee a designated number of shares for which an option is available at their current market price. The number of shares is generally related to the employee's annual earnings. Part of his earnings is withheld and accumulated in a fund from which payment for the stock is made upon exercise of the options. Risks of decline in the price of company stock are avoided by the employee prior to his exercise of the option, but increases in the value of the stock accrued to his benefit as the exercise price is fixed at the date of award of the stock option. The company does not, however, make any direct monetary contribution to the purchase price of the common stock, and therefore this technique may be of limited relevance to a company that employs large numbers of relatively untrained and low-wage scale workers from areas of high unemploy- ment. Until he exercises his option, the employee has no voting or dividend rights and is not an owner of company stock. Thus, the psychological rewards of participating in ownership would not accrue until the employee had accumu- lated sufficient funds to permit him to exercise his option. A stock option plan made broadly available to employees would have to be registered under the Securities Act; this requirement might deter smaller corporations from adopting a stock option plan for all classes of employees. Donative Transfer of Stock 20-15. In a recent foundation program, a substantial loan on favorable terms was offered to a company that employs a large number of minority group workers in an area of great poverty and high unemployment; the offer was made on the condition that the company transfer a substantial part of its common stock to its employees and that it estab- lish a generous plan for increasing the potential for profit- sharing and stock ownership in the company by its em- ployees. In the future this example may be followed and the possibility of donative transfer of stock by a company to its employees is worthy of mention. In some States the offer of stock to employees on favorable terms requires a waiver of preemptive rights by other shareholders. Where the favorable offer to employees is related to an infusion of capital which could not otherwise be obtained, the shareholders would presumably be willing to so waive their preemptive rights. Under the corporate law of most States, a corporation must receive some minimum consideration for the issuance of its stock. This problem can be circumvented by a direct grant of cash by the company to a trust fund established for purposes of holding the common stock to be transferred for the benefit of the employees, followed by an offer of sale of the shares of stock to the trust fund at a price equal to the amount of cash transferred. 123 Profit-sharing Plan 20-16. If the sponsor believes it inadvisable for the em- ployees to ask that company contributions be made or distributed by means of company stock, it would be advis- able to establish a qualified plan that permits the trustee to invest in diverse securities. A profit-sharing plan requires a contribution of profits earned by the company in a fixed or discretionary amount related to profits not to exceed 15 percent of compensation otherwise paid to participating employees. The premise for such a plan is that the beneficiaries, having contributed to the profits, are entitled to share in the profits. In a year in which there are no profits, however, a contribution cannot be made to this type of plan. The principal of the fund can be invested at the discretion of the trustee within his fiduciary responsibilities and subject to particular tax rules on prohibited transactions. The disadvantage of a profit-sharing plan is that the trustee would probably not wish to invest a large part of the assets of the fund in company stock. The Internal Revenue Service might question whether such in- vestment was consistent with the requirement that the fund be administered for the exclusive benefit of the employees. The amount of profits which a company might contribute typically would vary between 3 and 7 percent, but a higher figure could result under special circumstances and would be an appropriate commitment from a company which was the recipient of a loan or capital advance partially sub- sidized by a foundation or the government. The company contribution to a profit-sharing plan is a function of the company's profits, and employee contributions would not be required for participation in such a plan. Employee Savings Plan 20-17. In an employee savings plan, the participants agree to have part of their wages withheld. To encourage the thrift of his employees, the employer makes a matching contribution. A contribution by the employee is required for participation, and the company's contribution is usually proportionate to the employee's contribution. Typically, the employee can elect to join the plan and to have withheld from his wages as much as 10 percent of his total earnings. The company would match the contribution by an amount up to 100 percent — but usually from 25 to 50 percent — of the employee's contribution. The most common form of investment of these accumulated funds is the employer's common stock, but government bonds or other securities could be the medium of investment of the fund. The em- ployee could designate the type of securities in which his contribution and the matching employer contribution would be invested if securities other than company stock were available for investment. The employee's interest in the employer's contribution would vest over a period of time and might be forfeited in part if the employee terminates his service with the company prior to normal retirement age for reasons other than death or disability. Under some employee savings plans, the secu- rities purchased for the account of a participating employee are distributed immediately or shortly after their purchase, but distribution is usually deferred if a significant contribu- tion toward such purchase has been made by the employer. 4 If a plan invites employees to contribute toward the ultimate purchase of company stock, registration might be required under the Securities Act. This raises serious prob- lems which are discussed in other sections of this book. * See Proceedings of 3rd Annual Conference on Employee Benefits, Edited by R. W. Lord, Trusts and Estates. Pension & Welfare News, 1969. Address: Communications Channels, Inc., 132 West 31st Street, New York, New York 10001. Gives elaborate and detailed discussions of employee benefits plans as well as recent tax developments affecting employee benefits. 124 PART III FINANCING THE LEDC AND RELATED ORGANIZATIONS 125 Section 21 ELEMENTS OF SOUND FISCAL MANAGEMENT NEEDED TO OBTAIN FINANCING REQUIREMENTS OF SOUND FISCAL MANAGEMENT 21—1. Access to available sources of funds for economic development requires more than good intentions on the part of the Local Economic Development Company. To compete successfully for available financing, LEDCs must exhibit evi- dence of sound fiscal management when seeking grants or loans from government or private sources. This is true whether or not the LEDC is organized for profit. Fiscal management has many aspects but the fundamentals involve capability in: (1) Planning the long-term financial course of the company's development. (2) Budgeting the flow of financial resources for cur- rent operating and capital outlay requirements for each year. (3) Controlling the receipt and expenditure of funds through a well organized system of internal control with appropriate checks and balances. (4) Reporting on the financial position and results of operation at appropriate intervals to persons and agencies inside and outside the company. Each of these four functions is of crucial concern to funding sources, and is directly related to their willingness to supply appropriate financing. While each company's needs differ, the principles involved in the four functions are similar for most organizations. Particulars vary, of course, with differences in activities, goals, and structure. The main characteristics of each of the four functions of financial management are discussed below. Planning 21-2. This phase of financial management requires the development of a relatively long-term perspective of the company's plans and goals. Well meaning groups very often consider only short-range costs and funding requirements, failing to anticipate requirements of the next few years or so. This has been a particular problem with projects that have found themselves in difficulty after short-term financing, by foundations and others, has run out. Before any company is created, a decision must be made as to which of the community's many needs are to be met by the new organization. The nature of the service or product to be provided must be defined. The extent of need must be determined. General estimates of costs must be made for every aspect of the operation. Revenues anticipated should be analyzed and projected. Capital costs need to be considered, as well as current operating requirements. Knowledge must be gained of which other organizations already provide similar services or products. Unnecessary duplication of services and uneconomical competition must be avoided if financial resources are to be used prudently. Budgeting 21-3. Budgeting, as compared with planning, is concerned with creating a detailed financial plan for the immediate future, usually the forthcoming fiscal year. The budget plan draws on the results of the planning process described above. For a new company the budget and the longer range plan would be the only financial representations which could be made because of the company's lack of financial history. Even for a well-established company, budget forecasts are important and are closely scrutinized by agencies concerned with funding the company's future operations. Each of several types of budgets has a special use: (1) The operating budget is a detailed estimate of the costs of carrying out the company's programs for the coming year, together with estimates of revenue to be derived. This budget is a statement of the company's finan- cial goals for the ensuing fiscal year. It establishes the financial commitments for each part of the company's organization and becomes the standard against which actual performance is measured. (2) The capital budget is a detailed estimate of the costs of planned purchase or construction of new facilities, acquisition of land, remodeling of existing facilities, acquisi- tion of equipment, and the like. Budgets of this sort are often related to the total time needed to complete the project, such as new construction. Recasting of this informa- tion into segments for each fiscal year is also required. All costs incident to the project must be considered, such as architect's fees, financing charges, legal fees, test borings, utility connections, site development, and the like. Provision must also be made in the operating budget for the cost of maintaining new facilities which will come into use during the fiscal year. (3) The cash flow budget is a forecast of cash receipts and disbursements. Information needed for this forecast is derived from the operating and capital budgets. Projections may be made for a year or more and are subdivided into monthly amounts, with more frequent intervals used by many organizations. This forecast shows how inward and outward flows of cash will relate to each other. In this manner, shortages of cash can be anticipated and appro- priate financing arranged in advance. Similarly excess cash balances can be invested on a more profitable basis. Cash flow is a crucial factor in financial management and is of particular interest to bankers and other businessmen when deciding on the making of both short- and long-term loans. Just as the ability to develop initial forecasts is essential, so too is the ability to recognize new conditions which necessitate modifications of the initial budgets. A procedure for periodic review, evaluation, and revision of budget estimates is required if these estimates are to serve any use- ful purpose. Controlling 21-4. Before granting funds to any company, foundations and government agencies may require an evaluation of the grantees' accounting system and system of internal control. Whether or not explicitly required, the management of any company is obliged to maintain an accounting system inte- grated with controls that effectively safeguard the assets 126 and check the accuracy and reliability of accounting data. The system of internal control should be properly planned, installed, tested, and supervised and should not be com- promised because of the size and scope of the company's operations. A satisfactory system of internal control in- cludes the following characteristics: (1) Plan of Organization. The basic element of control within any organization is formal definition of responsi- bilities, duties, and authority. Responsibilities should be approprately segregated, should not overlap and should be comparable with delegated authority. (2) System of Authorization and Recording Procedures. A distinct separation of duties and a logical flow of record- keeping and approval procedures are essential in an ade- quate system of authorization and recording procedures. A system that implies adequate control through a proper segregation of duties includes the following elements: (a) Duties are divided to assure that no one person handles a transaction completely from beginning to end. (b) Custodians of assets do not maintain the ac- counting records applicable to such assets. (c) Bank accounts are reconciled by an individual who does not sign checks or handle or record cash. (d) A clear separation of duties is maintained be- tween accounts receivable ledger clerks, mail clerks, cashiers, and those who control the billings for services or otherwise establish accountability. (e) A clear separation of duties is established be- tween persons involved in preparing payrolls and persons distributing pay to employees. In short, the authorization and recording procedures should provide the checks and cross checks needed to mini- mize clerical errors and the probability of fraud. (3) Personnel. An adequately designed accounting sys- tem cannot be satisfactorily implemented without com- petent, trustworthy personnel of quality commensurate with responsibilities. Untrained and unqualified personnel as- signed to accounting functions can diminish the effectiveness of a system below satisfactory standards. It is the obligation of management to define the duties and responsibilities and to fill the designed positions with qualified personnel. Man- agement should also recognize its responsibility to its em- ployees to provide a healthy, going concern capable of maintaining regular employment at satisfactory rates of pay under favorable working conditions. Employees should be made to feel that all have a stake in a continuous and successful operation and that they are an important part of the organization. Continuing effectiveness of the internal control system as designed requires continuing surveillance by management and can only be substantiated by subsequent audits. The effectiveness of any system of internal control at any given time depends on whether individuals are, in fact, conform- ing to policies and procedures prescribed by the system. Reporting 21-5. Accountability, whether for internal or external pur- poses, necessitates a system of accounts and reports that will ensure full disclosure of the financial activities. Internal financial reports are control devices to be used as a basis for managerial decisions. The design of internal reports should be adequate to provide management with the financial data essential for its purposes. Because service rather than profit is the main purpose of nonprofit organizations and because of restrictions on the use of certain funds made available to them, the principles of classifications and presentation of accounting data for nonprofit organizations differ from those generally accepted for commercial enterprises. The concept of fund account- ing, grouping funds with similar restrictions, permits non- profit organization to report on their stewardship and use of funds. If grantor organizations require special reports on the use and balance of funds provided to a company, the system of accounts must be designed to readily fulfill the reporting requirements. It is not unusual for grantor organizations to require not only an accounting of the expenditures of funds in total, but also by predetermined object and functional classifications in detail, compared with budget estimates. To be meaningful, all financial reports should be prepared and issued on a timely basis. A delay in rendering an accounting may be interpreted to result from an inadequate system of accounts, incompetent personnel, or both. FINANCIAL STATEMENTS 21-6. When a company which has been in operation for some time applies to a funding agency for a grant or loan, it should be prepared to present at least the following types of financial statements: ( 1 ) Balance sheet — which is a statement setting forth the financial position of the company as of a given date, usually the end of the fiscal year. (2) Statement of operations — which sets forth the revenues and expenses and net earnings for a given period of time, usually a fiscal year but may be for a greater or lesser length of time, if desired. (3) Statements of changes in fund balances for non- profit organizations on a fund accounting basis — which is a statement setting forth the increases and decreases in balances of each of the fund groups. In addition many commercial companies normally pre- sent a statement of source and application of funds and changes in working capital. Potential grantors and lenders may require these basic financial statements to be accom- panied by the opinion of a certified public accountant. Supporting schedules covering various facets of the com- pany's financial position and results of operations in more detail may also be required. 1 THE IMPORTANCE OF FISCAL MANAGEMENT 21-7. The Local Economic Development Company which is seeking financial support for its programs or products will soon discover that funding agencies must operate in a condition of constrained choice. Funds made available to one company cannot be made available to another. While many more funding agencies are becoming inter- ested in community development work, funds available at any one time are always limited and are less than the total demand for them. Thus, companies compete for grants and loans, whether intentionally or otherwise. This competition has led to a growing sophistication on the part of funding agencies, which in turn leads them to ask questions about past operations and future plans that must be answered by the company if it expects to receive finan- cial support. Despite the best of intentions, if a company does not use its financial resources wisely, does not know how to plan, budget, or control its financial activities, or fails to report adequately thereon, few sponsors, grantors, or lenders will look favorably upon such an organization as a good opportunity for "investment." BIBLIOGRAPHY 21-8. Practising Law Institute, Tax and Business Planning, Tax Law and Practice Handbook No. 10, 1969. "Financing — A Major Problem of Small Business," 18 Vand. L. Rev. 1683. 1965. 1 See Grimm. Knus, and Goodwin, 1 Small Business Financing Library, pp. 2-32. 127 Section 22 TAX ASPECTS OF SEEKING FUNDS FOR LEDC ACTIVITIES TAX ASPECTS OF SEEKING FUNDS THAT NEED NOT BE REPAID 22-1. To finance a Local Economic Development Com- pany, at least part of the necessary money — especially the "seed money" — will have to be funds that do not have to be repaid for a long time or, better yet, do not ever have to be repaid. Government grants, one possible source of such funds, are discussed in another section of this book. 1 However, since government grants are limited in scope and amount, various private sources must be con- sidered as possible alternatives. Tax Savings as an Inducement for Contributions 22-2. The three major potential private sources of funds are (1) individuals, (2) business organizations, and (3) foundations, usually those classified as private foundations. 2 The impact of the tax law is obviously relevant to ob- taining funds from these sources. To the extent that con- tributions from individuals and business corporations are deductible, their possibility is increased. Individuals may deduct contributions to "public chari- ties" 3 and private operating foundations in an amount up to 50 percent of their adjusted gross income. 4 Contribu- tions in excess of this limitation may be "carried over" and deducted in the next 5 succeeding years so long as the 50 percent maximum deduction is not exceeded in any such year. 5 Corporations are permitted a deduction of up to 5 percent of their taxable income. ''' Corporations may also carry over excess contributions for a 5-year period, provided the deductions for charitable contributions in any one year do not exceed 5 percent. 7 Foundations may also distribute funds to charitable or- ganizations including Local Economic Development Com- panies. Since they are tax-exempt, they do not obtain a deduction for charitable contributions. However, private foundations are required to distribute certain amounts annually for specified charitable purposes, including con- tributions to public charities or private operating founda- tions, but generally not including contributions to other private foundations.* In the case of contributions to other private foundations, including private operating founda- tions (but not for contributions to public charities), pri- vate foundations are required to insist on certain record- keeping standards." Obviously, an LEDC's qualification as a public charity or private operating foundation will assist in raising funds from private foundations. Once a charitable organization has filed a Form 4653 claiming status as a public charity or a private operating foundation under Temporary Regulations, if the Internal Revenue Service does not challenge the claim within 30 days, contributors, including foundations, are entitled to assume that it has the claimed status until the Internal Revenue Service gives public notice to the contrary. 1 " Pre- sumably the exemption letters for new organizations will include a recognition of their status. It should also be noted that, under certain circumstances, business organizations can obtain tax deductions in the nature of business expenses free of the 5-percent limita- tion on corporate charitable deductions mentioned above. Business Deductions as an Inducement for Contributions 22-3. Since an LEDC will, by definition, be trying to im- prove conditions in a community, there is a possibility that a business in the community can obtain a deduction for contributions to it as a business expense. The Regula- tions provide: "(a) Contributions to organizations described in section 170, "(1) In general. No deduction is allowable under section 162(a) for a contribution or gift by an individual or a corporation if any part thereof is deductible under section 170. For example, if a taxpayer makes a contri- bution of $5,000 and only $4,000 of this amount is de- ductible under section 170(a) (whether because of the percentage limitation under either section 170(b) (1) or (2), the requirement as to time of payment, or both), no deduction is allowable under section 162(a) for the re- maining $1,000. "(2) Scope of limitations. The limitations provided in section 162(b) and this paragraph apply only to pay- ments which are in fact contributions or gifts to organi- zations described in section 170. For example, payments by a transit company to a local hospital (which is a chari- table organization within the meaning of section 170) in consideration of a binding obligation on the part of the hospital to provide hospital services and facilities for the company's employees are not contributions or gifts within the meaning of section 170 and may be deductible under section 162(a) if the requirements of section 162(a) are otherwise satisfied. i See Section 26. - See Section 5-8 for a discussion of the distinction between private foundations and public charities. :i Organizations listed in Internal Revenue Code (Code) Section 170(b)(1)(a). Contributions to organizations not classified as public charities or private operating foundations, but falling within the definition "charitable contributions" set forth by Sec. 170(c), are deductible only to the extent of 20 percent of adjusted gross income. The Internal Revenue Service publishes a comprehensive list of such organizations, titled "Cumulative List, Organizations Described in Section 170(c) of the Internal Revenue Code of 1954." It is available, with current supplements, from the Superintendent of Documents, U.S. Government Printing Office, Washington, D.C. 20402. •iCode Sec. 170(b)(1)(a). •'•Code Sec. 170 (b)(ll). "Code Section 170(b)(2). ~ Code Section 170(d)(2). N Code Section 4942. "Code Section 4945(d). (h). '"Temp. Treas. Regs. Section 13.9. 128 "(b) Other contributions. Donations to organizations other than those described in section 170 which bear a direct relationship to the taxpayer's business and are made with a reasonable expectation of a financial return com- mensurate with the amount of the donation may constitute allowable deductions as business expenses, provided the donation is not allowable by reason of the provisions of paragraph (b)(l)(i) or (c) of 1.162-20. For example, a transit company may donate a sum of money to an organization (of a class not referred to in section 170) intending to hold a convention in the city in which it oper- ates, with a reasonable expectation that the holding of such convention will augment its income through a greater number of people using its transportation facilities." u Examples of approved deductions as business expenses include amounts paid to a school board to assist in pro- viding quality education, 12 to a city hospital by a company that was a major factor in the community, 13 and to a city by businessmen to provide municipal improvements which were anticipated to be a direct benefit by revitalizing the business district. 14 On the other hand, certain contributions by business to provide general parking facilities in the area were held to be only charitable contributions. 15 The LEDC, seeking to encourage corporate contributions, should structure its appeals accordingly. loan or other investment in the LEDC. At present, it can only be stated that the answer is unclear. In general, a charitable organization can only make investments which can be justified as investments. If it makes major and speculative investments it risks losing its tax-exempt status. 19 Whether it can justify a speculative investment because of a charitable motive where the charitable activi- ties of the borrower are not within the investor's approved charitable activities is unclear. It would appear that any investment in an LEDC that has the status of a Section 501(c)(3) tax-exempt entity should not cause problems to the investing organization. Obviously, there is more of , a problem if the recipient is a social welfare organization. 20 Even more troublesome is whether an organization which does have as a regular part of its approved activities the promotion of such things as low-income housing or inte- grated housing can make risky investments to promote these goals, which have been ruled to be legitimate activi- ties of a Section 501(c)(3) tax-exempt entity. 21 It would seem that the answer should be that it can, but obviously the only safe course of action for the donor is to obtain a determination from the Internal Revenue Service ap- proving the new activity. BIBLIOGRAPHY TAX ASPECTS OF SEEKING REPAYABLE FUNDS 22—4. At times individuals or businesses will be willing to advance funds to a Local Economic Development Com- pany only as loans (possibly on very generous terms) and not as an outright contribution. Of course, such loans do not give rise to immediate tax deductions for these indi- viduals or businesses. If the LEDC ultimately repays the loan, of course, no tax deduction ever results. If it does not repay the loan, the individual or business organization will usually be entitled to a deduction for the loss. If the LEDC gave a bond, debenture, or other evidence of the debt that is considered to be a security, the loss will usually be considered to be a capital loss (long-term if held for more than 6 months). 16 If the loan was an open account or not evidenced by a security, the loss will probably be a business loss to a business organization 17 and a short- term capital loss (regardless of how long held) for an individual. 18 It should be noted that the results would be the same if the loan or investment were made, not to the LEDC, but to help finance a particular project such as a business sponsored or assisted by the LEDC. Sometimes foundations or other tax-exempt organiza- tions will only be willing to make investments and loans rather than outright grants. Such investments, if directly related to the activities of the donor organization create no particular tax problems. A question may arise as to whether an organization which cannot make a direct grant because the activities of the LEDC are not within the scope of the charitable activities of the prospective donor can make a 22-5. "Charitable Contributions Under the Tax Reform Act of 1969," 16 Practical Lawyer 41. February 1970. "Tax Reform Act of 1969," Business Lawyer 972. April 1970. Treat- ment of charitable contributions. "Summary of Tax Reform Act as It Affects Foundations," 40 Foundation News May-June 1970, pp. 87, 89, The Foundation Center, 444 Madison Avenue, New York, N.Y. 10022. Knapp, Semmel. Forms of Business Organization and the Federal Tax Laws. New York: Practising Law Institute, 1967. Private Foundations' Tax Exemption and Charitable Contributions Under the Tax Reform Act of 1969. Tax Law and Practice Course Handbook Series No. 24 (J4-2442), Practising Law Institute, New York, N.Y. The Tax Reform Act — 2d. Tax Law and Practice Course Series No. 21 (J4-2439), Practising Law Institute, New York, N.Y. General Explanation of the Tax Reform Act of 1969. Prepared by Staff of the Joint Committee on Internal Revenue Taxation, U.S. Congress. Superintendent of Documents, Government Printing Office, Washington, D.C. nTreas. Reg. Section 1.162-15(a) (b). 12 United States v. Jefferson Mills. Inc., 367 F. 2d 392 (5th Cir. 1966). is Corning Glass Works v. Lucas. 37 F. 2d 798 (D.C. Cir. 1929). 14 Rev. Rul. 69-86, 1969-1 Cum. Bull. 50. 15 Rev. Rul. 69-90, 1969-1 Cum. Bull. 63. 16 Code Section 166(e). 17 Code Section 166(9). is Code Section 166(d). 19 See Randall Foundation, Inc. v. Riddell, 244 F. 2d 803 (9th Cir. 1957). See also Samuel Friedland Foundation v. United States, 144 F. Supp. 74 (D.N.J. 1956); Leon A. Beeghly Fund, 35 T.C. 490 (1960). 20 See Section 5-13 for discussion of social welfare organizations and contributions by Section 501(c)(3) organizations to social welfare organizations. 2i See Section 5-5 for discussion of types of investments and activi- ties that are permitted to a Section 501(c)(3). 129 Section 23 FOUNDATIONS AS A SOURCE OF INITIAL GRANT FINANCING GRANT FUNDS 23-1. One source of grant funds for a Local Economic Development Company may be one or more of the ap- proximately 24,000 foundations in the United States. The word "foundation" is used to refer to, and may be denned as: "a non-governmental, non-profit organization, having a principal fund of its own managed by its own trustees, or directors, and established to maintain or aid social, educational, charitable, religious, or other activities serving the common welfare." * For purposes here, founda- tions fall generally into three groups: (1) large, profes- sionally staffed general welfare foundations that are trying to do a systematic job of philanthropy; (2) company- sponsored foundations; and (3) small, family foundations. One recent development has been the creation of founda- tions by various national or regional bodies of diverse backgrounds who join together to form foundations as a means of jointly channeling their funds into new areas of vital interest to them all. 2 As a general rule, foundations confine their activities to particular fields of endeavor and must fit projects within their budget and balance their programs among their own various fields of interest. To achieve the highest return for their efforts, individuals or organizations seeking funds from a foundation must first do preliminary research and analyses in terms of the specific fields of interest of various foundations which may be related to the fund-seeker's needs. Some types of assistance fit into the pattern of giv- ing of various larger and smaller foundations and others ordinarily do not. SOURCES OF INFORMATION ON FOUNDATIONS 23-2. While there are some 24,000 foundations in the United States, only 6,803 of these make 95 percent of the grants distributed annually. The Foundation Directory, prepared by the Foundation Center 3 lists the 6,803 principal foundations by State and city, and briefly describes the particular fields in which each foundation concentrates its grants. The information is also indexed by fields of activity in which foundations are interested. No specific classification has been created, as of the 1967 edition, for minority economic development or urban affairs. However, the "Index of Fields of Interest" lists foundations which have made grants in the areas of Citi- zenship; Civic Improvement; Community Planning; Educa- tion-Vocational Training; Housing; Intercultural Relations; Rehabilitation; Welfare; and listings under these topics should be checked. The Foundation Center also publishes the bimonthly Foundation News, 1 which presents up-to-date reports, con- taining specific information on recent grant awards by particular foundations. Since interest and involvement in minority economic development are growing rapidly, many foundations whose prior activity was in other fields, are now making grants in this area. Recent issues of this pub- lication should be carefully checked for reports of grants by foundations whose current activities may indicate policy shifts or patterns of greater emphasis in your special areas of interest. Foundations in the region where a project is located should be checked in the geographically classified section of the directory. Since many foundations treat local prob- lems as their field of concern, a local project may have an advantage over proposals of non-local fund seekers. At some point, however, action is needed; and that action is a proposal to a foundation. HOW TO DRAFT A PROPOSAL 23-3. A request for funds from a foundation is generally called a "proposal." The drafting of the proposal may be an important factor in the success of a request for funds. The following are suggestions of foundation officials as to what information should be in a proposal. 5 A proposal "should include a statement of purposes and why they are important; how they are to be achieved; what specific results may be expected; what persons will direct the work; how much it will cost; and, usually, why this particular institution or agency is the proper one to undertake the project or program. ... In the great ma- jority of cases the essential facts can be stated in 3 or 4 pages. If it takes much more space than to outline the proposal, probably it has not been thought through suffi- ciently." 6 "Foundation executives are obliged to review many and varied appeals in the course of a day. Hence, fund raisers are right in suggesting that the initial written request or covering letter should be short — one or two pages — de- scribing the proposition accurately and completely. In determining which projects are plausible and articulately described but lack substance, and which may have real or potential merit, it is helpful when the organization making an appeal attaches to its request a balance sheet, income statement, and budgetary estimates setting forth its own financial position ... a complex financial statement fre- quently reflects an obsolete organizational structure, or overlapping and ineffective operating procedures; whereas i F. Emerson Andrews, Philanthropic Foundations, Russell Sage Foundation. New York, page 11. - See Section 25-10. 3 Published by the Russell Sage Foundation, third edition, 1967, price $12. i If this publication is not available in local libraries, it may be obtained from the Foundation Center, 444 Madison Ave., New York, N.Y. 10022. Subscriptions are $6 per year. •"■ Much of the material in the following three sections has been quoted or summarized from "Preparing the Foundation Proposal," by Manning M. Pattillo, in Andrews, ed., Foundations — 20 Viewpoints, Russell Sage Foundation, New York, 1965, pp. 89-94. Id., page 90. 130 a simple, straightforward format often indicates efficient management." " The foundation will thus inevitably assess all aspects of the proposal. Form of the Proposal 23-4. Some grant-making organizations have a printed form or prescribe a certain order of items in application for funds. 8 Others leave it to the applicant to write the proposal as he sees fit. These are details of procedure. The main thing is to state concisely and clearly what is to be done and how it is to be done. A timetable for implementation of a proposal should be submitted, and when it is estimated that the project will be completed. There is no need, in dealing with the better foundations, to be concerned with dressing up the outward appearance of the proposal, for this is not likely to impress an ex- perienced foundation officer. Too much attention to ap- pearances may seem to reflect bad taste or a preoccupation with trivialities. Sample Checklist for Grant Proposals 23-5. One typical foundation 9 prefers that the request for a grant be mailed to the foundation office. There are no application forms, but the board of directors looks for this information in each application: ( 1 ) Name and address of tax-exempt organization which will be the recipient if a grant is made. (2) Relationship of individual signing the application to the applicant organization. (3) Amount asked and specific purposes. (4) Significance — -that is, what the grant is expected to accomplish. (5) The need or problem including the background. (6) The proposed solution and method of approach to the problem. (7) Use to which the findings will be put, including plans to publish or publicize results. (8) Relationship of this proposal to the foundation's program as discernible in its recent published reports. (9) Endorsement of request by qualified individuals. (10) A detailed budget showing how the requested grant would be spent. (11) Length of time for which the foundation's aid will be needed. Include a schedule indicating most desirable lime to start and terminate grant. (12) If you are going to add staff to carry out this project, what qualifications will the staff need and what evidence is there that they are available? (13) A copy of the ruling from the U.S. Treasury granting Federal tax exemption. The following suggested outline for filing project appli- cations for grants has been used by the Louis W. and Maud Hill Family Foundation: 10 ( 1 ) Name of project. (2) Organization sponsoring or proposing project. Is organization tax exempt under Federal and State revenue acts? (3) Address. (4) Name of Director responsible for organization and its proposed project. (5) Field of operation (Public Health, Physical medi- cine, Recreation, Education, Case work, etc.). (6) Purpose of project — i.e., Why the project? (7) Historical background of problem to which project is directed. (8) Plan of development of project. (9) How are results to be tested and proved? (10) What does proposer of project expect to be the outcome or results of the project? (11) What will be the value of these expected results? (12) What will the expected results lead to in the way of new methods, changes in practice, new services, lengthen- ing of life, etc., etc.? (13) Is the proposal diplomatically expedient? Will it be likely to arouse antagonisms, controversies, or create "splits" and schisms? (14) Information on the personnel involved in the project (a) Who are they and what are their qualifications? (b) Have they done this kind of work or similar kinds of work before? (c) Are they replaceable? If so, to what extent? (d) What is the history of their ability to cooper- ate and work together as a team? (e) Who will serve as consultants to the staff and project? (f ) Qualifications? (15) What is the time budget? At what time and stages can certain results be expected and when will final project be completed? (16) Complete financial budget. (17) What provisions or plans have been made for publishing results of project? (18) Plan for progress reports to the Foundation. (Usually the Foundation requires 6-month progress reports. However, certain types of projects might best lend them- selves to less frequent progress reports.) (19) Are other foundations or sources of funds finan- cially involved in this project? MANAGEMENT EVALUATION 23-6. One of the most important factors in a foundation's assessment of a project is the evaluation of leaders of the organization, their devotion to purposes to be achieved, and their ability to carry out the proposal. As one preliminary means of projecting wholehearted support for the project, the request should be submitted, where possible, by the head of the organization or by a key figure in the proposed project, rather than by one of its subordinate officials. This person should be familiar with all aspects of the proposal. Foundations are adversely impressed by token endorsement or sponsorship by eminent people who actually know little about the operation of the proposed project and who in truth will be lending but a brief amount of their time to it. However, the in-depth planned participation of an eminent person is of great interest to most foundations. MULTIPLIER EFFECT OF GRANT 23-7. The likely result of implementing the proposed project is obviously of prime consideration to a foundation. Founda- tions may be particularly attracted by projects which are not only carrying out useful social aims, but which are testing and developing ideas. 11 Thus, in stating why the purposes sought to be accomplished are important and what results should be expected, the proposal drafter should point out ways in which experience to be gained in the project in ques- tion may benefit future community projects and serve as a catalyst to draw the attention of government or private " "How Foundations Evaluate Requests," by Yorke Allen, Jr., in Andrews, ed., op. cit., pp. 95, 99. For a discussion of financial state- ments and related financial procedures, see Section 21. H Pattillo, op. cit., pp. 91 et. seq. 9 Legal Instruments of Foundations, compiled by F. Emerson Andrews, Russell Sage Foundation, 1958, p. 279. i° F. Emerson Andrews, Philanthropic Foundations, Russell Sage Foundation, 1956, p. 183. 11 See generally. Ylvisaker, "New Ideas for Cities as Learned from Foundation Grants," in Andrews, op. cit., pp. 51-56. Emphasis on the innovative has been particularly true of the Ford Foundation, and is of great appeal to most foundations. 131 bodies. The foundation may thereby have the added induce- ment of feeling that its grant may have a multiplier effect rather than being a one-shot investment; the effect of which will terminate when the last dollar has been spent. With this in mind, the substance of the proposal takes on a new dimension. FOLLOW-UPS 23-8. Once a request is submitted to a foundation, the initiative usually lies with the prospective donor. 12 Someone on the foundation staff will acknowledge the application and either say that a grant cannot be made or suggest that the matter be pursued in conversation or by submission of addi- tional information. The organization presenting a proposal may be invited to send a representative to the foundation offices, or a foundation staff person may visit the organiza- tion's office. A reasonably prompt reply can normally be expected from the better organized foundations. Every foundation has its own procedure for initial con- sideration of applications. The decision as to what further steps, if any, should be taken will usually rest with a staff committee or an officer of the foundation. Often, if special expertness is required for a proper evaluation, the proposal will be referred to outside scholars or experts in whose judgment the foundation has confidence. The proposal will be examined in the light of board policy, funds currently available for new grants, the merit of the proposal itself, other proposals and plans before the foundation, commit- ments already made for projects and programs, and perhaps other factors. Applicants generally feel that they have a worthy project or program and that that is sufficient to assure favorable action. If the request is declined, they are likely to conclude that the foundation did not appreciate the importance of the proposal. It is frequently not understood by applicants that the intrinsic value of the proposal is only one of several factors that will govern the foundation's action. Foundation officers who act on applications are doing their best to interpret the wishes of their board of trustees and are not free to do as they please about individual requests or to operate on the basis of personal impulse. They must carry on their work within a framework of institutional policy which is ultimately determined by a board. In most foundations, affirmative actions on requests, or at least the larger requests, require board action. The unwillingness of a foundation representative to give a definite answer — yes or no — on a request in the early stages of consideration is probably due to the fact that he himself is not sure what the final decision will be. Even if the foundation staff is much impressed with a given proposal and recommends it heartily to the board, authorization of the grant is not thereby guaranteed. Most of the larger foundations face the necessity of declining many sound requests simply because the funds are not currently available to support all the good proposals. As emphasized earlier, a study of the publicly expressed policies defining a foundation's areas of interest may help fit the applicant's project more effectively within their pattern. FOUNDATION DIVERSITY 23-9. If a request is turned down by a foundation, the proper thing to do is to thank them for their consideration of the matter and then look for another appropriate founda- tion. There are some 24,000 foundations in the United States and an applicant with a promising proposal, and persistence, can hope to secure the funds required, soonor or later. Do not get discouraged after one or two rejections unless basic weaknesses in the proposal have been uncovered in the process of negotiation. If two or three experienced founda- tion officers, in frank conversation, say that they think the proposal is a strong one but that their foundations, for reasons which do not reflect unfavorably on the proposal, must decline the request, this encouragement should stimu- late the applicant to pursue his search for a grant. The inexperienced applicant is likely to become discouraged and give up too soon. Persistence should be shown, however, not in attempting to browbeat the foundation that has already taken a negative action but in approaching other foundations. It should be remembered that, while the larger foundations have more substantial resources, they also have greater demands made on them. A smaller foundation that is less well-known may be an excellent prospect for a particular request. BIBLIOGRAPHY 23-10. Andrews. Philanthropic Foundations, Russell Sage Foundation, New York, N.Y. Andrews, ed.. Foundations — 20 Viewpoints, Russell Sage Foundation, New York, N.Y. The Foundation Directory, 3rd ed., 1967. Prepared by the Founda- tion Center and published by the Russell Sage Foundation, New York, N.Y. The Foundation News, a bimonthly publication of the Foundation Center, 444 Madison Avenue, New York, N.Y. 10022. 12 Pattillo, op. cit., page 93, et. seq. 132 Section 24 FOUNDATIONS AS A SOURCE OF LOANS AND EQUITY CAPITAL BASIS FOR INVESTMENT BY FOUNDATIONS 24-1. Normally, tax-exempt foundations invest their funds in order to earn income which they use to make grants or conduct programs in furtherance of charitable objectives. However, some foundations regard investment of their funds as an additional technique to be used to accom- plish their charitable objectives. They have embarked on programs of investing a limited portion of their capital funds to further specific charitable goals. 1 This type of investment is sometimes called a "program-related invest- ment." Foundations engaged in this type of investment pro- gram may be a source of investment capital for Local Economic Development Companies. However, the factor that must be kept in mind when approaching a founda- tion as a potential investor is that program-related invest- ments are an extension of the foundation's normal chari- table functions and therefore primarily charitable criteria rather than investment criteria will be used to evaluate a proposal. 2 Therefore, foundations will require investment proposals to have the same type of data that is required with applications for grants. 3 EXAMPLES OF FOUNDATION ACTIVITY 24-2. The following are examples of activities of the Ford Foundation and of the Cooperative Assistance Fund. These are just two of the many foundation activities that are of special interest to LEDCs. (1) The Ford Foundation. In September 1968, the Ford Foundation issued a statement setting forth a new program of investments: "As the struggle against poverty and racism grows in complexity, the Foundation, like other social institutions, seeks ways of working more effectively, even if they break the bounds of time-honored traditions. One such tradition, embodied in policy and practice, has limited the Founda- tion's philanthropy primarily to a single mode — the out- right grant to nonprofit institutions, particularly those exempt from taxation under Section 501(c)(3) of the Internal Revenue Code. . . . some of the most promising work in certain fields of high Foundation priority — minority entrepreneurship and housing, for example — is being car- ried out by organizations that are ineligible for grants but with which connections could be made through the Foundation's investment accounts." 4 The Ford Foundation indicated that initially its invest- ment transactions would be in support of Foundation pro- grams in the areas of Negro business development, open housing, the production of low-income housing, and the preservation of open space and other environmental amenities. The general criteria for such investments were stated as follows: ". . . [T]he Foundation will be guided by some of the same factors that enter into decisions on outright grants — the competence and motivation of the recipient, leverage in terms of attracting other sources of support for the venture, transferability of results to other projects and localities, and the prospects for constructive institu- tional change." (2) The Cooperative Assistance Fund. The Cooperative Assistance Fund was formed by a group of foundations to provide, directly or through other organizations, in- vestments in, and technical assistance for, enterprises which have the capacity to increase the economic oppor- tunities of minority and poverty groups. The Fund operates through or with intermediary organizations in placing in- vestments and in providing technical assistance. Economic leverage from the use of its funds is a key goal of the Fund. It tries to demonstrate the viability of economic development programs. It hopes to encourage forms of activity which can result in widespread economic benefits, such as cooperative enterprises, corporations with employee stock distribution plans, enterprises with profit sharing plans, etc. The Fund is interested in enterprises which are likely to stimulate community development and offer the promise of future growth. EVALUATION OF POTENTIAL INVESTMENTS 24-3. The limited resources of foundations cause them to try to maximize the effectiveness of their grants. Similarly, foundations try to maximize the "social return" from "pro- gram related investments." Thus, the innovative effect of a particular investment will be an important consideration. Merely furnishing investment capital to "needy" recipients may not be considered adequate utilization of a foundation's investment funds. For example, one innovative effect of program related investments being sought by foundations is the stimulation of the business sector to participate in socially useful investment programs. 3 Thus, investments which accomplish this effect may be given preferred con- sideration. Relationship to Program Goals 24-4. Each foundation has specific program goals and administrative criteria which it will use to evaluate poten- tial investments. Need for the funds, alone, will not qualify an organization for a program-related investment by a i For example, minority group entrepreneurship, open and low- income housing, or other programs that mobilize community interest in solving social problems and arresting community deterioration. - If a foundation makes a high-risk investment, the primary purpose of such investment must be charitable and no significant purpose may be the production of income or the appreciation of property, otherwise such investment will cause a penalty tax to be imposed on the founda- tion under Section 4944 of the Internal Revenue Code of 1954, as amended by the Tax Reform Act of 1969. :! See Section 23-3 on preparation of foundation grant proposals. ■* "New Options in the Philanthropic Process," a Ford Foundation statement of policy, September 1968. 3 See Section 24-10. 133 foundation. The question that organizations must be pre- pared to answer is: "How will the foundation's program goals be furthered by an investment in your proposed venture?" Before deciding to approach any particular foundation, determine which foundations have program goals which will tie into the community organization proj- ect to be aided; then shape your approach and proposal accordingly. 6 Financial Criteria 24—5. Although foundations may not take a traditional investor's view toward proposed program-related invest- ments, such investments will still be subjected to careful financial evaluation. Business considerations play an important role in a foundation's decision to make such investments. This does not mean that foundations are only interested in investing in "safe ventures" which have a high probability of success. Foundations, like commercial lending institutions, have to accept a certain number of investment losses. But busi- ness ventures which appear to have minimal prospects for success because of unsound financial premises will not be attractive even to foundations willing to assume higher risks or forego higher returns in anticipation of furthering important charitable goals. If the business and financial aspects of a proposed investment are not sound, achieve- ment of the foundation's goals will be jeopardized. TERMS OF INVESTMENTS 24-6. Although the foundation may advance funds in situations where the risk is higher than commercial lenders are willing to incur, the terms will not necessarily be dif- ferent from those which a commercial lender might offer. This would occur where unavailability of credit because of prejudice or discrimination is the key roadblock to a community organization's business venture rather than a potential lack of cash flow to meet the costs of borrowing. Specific Charitable Purpose of Investment 24-7. Foundations must use their funds to further "chari- table purposes" in order to maintain their tax-exempt status and comply with the terms of the charters or trust agreements under which they operate." In addition, if the foundation is to avoid penalty taxes imposed by the In- ternal Revenue Code, the primary purpose of any high risk investment must be charitable and no significant pur- pose may be financial." Therefore, the terms of a program- related investment must assure that the funds invested will in fact be used to further charitable purposes. Restrictions on Use of Funds 24-8. The terms of an investment by a foundation may be shaped by the foundation's concern that the charitable purposes furthered by the investment are maximized. Foundations may seek to obtain maximum charitable bene- fit in a number of ways: (1) The investment may be made on the condition that an equity interest is made available to employees who are disadvantaged minority group members or low- income persons. (2) The investment may be made on the condition that if the venture is successful, a portion of profits will be diverted to social purposes (for example, by requiring a successful company to use a specified portion of its profits to make socially useful investments itself). 9 (3) The use of investment funds may be restricted to specific purposes. 10 Requirements for Reports 24-9. Since foundations are responsible for assuring that their funds are properly utilized, a key condition of a foundation's investment will be the requirement for reports. In addition to requiring normal types of reports and finan- cial statements that are provided to commercial lenders, reports concerning the social aspects of a company's opera- tions will be required. Close scrutiny over management's actions may be maintained and restrictive contractual pro- visions may be inserted which require the foundation's consent to be obtained before certain actions can be taken. 11 SOME GUIDELINES FOR PREPARING INVESTMENT PROPOSALS 24-10. Foundations may be willing to make investments in the form of stock purchases, loans, guarantees, and any other type of financing used to provide venture capital. The particular facts of an investment situation will shape the form of the investment by the foundation. 12 The following general propositions demonstrate some of the factors on which investment decisions by founda- tions may be based: (1) Investments involving a 5-10 year commitment may be preferred over a long-term arrangement because a foundation may be interested in investing in a number of worthwhile ventures rather than committing its funds to one venture for a substantial period of time. (2) A foundation may prefer to make investments in the form of loans rather than by purchasing stock because as a creditor the foundation may be better able to assure that its funds are used for the purposes intended. (3) Investments in businesses owned by a large num- ber of minority group members or low-income persons may be preferred over ventures where ownership is con- centrated in fewer hands. (4) Ventures having innovative elements or which further community economic development using untried techniques may be more attractive to foundations than ventures involving more conventional business operations. (5) Situations where the foundation will not be the sole source of capital may be more attractive, particularly if the foundation's involvement will stimulate participation by conventional financial institutions in socially useful investments or if a participating financial institution is will- ing to administer the investments on behalf of the founda- tion and provide financial and management assistance. 13 6 See Section 2.1-3 on drafting foundation proposals. 7 See Section 5. * See Internal Revenue Code Section 4944(c). '■> See Appendix 24-A for a sample investment requirement. i" See Appendix 24-B for a sample preliminary letter agreement. ll See Appendix 24-C for sample restrictions. i- See Appendix 24-D for specific forms of investment. IS See Appendix 24-E for sample administrative agreement. 134 Section 25 CHURCH GROUPS AS A SOURCE OF FUNDS CHURCH ACTIVITY 1 25-1. A number of religious institutions encourage and support economic development in disadvantaged sectors of American society. This discussion seeks to pinpoint existing activities and approaches taken by certain denomi- national, interdenominational, and interfaith institutions in such efforts and sources which may be contacted by Local Economic Development Companies. The approaches dis- cussed deal with the flow of money for economic de- velopment, primarily as "investment" (that is, funds injected with an expectation of an eventual return of capital plus some form of income) and secondarily as "grants" (that is, outright gifts). Although most religious organizations have throughout their histories maintained some kind of giving program to the sick, hungry, and distressed, the concept of investment in economic development projects is relatively new. It evolves from a growing recognition by organized religion that it is difficult, if not impossible, to isolate the religious from the secular elements of present day life and that religion, if it is to maintain its vitality and appeal, must involve itself with secular problems — in this case, the elimination of poverty in its broadest definition from the American scene. To date, the form and techniques of investment have been fairly conventional in the case of the large national religious groups. The extent to which they become less conventional as a result of internal revaluation and in response to outside pressure is problematical. An evidence of change would be release for use in economic develop- ment programs of a certain portion of funds previously considered "restricted" for purely religious purposes. Many of the organized religious, particularly the Protestant de- nominations, segregate their capital funds into categories of available use, and it is usually the "unrestricted funds" (that is, those not earmarked for special church projects) which are available for economic development investment. In theory these funds could be given away in the form of grants for economic development or used for capital investment purposes. ANALYSIS OF EXISTING INVESTMENT PROGRAMS 25-2. Various churches and related organizations have initiated some form of investment program for economic development and should be contacted as potential sources of funds available to LEDCs and their enterprises. Al- though subject to change and not definitive, a list of cur- rently active groups appears in Appendix 25-B. Criteria for Investment 25-3. Business organizations seeking financing from re- ligious institutions should be aware of general criteria which may be applied to investment decisions. For example, during 1968 the National Council of Churches of Christ in the United States of America, as part of its "Crisis in the Nation" program, issued a Guide- line Statement for its members. This statement defines terms set forth in a previous resolution of its General Board, which directed a committee to make available certain "funds to be used for low-return investment (whether or not at high risk) in development programs in ghetto com- munities which are planned and directed by representatives of those communities for maximum benefit to the com- munities." While earlier plans for the National Council of Churches to act as an interdenominational conduit providing an investment vehicle, staff support, and facilities for the various members have not so far materialized to the de- gree hoped, the Guideline Statement defines certain in- vestment criteria which should be helpful to those who approach church groups for funds. The Guideline Statement sets forth the following defini- tions: "Low-Return Investment" means that the capital funds committed to this program are to be handled as investments as distinguished from "grants" or program funds; and that the Committee anticipates full return of the principal to- gether with some rate of interest. The interest rate may be below the going interest rate for the type of investment involved and may be very low indeed, since community development, rather than return on the investment, is a prime motivation of the program. "Whether or not at a high risk" means that com- munity development, rather than security of the invest- ment, is a prime consideration in the program. Govern- ment insured projects, or projects which are solidly or even partially secured by collateral, are not excluded but neither are high risk and generally unsecured ventures. Degree of risk is not to be the major determining factor. "Development programs" means that priority will be assigned to investment in enterprises and projects which have demonstrated or give promise of capacity to con- tribute substantially to the economic and social develop- ment of the communities in which they are located. "Ghetto communities" means, for purposes of this program, low-income communities, usually black. Within the definition are included both urban and rural com- munities. "Planned and directed by representatives of those communities" refers to the planning and direction of the "development programs" in which funds from this pro- gram are to be invested and specifies that it shall be pre- dominantly in the hands of "representatives" of the ghetto communities into which the investments are to go. "Repre- sentatives" is understood to mean persons who reside in the community, who identify socially and economically l Readers are cautioned to check on the currency of the programs described throughout this section. 135 with the community, and who represent a significant popu- lation or group in the community. Some church groups prefer to act only through "umbrella- type community organizations which serve as intermediaries between the investor and the ultimate user of the funds. While well-established entities such as the Urban Coalition and the Interracial Council for Business Opportunity (ICBO) have been recipients of such grants and invest- ments, a nonprofit LEDC should consider approaching such church groups. The decision of some groups to in- vest through intermediaries appears to be, in part, based on a reluctance to have a religious institution forced to "call the loan" of a defaulting debtor. Additionally such institutions have decided that it was unwise to spend money on their own managerial, financial, and other technical staffs to support the desired investment program. In selecting these intermediary organizations for invest- ment, one church group has the following criteria: (1) Indigenous ghetto leadership must have an in- fluential voice in determining the direction of the indi- vidual intermediary's overall program, and in identifying and working directly with ghetto business managers or entrepreneurs to provide them with the necessary man- agerial financial, and legal "technical assistance." (2) Management advice and other technical assistance must be made available to the enterprises to be financed to ensure that they have the operating support they need to ensure their success. This management and technical assistance could take the form of advice on organizational relationships and procedures, marketing, planning tech- niques, or financial and accounting control methods. (3) Profitmaking enterprises must be the ultimate re- cipients of the investment money. The goal is to build community-owned and managed businesses, thereby in- creasing the standard of living and the economic inde- pendence and capacity of the minority groups living in the nation's ghettos. Also, these enterprises must be put on a firm profitmaking basis as soon as possible, and are expected to pay back the loans they have received. (4) A "buy back" clause, wherever feasible, should be a feature of the funding provided to the ghetto enter- prises so that the minority group entrepreneurs — that is, the individuals who bring the enterprises into being — can (a) "buy out" the equity interest held by the intermediary financing organization or others, or (b) liquidate the debt owed to the intermediary or others under a formula to be agreed upon at the time the investment is first made. (5) An "important" objective of the intermediary must be to aid ghetto-based enterprises. The church in- tends to direct this specific program toward investments which will be made as directly as possible in organizations assisting and channeling funds into ghetto enterprises. Therefore, this excludes investment in major industrial cor- porations and banks which, for their part, may be expected also to undertake ghetto aid projects and loans as a part of their community service or commercial operating objectives. (6) National impact is important to the church, be- cause the church represents people in all parts of the United States. Accordingly, it is important for the benefits of this program to reach all areas of the country. (7) Reviews of performance must be provided to the church on a regular basis (at least semiannually) so that the church may (a) maintain an active interest in, and be well informed on, the kinds of results its commitments have achieved; (b) periodically evaluate the effectiveness of its program; and (c) adjust its program as appreciated. Loans 25-4. Where the organized religions have chosen to invest directly, the greatest portion of the funds invested in eco- nomic development projects has been in the form of loans, often unsecured and, exclusive of housing loans secured by mortgages, maturing in from 3 to 5 years. Many of the debt instruments reflect the fact that they have been drafted by lawyers who have had previous loan experience. The first draft may contain many of the customary clauses found in commercial bank term loan agreements. An outline of such an agreement might include the following: Introduction: (a) purpose of loan, (b) definition of terms. Representations and Warranties: (a) corporate exist- ence and authority (if corporate borrower), (b) no out- standing liens, unpaid taxes, lawsuits, etc., (c) no violation of the law. Usual Terms: (a) amount, (b) effective date, (c) restrictions on use of funds, if any, (d) interest rate — fixed or floating basis — 360/365 days, (e) maturity — in- stallments, where payable, (f) form of note, (g) prepay- ments — in whole or in part — penalty, if any — order of application, (h) maturity — due dates. Conditions of Lending: (a) documentation, (b) opin- ion of counsel, (c) recent financial statements. Affirmative covenants: (a) furnish financial statements regularly, (b) access to records, (c) notice of default under other indebtedness, (d) maintain property, insur- ance, corporate existence. Negative Covenants: (a) nonpayment of dividends, (b) net worth requirement, (c) debt limitation, (d) nega- tive pledge, (e) limitation on investments/concentration, (f) limitation on salary or bonuses, (g) limitation on rental obligations, (h) no change in management without approval, (i) no change in type of business conducted. Default: (a) nonpayment of principal or interest, (b) insolvency, bankruptcy, etc., (c) violation of covenants, (d) representations or warranties incorrect, (e) accelera- tion of other debt. Acceleration: upon event of default. In most cases, to insist on all the elements of a normal commercial bank loan would simply be avoiding the whole purpose of the investment, that is, getting funds to an investee who could not otherwise obtain it. Therefore, several of the terms of the above outline may be eliminated. Loans Combined with Equity 25-5. Loans have been made that involve equity participa- tion in the form of either warrants for stock, common or preferred stock, or a conversion privilege which gives the investor the right to convert all or part of his debt into an equity investment. In one case, common stock was issued concurrently with a promissory note. The agreement between investor and investee provided that the issuing company could repur- chase the stock on 30 days notice at a price to be de- termined by an ascertainable market standard, if any, or by agreement between the parties. It is interesting to note that the agreement contained a statement to the investor by the investee that: "You have informed us that you in- tend to add any profit realized by you on any purchase pursuant to this paragraph 4(a) to any funds that you may then hold for investment in ghetto enterprises." Interest rates on the loan instruments reviewed have varied from 3 percent all the way up to the existing prime rate. In the latter case, the investing entity justified such a rate on the grounds that no other lender would have been willing to make such a loan and on other grounds, 136 ich as a willingness to forego any security. The interest n most loans reviewed ranged between 5 and IV2 percent. A moratorium on repayment of principal rather than aual payments beginning the year after the closing is a ommon feature of these loans. It reflects the obvious nec- ssity of allowing the investee maximum use of borrowed apital for as long as possible prior to the commencement f repayment. In addition to the normal default provisions found in ommercial bank, loans (such as failure to pay interest and rincipal on schedule, insolvency, any general assignment ar the benefit of creditors, dissolution, etc.), a clause elating to the use of proceeds of the loan is sometimes lcluded. For example, one loan agreement made as an vent of default "the failure of the obligor to establish nd place in active operation the shopping center on the bove mentioned mortgaged premises as indicated in the tatements filed with obligee to induce this loan within 12 nonths after the date hereof." In Appendix 25-A are excerpts from a Guidesheet for .oan Applications and Loan Application from MELIC, the Mission Enterprise and Investment Loan Fund of the ioard of Missions of the United Methodist Church. The Dan application is comprehensive and calls for the type if information required by several other churches in their nvestment programs. )ther Forms of Investment ,5-6. In addition to the above debt and debt/equity tech- liques, other conventional investment methods have been ised. Many denominational organizations and, in fact, in- lividual churches and synagogues have purchased certifi- :ates of deposit or made time deposits in banks chosen hroughout the country for the impact that funds rein- 'ested by those banks would have in economic develop- nent. Several religious groups are using grants in connec- ion with their loan programs. MELIC is funding part of he staff cost of the Interracial Council for Business Op- >ortunity (ICBO) in return for the technical services of )rocessing and reviewing MELIC projects. Without immediate expenditure of funds MELIC is pre- jaring to enter into a program to supplement SBA guaran- ees of bank loans to businesses that MELIC is trying to issist. SBA will guarantee 90 percent of a given loan and MELIC the remaining 10 percent. The MELIC staff be- ieves this kind of investment has great advantages over iirect loans for the following reasons: ( 1 ) It provides leverage and stretches funds to cover nore than one project. (2) It gets commercial banks involved in and com- nitted to an economic development program. (3) It gives investees experience in dealing with com- nercial banks. EFFORTS BY INDIVIDUAL CHURCHES 15-7. The efforts of individual churches, synagogues, and •elated organizations within the structure of larger bodies nay be a prime source of aid and support for Local Eco- lomic Development Companies. Combination Grant and Equity 15—8. Perhaps the most dramatic and innovative steps have seen taken not by large denominational bodies but by in- dividual churches within or allied with the larger groups. Kn example is the "10-36 Plan," a program originated, sponsored, and promoted by the members of the Zion Baptist Church in Philadelphia. Using a grant-plus-equity investment approach, church members decided to commit $10 per month for 36 months in order to raise monies to initiate housing projects, shopping centers, and other busi- ness enterprises aimed at bettering the quality of life in the community in which the church is located. Of each $360 increment, $200 is invested in profitmaking ventures such as shopping centers and garment manufacturing through a ven- ture capital corporation; and $120 goes to a nonprofit corporation for scholarships, nonprofit housing, and other charitable efforts. Housing Sponsorship 25-9. Local church groups which have acted as seed money sources and joint sponsors for housing projects should be contacted by LEDCs. For example, in Brooklyn, New York, two churches (St. Augustine's Roman Catholic Church and St. John's Episcopal Church) have joined with the Frederick W. Richmond Foundation to sponsor a brownstone renova- tion project. In Pittsburgh, several church groups, including the Episcopal Diocese of Pittsburgh, the American Jewish Congress, an order of St. Francis Nuns, the Alleghany Baptist Union, and the Bethel A.M.E. Church have joined together to sponsor a plan for 900 housing units. NEW ORGANIZATIONS CHANNELING INTERFAITH EFFORTS 25-10. In addition to the National Council of Churches, several other agencies are seeking to mobilize interfaith approaches to economic development. Among them are Operation Connection (1120 Connecticut Avenue, N.W., Room 860, Washington, D.C. 20036); the Inter-religious Foundation for Community Organization, Inc. (211 East 43rd Street, New York, N.Y. 10017); and the Interchurch Center (475 Riverside Drive, New York, N.Y. 10025). Operation Connection was founded by church leaders belonging to the established religious institution as a liaison group between local groups, primarily black, and white power groups whose resources could be brought to bear on economic development. Its goal is to '"help mobilize and release the resources of the community toward economic power by the poor, especially the black poor." The Interreligious Foundation for Community Organiza- tion, Inc. (IFCO), a vital new force on the church scene, describes itself as a "unique coalition of Roman Catholic, Jewish, Protestant, black, and Mexican organizations [which] joins together black-brown militant spokesmen with religious, civic, and business spokesmen to coordinate financial support for community organization, community development, and indigenous economic development efforts across the nation to develop cooperative and self-determined programs in their communities." Created in late 1966 by 10 national religious agencies, IFCO has received tax-deductible grants from various church groups, businesses, foundations, and individual sources. IFCO does not invest its own funds but seeks to coordinate involvement of member and cooperating agencies and to allocate grant funds supplied by others to worthy groups who "define their own goals, select their own experts, set their own priorities, choose their own strategies." The criteria used in screening proposals for grants include: (1) need, (2) indigenous participation, (3) creative ideas, (4) potential for self-support, (5) leadership development, (6) ability to implement. 137 Section 26 FEDERAL SOURCES OF FINANCIAL ASSISTANCE SOURCES OF INFORMATION ON FEDERAL PROGRAMS 26-1. A number of Federal programs emphasize assistance for minority businessmen. In many cases the funds available are primarily for financing Local Economic Development Companies which can serve as the core of business and capital-generating efforts in a low-income community. The Office of Economic Opportunity, the Department of Labor, the Economic Development Administration of the Depart- ment of Commerce, and the Small Business Administration all have limited funds devoted to this purpose. Except for some SBA and EDA financial assistance, Federal funding programs do not provide financial assistance directly to minority businessmen. This does not mean that Federal financial assistance is not available to a minority entrepreneur; in most cases, however, the funds must be requested by or channeled through an LEDC or other quali- fied local organization. Furthermore, they may be available only in specific localities, such as those with high unempoly- ment or minimal economic development. Information about all programs discussed here may be obtained directly by phone, visit, or letter to the appropriate Federal agency. Summaries of relevant Federal programs can be found both in the Catalog of Federal Assistance Pro- grams 1 and in the Special Catalogue of Federal Assistance Programs for Minority Entrepreneurs. 2 In early 1969 the Office of Minority Business Enterprise (OMBE) was formed in the Department of Commerce to be the focal point for Federal efforts to assist in establishing new minority enterprises and in expanding existing ones. While OMBE does not provide financing, it seeks to coordi- nate Federal aids to minority enterpreneurs and may be a major source of information on available Government financing. 3 OEO SPECIAL IMPACT GRANTS 26-2. Special Impact under Title I.D of the Economic Op- portunity Act of 1964 4 is a grant program to aid and foster economic and business development, community develop- ment, and manpower training for unemployed or low- income persons. It is directed to the solution of the critical problems existing in communities or neighborhoods (defined without regard to political or other subdivisions or bound- aries) in urban areas that have especially large concentra- tions of low-income persons and in rural areas that have substantial out-migration to eligible urban areas. Grants may be made through public agencies or to private organiz- ations. Typically grants are made directly to LEDCs. Federal grants to a Special Impact program are not to exceed 90 percent of the cost of the programs, but this requirement can be waived to further the purposes of the program. The non-Federal contribution may be in cash or in kind (including but not limited to plant, equipment, and services). The 10 percent non-Federal contribution may include the value of such items as: existing assets of a business assisted under the program; financing provided by banks or other private lenders in conjunction with Special Impact financing; any assistance by State or local governments; and grants from foundations. The reasonable value of an entrepreneur's time in planning and preparing to launch a business project may be taken into account in determining whether there has been a 10 percent private contribution. In short any non- Federal funds committed to a Special Impact project, whether or not by the sponsoring LEDC, may serve to satisfy the statutory requirements. Qualification for Special Aid 26-3. If an LEDC can obtain qualification for its area, it could attain 20-to-l leverage on its locally raised funds for specific types of investment. The most flexible standards for obtaining designation as a Redevelopment Area are applied when an LEDC first ob- tains recognition for its community as a Special Impact area as outlined in Section 26-7. Urban areas can qualify for Special Impact grants if they have "especially large con- centrations of low-income persons." Rural areas can qualify if they have "substantial out-migration to eligible urban areas" without regard to political subdivisions or boundaries. Most areas that have been designated as Redevelopment Areas by the Economic Development Administration are areas where there has been "substantial and persistent un- employment for an extended period of time" or where "there has been a substantial loss of population due to lack of employment opportunity." Included are areas where un- employment has been 6 percent or more for the most recent calendar year and has been 6 percent or more while the average annual rate of unemployment has been at least 50 percent above the national average for 3 of the preceding 4 calendar years, or 75 percent above the national average for 2 of the preceding 4 calendar years, or 100 percent above the national average for one of the preceding 2 calendar years. Additional areas can qualify which have a median family income of not more than 40 percent of the national median. Indian reservations may also qualify if they manifest a great degree of economic distress. An area may qualify if there has been a loss, removal curtailment, or closing of a major source of employment 1 A copy may be obtained from the Superintendent of Documents, U.S. Government Printing Office, Washington, D.C. 20402, for $6.75. S Compiled for the Executive Office of the President with the cooperation of the Office of Economic Opportunity. a Inquiries should be addressed to the Office of Minority Business Enterprise, U.S. Department of Commerce, Nth Street and Constitu- tion Avenue NW., Washington, D.C. 20230. 4 Title I, Part D (Special Impact Programs) was added to the Economic Opportunity Act of 1964 by Sec. 113 of the Economic Opportunity Amendments of 1966 (80 Stat. 1455-1456). The part was redrafted in Sec. 103 of the Economic Opportunity Amendments of 1967 (81 Stat. 688-690). 138 which has caused or threatens to cause an unusual and abrupt rise in unemployment which exceeds or can be ex- pected to exceed the national average by 50 percent or more. Closing the Brooklyn Navy Yard qualified the facility and the area immediately surrounding it as a Redevelopment Area. Except for Indian reservations and areas which lose a major source of employment, no area shall be designated which is smaller than a county, or a municipality with a population of more than 250,000, or a "labor area" as defined by the Secretary of Labor. This has prevened ap- plication of the benefits of the Public Works and Economic Development Act of 1965 to communities or neighborhoods which would meet the unemployment criteria but for the fact that they are part of a larger local government unit whose overall employment record is higher than the statu- tory standards for qualification. Operation of the Special Impact Program 26-4. The Special Impact program was established under the Office of Economic Opportunity. r * In practice, however, administration of Special Impact has been divided between the Department of Commerce, the Department of Labor, and the Office of Economic Opportunity. Each agency in- dependently determines (a) the qualifications of an area for a Special Impact program and (b) the details of a contract with an LEDC or local government agency repre- senting the area; the same Federal agency then takes re- sponsibility for administering the contract. Title I.D. provides that programs "shall be restricted in number so that each is of sufficient size and scope to have an appreciable impact on the area served." Average grants have been about $1 million. Program standards are very flexible. Title I.D. is only two pages long and the Federal agencies administering Special Impact have allowed each project to develop its programs with minimal restrictions beyond those in the LEDC's proposal and contract. Funds can be used to de- velop community-owned business enterprises, to provide financial and technical assistance to minority entrepreneurs, and to furnish incentives for the location of new business in the community. No model form exists or is desired for organizations to contract for and administer Special Impact grants. The first Special Impact program to be funded was for the Bedford-Stuyvesant area of Brooklyn, New York. It is run by two separate membership corporations. One has a board of directors composed mainly of major corporations in New York City. The other corporation is community based, with a board of directors composed of local business- men, public officials, labor union officers, clergymen, and others. The two corporations jointly administer the Federal funds; primary policy direction stems from the community corporation. Lhe business leaders are active in fund raising and mobilizing business support. They also provide some technical expertise. In other cities single corporations have entered into con- tracts with the responsible Federal agency. The makeup of their boards of directors has varied considerably, depending on local desires and the identity of the persons and groups who come together to create and support the program. Nonresidents with a contribution to make can sit on the same boards of directors as local representatives. Whether a single or dual corporate structure is preferable appears to be a matter of local choice. Title I.D. does not restrict or provide for the form of private organization which may receive Special Impact grants. Its only guideline concerning their makeup and func- tion is the requirement that "projects will be planned and carried out with the maximum participation of local busi- nessmen by their inclusion on program board of directors, advisory councils, or through other appropriate means." Activities financed under Special Impact programs have been oriented mainly toward business development with emphasis on manpower training and employment of the disadvantaged. Special Impact grants also enable LEDCs to finance other projects of importance to the community. These have included construction of community facilities, planning and survey grants, manpower training schools, housing rehabilitation, and other projects designed to meet specific community needs. Use of Special Impact Funds 26-5. Special Impact programs may be used to obtain at least 9-to-l leverage for the non-Federal funds raised. The Federal and non-Federal funds may be still further lever- aged. Special Impact funds can be loaned to a business by the LEDC on a long-term basis subordinated to bank or other institutional financing. This subordinated debt will be re- garded by the lending institution as additional capital of the business and, depending on the circumstances in each case, will serve to expand, often to a substantial degree, the borrowing capacity of the business. If the bank applies for an SBA guarantee of most of the loan it provides, an even larger amount may be forthcom- ing from the bank. With the help of an SBA guarantee, the bank may find it possible to provide 2-to-l leverage for the combined Special Impact and individual businessmen's in- vestment which is in addition to the 9-to-l leverage already obtained under Special Impact. Special Impact programs have provided money to a va- riety of business ventures which are usually subcontractors of the LEDC administering the Special Impact program. No type has dominated or appears to have been preferred. Long-term subordinated Special Impact loans can be tied to manpower training efforts of the entrepreneur so that as he trains unemployed or unskilled neighborhood residents he may receive agreed credits from the LEDC against the unpaid principal of his loan. Special Impact loans have been made to locally owned businesses and businesses from outside the community which are thereby encouraged to create new facilities and employment opportunities in the community." ASSISTANCE UNDER THE PUBLIC WORKS AND ECONOMIC DEVELOPMENT ACT 26-6. Special Impact areas are also deemed to be "Redevel- opment Areas" within the meaning of Section 401 of the Public Works and Economic Development Act of 1965 7 and thereby qualify for assistance under Title II of the Act. This gives the LEDC an entirely new opportunity to lever- age its privately raised funds. "' Copies of Guidelines for OEO Special Impact Programs — Fiscal Year 1969 are available from the Office of Economic Opportunity, Economic Development Branch, Community Action Program, 1200 19th Street NW„ Washington, D.C. 20506. Applications are available from the Chief, Economic Division Branch, Community Action Pro- gram, Office of Economic Opportunity, at the same address. >' For a discussion of certain planned additions to the Special Impact Program, inserted by the editors, see the Annex to this section. ■ 79 Stat. 560; 80 Stat. 1477. 139 Redevelopment Areas 26-7. The Redevelopment Area program is designed to "help areas and regions of substantial and persistent un- employment and underemployment to take effective steps in planning and financing their public works and economic development." Both grants and loans are authorized under the Act. Designation as a Redevelopment Area requires qualifica- tion under a precise statutory formula. (See Section 26-3.) If an area can qualify as a Redevelopment Area and wishes to be so designated, this is usually communicated to the Economic Development Administration by a principal offi- cial from the area. EDA then requires that an Overall Eco- nomic Development Program (OEDP) be submitted to EDA. The LEDC which prepares the program becomes the OEDP Committee. 8 EDA looks for broad representation on the committee, including local government officials, industry, labor, busi- ness and finance, professional men, minority group repre- sentatives, and unemployed persons. This committee works with EDA to create its investment and development pro- gram. An LEDC can be recognized as an OEDP Commit- tee if it has the broad representation that EDA seeks. To obtain Redevelopment Area or Title I area designation the OEDP Committee must submit an initial report which includes the background of the area's resources, economic activities, and problems. In the report, the committee's economic development goals must be outlined and details on how the committee hopes to accomplish these goals must be described. A principal public official of an area qualified for desig- nation as a Redevelopment Area or a Title I Area 9 will be so notified by EDA after which an OEDP Committee which is representative of the area must be formed if formal desig- nation is to be obtained. However, an LEDC may initiate discussions with EDA; the LEDC may recognize impending losses of employment (for example, from an announced closing of a military base or loss of a major industry) that will lead to qualification of the area as a Redevelopment Area. The LEDC may also seek to develop and gain accept- ance of a program under the more flexible Special Impact standards and thereby be deemed a Redevelopment Area as well. Newly formed LEDCs in existing designated Rede- velopment Areas may wish to contact the present OEDP Committee to obtain program benefits. EDA maintains regional offices where an LEDC may seek such program assistance. The EDA staff in Washing- ton 10 will also provide direct assistance. Title I Areas 26-8. Title I 11 assistance from EDA is also available to areas that do not qualify as Redevelopment Areas but have had an average unemployment rate of 6 percent or more during the preceding calendar year. These Title I areas are determined by the Secretary of Labor to be areas of sub- stantial unemployment and then qualify for grants of 50 percent of the cost of public works and development facilities. Loans From EDA in Redevelopment Areas 26-9. EDA has limited funds available for long-term, low- interest loans for land, buildings, machinery, and equipment needed in establishing or expanding commercial facilities in Redevelopment Areas. There is no limit on the amount that EDA may provide to one applicant or for one development venture. It will lend up to 65 percent of the cost of land, buildings, ma- chinery, and equipment for industrial and commercial enter- prises. EDA will also guarantee up to 90 percent of the value of working capital loans made to businesses by private lending institutions if the business is already receiving a long-term loan from EDA for the construction and equip- ping of its facilities. With rare exceptions Special Impact financing is provided under a contract directly by the Federal Government to the LEDC which in turn subcontracts with businesses which have qualified for assistance. Loans from EDA for busi- ness projects in a Redevelopment Area are usually made directly to a qualifying business by arrangement with the recognized economic development group 12 but may be made to the LEDC directly. (1) Structure of the Loan. Loans may extend to 25 years, but if the fixed assets to be acquired have a shorter useful life the maturity of the loan will be limited accordingly. The interest rate is governed by the cost to the Government of funds which it borrows for similar periods. EDA will seek collateral for its long-term loans but is willing to subordinate its loan to other loans and other mortgages made in connection with the same project. At least 15 percent of the total project cost must be supplied as equity capital or as a loan subordinated to the EDA loan. At least one-third of this 15 percent is to be supplied by the State or local government or by the LEDC. Thus at the land, buildings, and equipment financing level the LEDC can obtain 20-to-l leverage. If State or local sources pick up any part of the required 5 percent the LEDCs leverage is further increased. The LEDC can raise the 5 percent minimum investment not only from State and local governments, but through a variety of private sub- scription efforts and the sale of its own securities to banks and foundations. Financing the remainder of the cost of land, buildings, and equipment is generally available, because the EDA sub- ordinated mortgage serves to attract private institutional financing on a first mortgage basis for 20 percent or more of the cost, particularly if the enterprise which will occupy the facility has any record of previous successful business operation. State development corporations in States where they are active and have direct lending authority will usu- ally provide more than a 10-percent contribution, thereby further closing any financing gap for the LEDC and the business being assisted. (2) Participation by Local Sources. The 5 percent of project cost which must be supplied by the State or local government or by the LEDC can be waived if the Secretary of Commerce determines that all or part of such funds are not reasonably available to the project because of the eco- nomic distress of the area or for other good cause. The 5 percent requirement also does not apply to projects in- volving financial participation by Indian tribes. Note that the requirement of 5-percent participation by the State or local government or LEDC (where applicable only applies to the long-term loan portion of a business development package. The LEDC is not required to provide any additional working capital to the business in order to qualify for an EDA guarantee of 90 percent of the amount N Detailed information on OEDP Committee organization and function and the preparation of OEDP reports is contained in the Guide for Area Overall Economic Development Programs, U.S. Department of Commerce, Economic Development Administration, November 1967, 24 pp. :l Sec Section 26-8. if Economic Development Administration, U.S. Department of Com- merce, Washington, D.C. 20230. 11 Public Works and Economic Development Act of 1965. '- Here "economic development groups" means those that are par- ticipating under the Overall Economic Development Program Com- mittees. 140 of a working capital loan provided by a private lending insti- tution. However, as the private lender is not likely to want to provide 100 percent of the working capital requirements of an applicant, the business will have to provide some of its own equity here as well as in support of the long-term loan for land, buildings, and equipment. Grants and Loans for Public Works and Development Facilities 26-10. Title I of the Public Works and Economic Develop- ment Act of 1965 also provides for grants to State or local governments, Indian tribes, or private or public nonprofit organizations for public works projects. This type of assist- ance usually requires a high degree of participation by local governments. The program is particularly effective where basic services such as roads, water, and sewerage are inadequate to sup- port an economic development program or construction of industrial parks. Without these services, land otherwise suited for development may not be competitively available. The difficulty involved in providing these improvements out of current tax dollars in an area of high unemployment or including them as part of the overall project cost to be paid by the user could tip the balance in favor of a location where the services are already provided. Title I grants can be made for up to 50 percent of project cost. The balance of the cost can (1) be provided by the local government (out of current revenues or municipal bond proceeds), (2) be charged to the overall project cost to be paid for by the user over a period of years, or (3) be paid for by both sources in agreed percentages. Other available Federal grant-in-aid programs for such facilities can be tapped at the same time, but in no event can the non-Federal share of project cost be less than 20 percent. The program is administered by EDA. 13 Technical Assistance 26-11. Besides grants and loans, EDA also provides tech- nical assistance in redevelopment areas and some other areas having substantial need. EDA technical assistance may be in the form of studies to identify area needs, to find solutions to industrial and economic development problems, or otherwise to help create new jobs. Technical assistance projects normally originate at the State or local level, where applications for such assistance are made by community groups (including LEDCs) in most instances. Also under its technical assistance program, EDA makes planning grants-in-aid to cover administrative expenses of nonprofit economic development groups, up to 75 percent of the cost of a project. MODEL CITIES PROGRAM 26-12. The Model Cities Program is a demonstration pro- gram designed to provide supplemental financial and tech- nical assistance to enable cities to improve the quality of urban life by attacking on a comprehensive basis the basic social, economic, and physical problems in slum areas. The Department of Housing and Urban Development is authorized ( 1 ) to pay 80 percent of the costs of planning and developing such programs; (2) to pay 80 percent of the cost of administering the approved programs, but not the cost of administering any project or activity assisted under a Federal grant-in-aid program; and (3) to pay the costs of projects and activities included in the approved programs, not to exceed 80 percent of the aggregate amount of non- Federal contributions otherwise required to be made to all projects or activities assisted by Federal grant-in-aid pro- grams which are undertaken in connection with such dem- onstration programs. Model Cities is thus of interest to persons working for the economic development of their communities as a new source of substantial funding both to pay the required local share in other programs and to fund new and innovative projects that are not covered by existing programs. The city has the basic responsibility for planning and developing the program. Execution of particular projects is usually the responsibility of various operating agencies (pub- lic and private, city-wide and neighborhood based). Cities must involve residents during planning and program imple- mentation to insure that the program is responsive to their needs. 14 It is the responsibility of each Model City to de- velop an administrative structure which makes possible such participation and which makes it possible to coordinate the various local efforts, including economic development. In- terested persons should, therefore, make contact with the city agency or department with responsibility for planning or administering the program or with groups that either are or may be operating agencies for economic development activities. SBA LOAN AND GUARANTEE PROGRAMS 26-13. The Small Business Administration administers sev- eral loan and guarantee programs that are of special interest to LEDCs. Local Development Companies (Section 502) 26-14. Under Section 502 of the Small Business Investment Act of 1958 loans may be made to a Local Development Company (LDC) by the Small Business Administration. Many LEDCs can qualify for assistance under Section 502. The loans are used by the LDC to assist small businesses in financing plant construction, conversion, or expansion, including the acquisition of land. A fuller discussion of Section 502 appears in Section 3, "The LEDC as a Source of Financial Assistance," which also provides a comparison of LDCs with Small Business Investment Companies (SBICs). Small Business Investment Companies (SBICs) 26-15. A Small Business Investment Company provides long-term loans and "equity" or "venture" capital to small businesses under the Small Business Investment Act. In addition, it may provide management consultant services directly or through a subsidiary. A Minority Enterprise Small Business Investment Company (MESBIC) is a special form of SBIC. SBICs and MESBICs are discussed in greater detail in Section 10, "Small Business Investment Compa- nies." A comparison of SBICs with Local Development Companies appears in Section 3, "The LEDC as a Source of Financial Assistance." SBA Regular Business Loan Program 26-16. SBA makes loans directly to small businesses for a wide variety of normal business needs. SBA first seeks to determine if the funds are available from other sources on reasonable terms. If not, then SBA will consider an appli- cation. Loans may be made for factory construction, equipment, supplies, or working capital. They are not available to pay out existing creditors who are in a probable loss position, 13 Economic Development Administration, U.S. Department of Commerce, Washington, D.C. 20230. 11 A recent case enjoined the Philadelphia Model Cities Program because there was not sufficient citizen participation. {North City Area Wide Council, Inc., et al. v. Romney, et al., F2d, 3rd Cir. July 15, 1970, No. 18,466). 141 nor to enable owners of the business to repay their own loans to the business. They are not to be used for specula- tion or by nonprofit enterprises. 15 Businesses whose sales are derived in any way from gambling activities are inelig- ible. Newspaper, magazine, and book publishers, and radio and television broadcasters are also ineligible. Loans may not be made to businesses primarily engaged in lending or investments nor may they be used for the acquisition or improvement of real property primarily for sale or invest- ment. Recreational or amusement facilities can be financed only if they contribute to the health or well-being of the general public. Loans may not be used primarily in farming or other agricultural activities. Loans may be used to effect a change in ownership but only if this aids in the sound development of the business or serves to keep it in opera- tion. (1) Structure of Loan Program. It is not the policy of SBA to make its funds available at two levels of the same trans- action. Therefore, if an LEDC has chosen an SBIC as the operating investment structure to aid local business, it will not be able to provide funds from the SBIC to an otherwise eligible small business at the same time the business is re- ceiving assistance directly from SBA. No SBA loan can be made to refund SBIC loans, but, SBA loans may be made if SBA's collateral position will be superior to the SBIC. SBA cannot participate in an SBIC. However, two separate corporate entities may receive SBA assistance at different levels of a related transaction. For example, a Section 502 Local Development Company may provide mortgage financing to build a small shopping center which will include space for a supermarket. The borrower may be a real estate development corporation which will not participate in the operation or ownership of the supermarket but only be its landlord. A separate oper- ating corporation, which will be the tenant, can then take advantage of any of the other SBA loan or guarantee programs. Loans made by SBA under its regular business loan pro- gram must be of such sound value or be so secured as reasonably to assure repayment. Collateral is usually taken, which can include mortgages on buildings and equipment, warehouse receipts, personal guarantees, and assignment of accounts receivable or other assets. The maximum amount available on a direct loan basis under the statute is $350,000. However, the amount avail- able for direct lending is constantly varying. If SBA is participating with a private lending institution in making the loan, the $350,000 maximum applies only to the SBA share of the loan; thus, in equal participation situations, a small business could obtain up to $700,000. But because of SBA budget restrictions, this upper limit is largely theoretical. Regular business loans generally have a maturity of 10 years. If provided for working capital purposes, they are generally limited to 5 or 6 years. If the money is used for building or factory construction the maximum maturity would be the time estimated for construction plus 15 years. SBA is encouraging lending institution participation as much as possible. It makes loans either in participation with private lending institutions (where a minimum of 25 per- cent of the money is supplied by the institution and the rest by SBA) or where all the money is supplied by the private lender and repayment is guaranteed in fixed per- centages by SBA. SBA is now giving major emphasis in its regular business loan program to guaranteed loans where all the funds are provided by a private lending institution under a guarantee agreement requiring SBA to purchase 90 percent of the loan from the lender in the event of default. (2) Eligibility Tied to Size of Business. SBA loan programs are available to businesses which meet size standards set by SBA. They must be independently owned and operated and not be dominant in their field. They must also not exceed employment or sales criteria set by SBA. Manufacturers are considered small if their average em- ployment in the preceding 4 quarters was below 250 persons. If they employed more than 1,500 persons they are con- sidered large and ineligible. Within the 250 to 1,500 em- ployee range, SBA bases its determination on the nature of the industry in which the business is primarily engaged. Wholesalers are considered small if their sales do not exceed $5 million. In certain industries this limitation may be $10 million or $15 million. Retailers are considered small if their annual sales do not exceed $1 million. In certain industries this may be increased to up to $5 million. A service company is considered small if its annual sales do not exceed $1 million. In some cases this may be as much as $5 milion. Economic Opportunity Loans 26-17. The Economic Opportunity Loan (EOL) program is authorized under Title IV of the Economic Opportunity Act of 1964 as amended. It is intended "to assist in the establishment, preservation, and strengthening of small business concerns and improve managerial skills employed in such enterprises, with special attention to small business concerns (1) located in urban or rural areas with high proportions of unemployed or low-income individuals, or (2) owned by low-income individuals." Economic Opportunity Loans (EOLs) are made to low- income and socially or economically disadvantaged persons who have been unable to acquire adequate business financ- ing through normal lending channels on reasonable terms. A cooperative association is eligible for EOL assistance if its members are each eligible small businesses. However, consumer cooperatives do not qualify under the program. Loans are made in amounts up to $25,000; repayment schedules run up to 15 years. Repayment is required as early as possible so that the proposed employment of the loan proceeds will be considered in determining maturity. Working capital loans are usually limited to 10-year terms whereas if investment is in fixed assets this may entitle a borrower to up to 15 years to repay. Grace periods on repayment of principal may run for 13 months from the date of the note although interest accrues and must be paid during that period. Interest rates on SBA's portion of a loan depend on the average market yield on outstanding U.S. Treasury obligations of comparable maturity. For fiscal year 1970 the interest rate was 6% percent. Where loans are made by a private lending institution with a guarantee of principal and interest by SBA, the interest rates are determined by the lending institution. The legislation emphasizes private sector involvement, and for this reason SBA will act as guarantor of a private lending institution's loan rather than as a direct lender. In these cases the guarantees may be made up to the full amount of the loan. Loan approvals are based on the applicant's character and ability to repay the loan from earnings. EOLs are not declined for lack of collateral, but the applicant is expected to pledge available assets as security. EOLs cannot be approved if the funds are available on reasonable terms IS If a nonprofit organization anticipates seeking SBA assistance for its own use, it should set up a profit corporation subsidiary to receive the SBA assistance. 142 through normal channels, the personal resources of the applicant, or other Federal lending programs. Because of the relaxation of traditional credit standards, it is possible that the LEDC may be able to serve solely as an advisor and processor for the applicant. In many cases the LEDC can help him prepare his projections and file his application and provide him with managerial advice and assistance without having to back him with subordinated loans or an equity investment out of its own capital. SBA Lease Guarantees 26-18. The SBA lease guarantee program may be of par- ticular value to an individual minority entrepreneur or to an LEDC which plans to build facilities for lease or rent to local small businessmen. Basically, a lease guarantee is an insurance policy issued to and paid for by a small businessman, which guarantees to his landlord that the necessary rent payments will be made. The shortest term for this insurance is 5 years and the longest is 20 years. When no private insurance com- pany is willing to insure the lease, SBA can directly insure the lease for a minimum of 15 years and a maximum of 20 years. The lease guarantee program can permit a minority fran- chise who would not otherwise be able to obtain space in a first-class area to be able to guarantee that his rental pay- ments will be met. In addition, it permits an LEDC to be able to produce a guarantee that it will have continuing funds from its own lessees to pay off the money which the organization wants to borrow to build a shopping center, grocery store, or retail facility. 10 VETERANS ADMINISTRATION LOAN GUARANTEES 26-19. The Veterans Administration has a limited business loan guarantee program, but it is available only to World War II veterans and Korean conflict veterans who served prior to January 1, 1955. The VA provides a partial guaran- tee of loans made by private lenders to eligible veterans for the purpose of buying a business, including land, sup- plies, inventory, equipment, working capital, construction, or renovation. The guarantee is limited to 50 percent of the loan or $4,000 for business real estate purposes and $2,000 for business nonrealty purposes. BIBLIOGRAPHY 26-20. Grimm, Knaus and Goodwin. 1 Small Business Financing Library, 6-73 et seq. Creative Business Financing, edited by V. D. Nordin, Inst, of Continuing L. Ed. 1968, p. 317. Practising Law Institute, Financing Corporate Growth and A Work- shop on Small Business Investment Companies, pp. 7, 29. 1970. "Small Business Financing: Meeting the Need for Equity Capital," 29 Fed. B.J. 121. Spring 1969. An analysis of sources of funds avail- able for small businesses. Zeidman, P. "Federal Financial Assistance Available to Business," West's Federal Practice Manual, 2nd ed., vol. 2, 1969. 16 For a detailed discussion of use of lease guarantees, see Section 32. ANNEX TO SECTION 26* OPPORTUNITY FUNDING CORPORATION As a complement to its Special Impact program the Office of Economic Opportunity plans to fund an experi- mental Opportunity Funding Corporation. This nonprofit organization will be composed of three units, each of which will offer a different kind of incentive for private invest- ment. The corporation will conduct activities in a large number of low-income communities throughout the coun- try, offering a positive program for improvement. The first unit, the Opportunity Guaranty Component, will demonstrate the feasibility of various guarantee tech- niques in attracting private resources to assist low-income communities. The main function of this unit will be to remove the risk aversion of private institutions to com- mitting capital and credit to the needs of the poor. It will operate in situations involving comparatively high risk and only in cases where comparable guarantee arrangements are not available from existing Federal, State, or private sources. The purpose is to determine whether or not risk of loss on credit, bonding, and insurance in low-income areas can be kept within tolerable limits. An evaluation of actual loss experience on these projects should furnish information for determining the desirability of Federal legislation providing permanent institutional guarantees. The second unit, the Community Development Discount Component, will be a small central discount facility in- tended to demonstrate the feasibility of a mechanism to purchase SBA- and EDA-backed obligations and other commercial paper generated by enterprises in low-income communities. It will repackage, guarantee, and resell these obligations as securities to private investors. It is intended to test whether or not a discount facility can increase liquidity and lending capacity of financial institutions serv- ing low-income areas. A successful demonstration of the Community Development Discount unit could lead to legis- lation creating such a facility on a permanent nationwide basis. A third unit, the Incentive Simulator Component, is in- tended to field test various new financial inducements (in- cluding simulated tax incentives) to encourage privately undertaken projects and investment in low-income com- munities. The new unit will devise new ways of applying these incentives in assisting LEDCs, low-income credit unions, and other public and private institutions now serv- ing the interests of these communities. The incentive unit will focus particularly on identifying institutions which are unresponsive to the needs of low-income communities and identifying new incentives to make them more suc- cessful. Project Agenda The Opportunity Guaranty Component will select proj- ects from a broad agenda: ( 1 ) Guaranteeing bank loans to finance working capi- tal requirements of LEDCs already being assisted by the Office of Economic Opportunity. This activity will supple- ment present OEO funding and assist these units in at- tracting private credit. (2) Guaranteeing savings and time deposits in credit unions serving the poor. At present, these units are not covered by any Federal insurance program. Providing the equivalent of deposit insurance may permit them to bid for a greater volume of deposits and in larger amounts. This could lead to State or Federal deposit insurance for these low-income credit unions. (3) Offering the equivalent of reinsurance or "back- up" commitments to bonding companies and fire and casualty insurance companies to encourage bonding of * Added by the editors. It should be pointed out that, at the time of printing of this manual, the complementary programs described herein had not yet become operational. 143 poverty-area contractors and the sale of fire and theft in- surance to poverty-area merchants. A successful demonstra- tion of the program could lead to permanent Federal or State reinsurance of risks which now prevent the develop- ment of commerce and retail services in low-income com- munities. (4) Guaranteeing deposits in poverty-area banks above the present $20,000 FDIC limit. This could permit the poverty-area banks to bid for large and profitable cor- porate deposits and could also lead to expanded FDIC coverage above the $20,000 ceiling. (5) Guaranteeing repayment of capital notes issued by poverty-area banks. This permits the notes to be sold to institutional investors. It gives the poverty-area bank an additional capital base for accepting deposits and making community loans. Important leverage of government funds is achieved. A favorable loss experience could also lead to expanded Federal deposit insurance covering notes is- sued by poverty-area banks. (6) Guaranteeing a standby loan issued by a bank to a community-owned shopping center to provide initial equity and funds for start-up expenses. This arrangement would be used to test the feasibility of accelerating develop- ment of low-income, community-owned shopping centers by permitting the community sponsors to "borrow on a reasonable expectancy" of accumulating, over a period of time, sufficient community capital to repay the standby loan. Even successful community savings plans, such as those undertaken in Philadelphia, lose momentum unless the initial flow of community savings into the plan can be immediately translated into a visible community facility. The guarantee furnished by Opportunity Guarantee unit would enable a bank to furnish the funds to accomplish this goal and would demonstrate the actual loss experi- enced on undertakings of this kind. The Opportunity Guaranty unit will seek other oppor- tunities of guaranteeing loans to finance facilities needed by the poor where FHA and SBA guarantees are not available. This will include shopping centers, health care units, day care facilities, inner-city bus companies, and even the guarantee of seed money funds needed to launch Minority Enterprise Small Business Investment Companies (MESBICS) and LEDCs. The Community Development Discount unit and the Opportunity Guaranty unit will work in concert to increase the financial resources available to a wide variety of poverty-area based institutions. The Community Development Discount unit will pur- chase notes held by LEDCs, limited-income credit unions, poverty-area banks, and MESBICs. It would then repackage or pool these notes and use them to back marketable securities which would then be backed by the Opportunity Guaranty unit. The Community Development Discount unit would then sell these guaranteed securities to churches, endowment funds, pension welfare funds, and individual investors. This project is intended to demonstrate the feasibility of a combination discount and guarantee concept operating in the field of low-income enterprise — comparable to the functions performed by FNMA and GNMA in the field of federally insured housing mortgages. If successful, it will have the effect of enabling poverty-area financial institutions to turn over their funds more rapidly and in- crease their lending capacity to persons and enterprises in low-income areas. The Incentive Simulator unit will demonstrate a series of economic inducements to encourage private investment in low-income communities. It may offer to pay an in- centive fee to a corporation, educational institution, or charitable organization to induce the purchase of capital notes issued by a poverty-area bank. Under present regu- lations if the bank were to sell a $100,000 capital note to one of these institutions, it would be permitted to make up to $800,000 in loans. In this example an incentive fee costing $2,000 could produce deposit and lending capacity up to $800,000 for use by the poverty-area bank in ex- tending credit to the low-income community it serves. This project is intended to demonstrate how, through a highly leveraged transaction, a very modest investment of Federal funds can generate up to 400 times that amount in additional lending capacity. Similarly, the Incentive Simulator unit may offer front- end payments and other incentives to encourage subcon- tracting arrangements and franchise enterprises in a de- fined poverty area. The agency will then evaluate whether the presence of the incentive produces a substantial in- crease in economic activity when measured by an adjoining high-index poverty area where similar incentives were not available. In the past, many Federal programs have stimulated new business start-ups by disadvantaged businessmen only in the poverty areas themselves. It is the view of the agency that this policy might be modified since it almost invariably matches the weakest individual with maximum risk. One national franchise company has experienced some success in franchising disadvantaged businessmen in locations out- side the poverty area and installing them in businesses in a less hostile economic environment. Other experiments of the Incentive Simulator unit may include payment of "points" to encourage low-interest loans to LEDCs and other poverty-area enterprises. It may also experiment with making deposits in banking institu- tions which are "linked" to commitments on the part of the banks to make specified types of loans and extending specified types of credits in low-income communities. Through the Incentive Simulator unit the agency expects to test a variety of incentive arrangements designed to as- sist OEO-funded institutions gradually to reduce their de- pendency on Government funding and private grants and become financially self-sustaining. 144 Section 27 STATE AND LOCAL GOVERNMENTAL SOURCES OF FINANCING ACCESS TO FUNDS TIED TO A PUBLIC PURPOSE 7—1. Tax-exempt bonds are a possible source of funds or rehabilitating economically depressed urban and rural reas. Such tax-exempt bonds could be issued by a prop- rly qualified Local Economic Development Corporation, iy a political subdivision working in cooperation with the JEDC, or by a State authority which has the power to issue ax-exempt bonds. Municipal bonds have been issued to finance sewer and /ater facilities, to pave and light streets, to acquire garbage rucks, to build hospitals, nursing homes, senior citizen nd daycare centers, and to rehabilitate and reconstruct irban business centers. Such uses of proceeds from the ale of municipal bonds have been determined by judicial lecision or legislative determination to serve a public pur- pose for which municipal bonds may be issued. Each use ould be said to have promoted the general welfare or to lave achieved recognition as a use which benefited the mblic notwithstanding a private benefit to individuals. Almost any environmental improvement to a depressed rea could be presented in such a way as to show that , public purpose will be served and therefore that municipal tonds could be issued to finance such purpose. Investors re always interested in an area that has a sufficient com- lination of business activity coupled with successful com- rtercial enterprises and stable residential communities. Historically, municipal bonds have been issued for a ingle purpose such as construction of a sewer system or . transit system. However, the transitional stages in which nany urban and underdeveloped rural communities are low involved require the most comprehensive and inte- ;rated planning for rounded development which will appeal o investors. Today, a purchaser of municipal bonds used o finance community economic development wants to ;now not only that the community will have a complete ewer system, but that it will have industrial, commercial, ind residential users that generate sufficient revenue to pay or the system. It is important for an LEDC to realize that a piecemeal ipproach will be possible only if the proposed facility will ;enerate sufficient revenues and that such revenues can be )ledged to payment of the bonds. An industrial plant, of :ourse, possesses this potential. A hospital would also have his potential since the various insurance programs could >rovide the hospital with the necessary insurance income, -lowever, a sewer system has no such guaranty behind it. Many municipalities have financed urban renewal proj- cts and low-rent housing programs in their communities hrough the issuance of obligations by local urban renewal igencies (LPAs) and local housing authorities. Such obliga- ions, if issued as "Project Notes" or "New Housing Au- hority Bonds," are secured by a guaranty of the Federal jovernment that the principal of and interest on the obliga- ions will be paid in full when due. A description of these instruments, which comprise a major part of the tax-exempt bond market, may be found in Moody's Municipal Bond annual publication. Federal Restrictions on the Use of Industrial Revenue Bonds 27-2. In 1968 Congress amended Section 103 of the In- ternal Revenue Code. Generally speaking, this amendment limits the amount of a bond issue for constructing a facil- ity for lease to a private business to $5 million in any one municipality. However, many commercial, industrial, manufacturing, warehouse, or research facilities can be constructed for less than this amount. Moreover, if sub- stantially all of the proceeds of an issue are to be used to acquire or develop land for an industrial park, the issue is exempt from the amendment. Thus, it is very important for an LEDC to study this amendment to the Internal Revenue Code in conjunction with new solutions to local problems and not to be deterred by a generally held view that Congress has eliminated the use of industrial revenue bonds. Use of Tax-Exempt Bonds to Finance Local Economic Development 27-3. An LEDC may ask why it should be interested in tax-exempt bonds. The basic reason for such interest is that tax-exempt bonds generally bear interest at a lower rate than other evidences of indebtedness such as a mort- gage loan, corporate bond, or bank loan. One reason for this, of course, is that the buyers of such bonds do not have to pay Federal income taxes and, under certain con- ditions, State or local income taxes for interest paid on the tax-exempt bonds. Therefore, an LEDC concerned with raising capital should consider the possible use of tax-exempt bonds since such a method usually would be the cheapest method of borrowing money. Monies raised by the sale of tax-exempt bonds are basically loans from the buyers to the issuer; the buyer expects a return of principal and interest over a stated period of time. The buyer is concerned about the fiscal integrity of the issuer and will not risk his capital unless he has a reasonable expectation that it will be returned with interest. Thus, while an LEDC may want to use revenue from tax-exempt bonds because the loan will be cheaper, it must remember that the money received must be repaid with interest. USES OF THE FUNDS 27-4. Bonds can become tax exempt only if the proceeds from their sale are used to serve a public purpose. In deciding the question of public purpose numerous courts have made it quite clear that public monies may be properly spent for construction of municipal facilities such as water systems, hospitals, sewers, highways, and sidewalks. 145 Other courts have ruled that public money also may be spent for purposes such as relief of unemployment and public acquisition of a subway system from private oper- ators. An LEDC may be able to demonstrate that a public purpose will be served by LEDC-supported programs such as (1) improvement of basic facilities in the community; (2) attracting private industry to the community; (3) re- developing land use in the community; and (4) develop- ment of new communities. Improvement of Basic Facilities in the Community 27-5. An LEDC knows the problems and needs of its community. Parking space may be inadequate. Railroad tracks may interfere with logical development of the com- munity. Streets may fail to provide convenient access by trucks. More important, residents, industry, and retailers may be unwilling to remain in the area. Generally speaking, solutions to any of the above prob- lems might serve a public purpose for which municipal bonds may be issued. For example, many facilities and projects in major cities were originally sponsored and financed by private organizations. In some cases it later became important for the public to control and finance such facilities; thus, many cities now own and operate water systems, subway systems, and, in some cases, entire public transportation systems. These are purposes for which municipal bonds may be issued. Attracting Private Industry Into the Community 27-6. The concept of public purpose has been extended so that municipal bonds may be issued to finance construc- tion of an industrial plant for lease to a private corporation. Municipal bonds have been issued to finance the develop- ment of large tracts of land for use as an industrial park. Public monies are spent on development of industrial parks to attract industry by providing publicly financed water, sewer, lighting, and street facilities. In many cases, indus- try, the municipality, and the LEDC have worked together using both public and private money to develop an indus- trial park. Redeveloping Land Use in the Community 27-7. The most common problem that faces an LEDC in an urban center is that of organizing and replanning for proper use of the land in a particular area. Piecemeal de- velopment of land in urban centers has more often than not caused problems which eventually require overall plan- ning rather than piecemeal redevelopment. Definite guide- lines must be adhered to if municipal bonds are to be used to finance the redevelopment of a depressed area. Historically the power of eminent domain has been linked to the power to condemn private property for a public use provided compensation is paid to the owner. The definition of public use has been read into the provi- sions of the Fourteenth Amendment which protect indi- viduals from being deprived of their property without due process of law. Thus, not only must the required statutory procedures (such as a public hearing) be adhered to but the property must be taken for a public use. The reclamation of large areas of land to promote the health, convenience, and welfare of the public was estab- lished as an important governmental function well before the 20th century. 1 The definition of public use has under- gone considerable change since courts of the 19th century interpreted it to mean use by the public. The landmark case of New York City Housing Authority V. Mullcr- was decided in 1936. This case upheld the con- demnation of slum areas for the purpose of constructing public housing to be used by persons of low income. It was found that public welfare, not sole use by the public ai large, was a purpose which could justify the use of the power of eminent domain. This power was further extendec in Murray v. LaGuardia, 3 which held that land taken by condemnation for a public purpose could later be sold to private developers who would make a profit in the private redevelopment of such land. The court stated: "If, upor completion of the project, the public good is enhanced it does not matter that private interests may be benefited. In Berman v. Parker 5 it was decided that not only slum areas but peripheral areas that tended to produce slums, could be condemned pursuant to the power of eminent domain for the purpose of completely eradicating the blighted area. There, the subject land was to be developed pursuant to a balanced, integrated plan. The court stated: "It is within the power of the legislature to determine that the community should be beautiful as well as healthy, spacious as well as clean, well balanced as well as carefully patrolled. A rapid expansion in the definition of public use and public purpose was made in Cannata v. City of New York," which upheld the taking of a vacant and poorly developed area because it might in the future become a slum area. There the private property was to be turned over to pri- vate developers to be developed as an "Industrial Park.' The court found that the area to be condemned was sub- divided into plots of such form and shape as to prevent effective economic development of the area, although there was no "tangible physical blight" as to constitute a slum area. In the Cannata case the condemnation upheld was au- thorized pursuant to a State statute. It would appear that a municipality does not possess inherent power to acquire private property for the purpose of establishing an indus- trial park. While there is perhaps a "trend" of the law in this direction, the underlying theory of the litigated cases to date is based on the police power of providing for the general welfare either by draining or reclaiming land, clearing up slum areas, or, as established in the Cannata Case, preventing an area from becoming blighted, for which purpose a specific statute has been enacted. Since munici- palities do not have the power to enter into the real estate business, communities are advised to comply strictly with all applicable statutory requirements relating to the acquisi- tion or condemnation of land. This word of caution must be heeded especially where tax-exempt bonds are to be issued to finance the acquisition and redevelopment of land. Development of New Communities 27-8. In addition to the redevelopment of land for indus- trial park purposes, a community may also wish to consider the issuance of tax-exempt bonds for the purpose of creat- ing new, balanced communities containing residential, commercial, and civic facilities. The cost of acquiring, reclaiming, filling in, developing, preparing, and improv- ing the land could be initially financed by the issue of such tax-exempt bonds. Upon completion of site improvements the land may be leased or sold to private developers who further develop the project area by the construction of houses and buil i Hagar v. Reclamation District No. 108, 111 U.S. 701 (1884); Sweet v. Rechel, 159 U.S. 380 (1895); In Re Ryers, 72 N.Y. 1 (1878). ^ 270 N.Y. 333, 1 N.E. 2d 153. 3 291 N.Y. 320, 52 N.E. 2d 884 (1943). 4 291 N.Y. 320, 52 N.E. 2d 888. •■' 348 U.S. 26 (1954). 348 U.S. 33. ' 182 N.E. 2d 395 (1962). 146 ngs for commercial use. The lease of sites to developers or high-value uses such as commercial office buildings iroduces revenues which then can be used to pay the prin- :ipal of and interest on the outstanding obligations of the nunicipality. In addition such income also may be used o finance the cost of civic and recreational facilities and o construct housing for persons of low income. This ar- angement makes the entire project self-supporting and equires no capital expenditures by the municipality or he State. If the redeveloped land is leased rather than sold to irivate developers, the municipality may establish more :asily standards for private construction in the area by legotiation of such standards into leases between the nunicipality and private developers. Redevelopment of arge areas in such a manner facilitates the creation of new ommunities pursuant to a modern, well-developed master )lan. The municipality can delineate what percentage of he total area is to be used for commercial, residential, >r open space purposes as well as establish the population lensity of the area. Redevelopment as outlined above is especially feasible n areas of large population where there is a demand for ommercial office facilities and where land, if developed >roperly, has a high-value use. It is also especially work- ible in cities situated on rivers or other waterfronts, where and now under water can be reclaimed and filled in with- >ut relocation headaches. 8 It should be noted that the metropolitan development iffice of HUD administers a new communities guarantee >rogram, but it is limited to private developers. It is doubt- ul that many public bodies have the authority to develop ind finance a new community. Because of its complexity his question cannot be adequately covered here. EGAL APPROACHES TO THE ISSUE )F TAX-EXEMPT BONDS 17-9. Community organizations can be incorporated under itate law as nonprofit entities and may be able to borrow noney and loan such money to local businesses by issuing ax-exempt bonds. In some cases these bonds can be issued lirectly by the community organization, but more often hey are issued by a political subdivision of the State. A political subdivision is usually a city or a village or i public authority created by the legislature to develop, :onstruct, finance, and operate projects such as bridges >r ports. ssue of Bonds by Public Development Corporations 17-10. Local interest groups can join to form what is ;nown as a public development corporation, which by itate law is organized not for profit but mainly to stimu- ate and promote business in a given area. In many in- tances such development corporations are set up to make :redit available to businesses which cannot obtain it from :onventional sources. These corporations are actually in- iurers of a loan made to a particular business. They usually epresent people in the community who are willing to work o attract industry into the area. Revenue Ruling 63-20 by the Internal Revenue Service las taken the position that a local development corpora- ion may issue tax-exempt bonds provided certain require- nents are met, as follows: "Obligations issued by a nonprofit corporation formed ander the general nonprofit corporation law of a state 'or the purpose of stimulating industrial development within a political subdivision of the state will be considered issued 'on behalf of the political subdivision, for the purposes of section 1.103-1 of the Income Tax Regula- tions, provided each of the following requirements is met: ( 1 ) the corporation must engage in activities which are essentially public in nature; (2) the corporation must be one which is not organized for profit (except to the extent of retiring indebtedness); (3) the corporate income must not inure to any private person; (4) the state or a political subdivision thereof must have a beneficial interest in the corporation while the indebtedness remains outstanding and it must obtain full legal title to the property of the corporation with respect to which the indebtedness was incurred upon retirement of such indebtedness; and (5) the corporation must have been approved by the state or a political subdivision thereof, either of which must also have approved the specific obligations issued by the cor- poration. Interest received from such obligations is ex- cludable from gross income under the provisions of section 103(a)(1) of the Internal Revenue Code of 1954." An analysis of this ruling should not deter a local de- velopment corporation from pursuing the possibilities of issuing tax-exempt bonds. A community organization may be able effectively to arrange for a community to have all the benefits of a community facility without substantial interference and control by the political subdivision and also to retain the advantage of issuing tax-exempt bonds. Assume for the moment that a solution to a community problem is the construction of a hospital. This could be accomplished by establishing a nonprofit corporation which would organize all the financing, and upon expiration of payment of the debt the hospital could be deeded to the State. A community organization so organized would, of course, have to do all the leg work needed to find a pur- chaser for the obligations of the hospital. The proceeds of these obligations could be used together with available State or Federal grants to build the hospital, and the fees and charges from the operation and maintenance of the hospital would be pledged to payment of the bonds and interest. Conferences would be held with the Internal Revenue Service to qualify the issue for tax exemption, and ar- rangements would be made with the political subdivision in which the hospital would be built to give it a beneficial interest in the corporation and eventually to obtain legal title to the hospital. If a 50-year repayment schedule on the bonds is contemplated, it must be remembered that a building or facility usually is not considered useful after having been operated for a period longer than 50 years. The hospital example shows that while the ruling by the Internal Revenue Service appears to prohibit a com- munity organization from issuing bonds bearing tax-exempt interest, such a solution can be achieved with the proper groundwork. Although it may be feasible to issue tax-exempt bonds to improve the community environment for economic development, such bonds can be marketed only if the public is assured of repayment. Such assurance that the loan will be repaid has been worked out in many instances by legis- lation. Thus, the State legislature, county, or municipality has become a guarantor of an issue of tax-exempt bonds. A statement of guarantee of such bonds is added to the actual municipal bond by the State or local subdivision, so that the purchaser can look to the State or local govern- ment for payment, as well as to the issuer; thus, the State has said in effect that if the issuer is unable to repay the principal and interest on the obligation, the State will be H This is being done in the Battery Park area of New York City. 147 willing to appropriate the money needed to make such payment. Issue of Bonds by Political Subdivision 27-11 Based on the IRS ruling the most realistic approach for the local community organization is to encourage the political subdivision to assume the job of issuing the bonds. The bonds of the political subdivision would clearly be tax exempt under the Internal Revenue Code, and the tedious work of securing an IRS ruling would be unnecessary if the political subdivision were actually issuing its general obliga- tion tax-exempt bond. (1) Bond Issues for Needed Improvements. Most States have statutes that grant local residents the right to petition for needed improvements. For example, in many States it is possible to circulate a petition among home owners for establishment of a sewer district where continued use of septic tanks proves to be inadequate. Upon filing the peti- tion with the governing board of the municipality a public hearing is held to determine whether the construction of a sewer system would benefit the petitioning area. The munici- pality issues tax-exempt bonds for construction of the sewer system; payments of principal and interest are assessed against those in the sewer district. In addition to sewer pro- grams this procedure has worked well over a number of years in most States for water, sidewalk, drainage, and other public improvements. (2) Bond Issues for Business Improvement Districts. A recent statute in the State of Pennsylvania has authorized establishment of what is known as a Business Improvement District whereby certain municipalities have authority to establish within their political boundaries a district for the purpose of acquiring real or personal property by purchase or lease. They also are permitted to improve sidewalks, pave and light streets, construct parking lots and garages, pur- chase and plant trees and shrubbery, build schools and water lines, and, most important, acquire or demolish blighted buildings. To finance such improvements within the district, bonds are authorized to be issued after a public hearing is held. The cost of such improvements, including preliminary plans or feasibility studies if necessary, is imposed on the benefited property within the Business Improvement Dis- trict. Thus, each year the payments of principal and interest on the bonds issued to finance the cost are charged back against the property in the improvement area. This legislation incorporates in one statute what many States have authorized by several statutes. Thus, in a given business area the merchants may create a Business Improve- ment District and may take advantage of the cheaper tax- exempt interest rate in order to remodel existing buildings. The statute provides that no improvements shall be made on property which has not been acquired, but this does not mean that property acquired by the governing body could not be leased later to private individuals. While tax-exempt bonds in effect may not be issued by a municipality on be- half of the Business District unless the municipality has a beneficial interest (which usually is defined in terms of own- ership of the facilities being improved or constructed), care- ful planning could make possible the private operation of structures improved with the proceeds from tax-exempt bonds. Issue of Bonds by a State Industrial Development Authority 27-12. An LEDC can cooperate with a State industrial development authority in persuading outside businesses to move in and employ numerous local residents of the area served by the LEDC. Some State statutes authorize the issu- ance of bonds by their State industrial development authori- ties to finance construction of facilities for lease to the invited business. Such projects, if deemed to be in the public interest, may be considered purposes for which public funds may be expended. 9 OTHER STATE SOURCES OF FINANCING FOR BUSINESS OPERATIONS AND PLANT CONSTRUCTION 27-13. Programs exist in a number of States for State- chartered business development corporations which by pool- ing risks make credit available to businesses that cannot obtain funds from conventional sources. Some States also channel State funds and credit through industrial finance authorities to Local Economic Development Companies to build and/or renovate plants for industry. State-Chartered Business Development Corporations 27-14. Although 40 of the 50 States have enabling legisla- tion for the formation of State-chartered business develop- ment corporations, only 23 business development corpora- tions are currently in active operation. 10 LEDC should in- vestigate the availability of funds for their projects from local sources. These business development credit corpora- tions obtain their capital from the sale of their stock to banks, insurance companies, other business firms, and indi- viduals. Although they do not have access to State govern- ment money or credit, they are authorized by special legis- lative action and are publicly accountable. They are able to lend many times their actual capital due to commitments from their member banks, savings and loan associations, and insurance companies agreeing to lend money directly to them upon call. Through this concept of risk pooling they can provide financing for new businesses or for the expan- sion or support of existing businesses that cannot obtain funds from conventional sources. ( 1 ) Operating Criteria of a Sample Credit Corporation. To illustrate the approaches generally taken the operating criteria of the Pennsylvania Development Credit Corpora- tion are listed below: (a) Eligibility: An applicant must be incorporated and must show reasonable expectancy of increased and lasting employment resulting from the loan. Particular regard will be accorded manufacturing and processing businesses because of their greater potential for creating jobs with multiplier effects. However, projects tied directly with tourism and recreation may be eligible. Applications involving the relocation of an industry from one section of the State to another will ordinarily not be approved and loans cannot be made if the credit is avail- able from local financial institutions. An application must also meet these qualifications: sound management; reasonable assurance of ability to generate earnings sufficient to service debt and provide working capi- tal adequate for current needs; growth potential of market and sales; and adequate equity capital. (b) Use of Loan Proceeds: Loans will be made for equipment and working capital, but money for plant con- struction or expansion is available when unobtainable else- where. The Corporation will not make a loan to bail out -nother lender. o The most recent statute of this kind to go on the books was in the State of New York in 1969. It declares that the public policy of the State of New York is to promote the economic welfare of its inhabitants and to actively promote, attract, encourage, and develop economically sound commerce and industry through governmental action for the purpose of preventing unemployment and economic deterioration by the creation of industrial development agencies. i" These corporations which may be contacted for information are listed in Appendix 27-A. 148 (c) Bank Participation: The Corporation tries to ob- lin maximum local bank participation in specific loans, nd the participating bank is encouraged to make and ervice the loan. This would be in addition to the broad articipation in the form of commitments from financial istitutions agreeing to lend money to PDCC, as afore- mentioned. (d) Terms and Conditions: Participation in loans by le Corporation is normally limited to $500,000. There is minimum amount for a loan to be considered, except lat it must be sufficient to ensure significant continued or ew employment. Terms and conditions will be tailored to fit each situa- bn. Normally maturities will be limited to 5 years for working capital and 10 years for fixed assets, but longer laturities can be negotiated. Interest will be charged on unpaid balance. The Corporation will try to secure its loans fully. Real state and equipment are preferable collateral, but subordi- ate liens may be acceptable. Life insurance, personal guar- nties, or other collateral may be required, depending on ircumstances. An option on a small percentage of the borrower's stock lay be required. tate Industrial Development Authorities 7-15. Several States have enacted legislation creating a tate industrial finance authority which has the power to isue tax-exempt bonds for the purpose of raising funds to lake loans to local nonprofit corporations for the construe- on, acquisition, and rehabilitation of industrial plants. (1) Loan Approach. Direct loans of State funds are avail- ble to LEDCs from specially established State authorities 1 several State jurisdictions. 11 The New York Job Development Authority provides jans to nonprofit LEDCs not in excess of 30 percent of le cost of the project, the repayment of which shall be jcured by a mortgage which shall not be a junior encum- rance thereon by more than 50 percent of such cost. The advantage to an LEDC working with a State authority is that the loan by the State authority to the LEDC will bear interest at a rate comparable to that the State authority pays on money that it borrows; since the State authority issues tax-exempt bonds, the interest advantage is passed on to the LEDC. While the amendments to the Internal Revenue Code are still applicable to the State authority, an LEDC should ascertain from the State in which it operates if such State authority financing is available. Another example of this approach is the Pennsylvania Industrial Development Authority, which was established to make second mortgage loans for industrial building pur- poses to nonprofit LEDCs in chronic labor surplus areas. The Development Authority may lend up to 30 percent of the cost of plant construction, provided the LEDC furnishes at least 20 percent as equity and arranges for the other 50 percent from conventional private financial institutions. A responsible manufacturer must be committed to occupy, equip, and operate the plant under a long-term lease or a lease-purchase agreement. Loans from the Authority may be made for a maximum term of 25 years with a minimum interest rate of 2 percent. (2) Guarantee Approach. Many States have statutes which guarantee or insure mortgages. Thus, while an LEDC may be able to obtain a loan from a bank at the going rate of interest, provided the State has a guarantee or an insurance program, the rate of interest on the loan would be a tax- able rate. This approach is typified by the Maine Industrial Build- ing Authority, which insures payments required by first mortgages on new industrial buildings. The insured mort- gages must not exceed 90 percent of the cost of the project, must have a maturity of less than 25 years, and cannot exceed $1 million for a single project. Title to the project must remain with the LEDC until the insured loan is repaid and the State is relieved of its contingent obligation. 11 Among these jurisdictions are Pennsylvania, New York, Alaska, Oklahoma, Kentucky, Georgia, Ohio, and West Virginia. 149 Section 28 STOCK ISSUES AS A SOURCE OF FUNDS SALE OF STOCK TO FINANCE LEDC ACTIVITIES 28-1. Local Economic Development Companies that are basically nonprofit membership corporations (or their vari- ous State equivalents) often rely on grants from govern- ment and various private sources as the cornerstone of their funding structure. In special circumstances, LEDCs that are profit-oriented may also seek grants or other funds which need not be repaid, but they will probably have to turn to the sale of their stock both within and outside the "poor" community as a means of raising equity capital. Such equity capital is needed to provide a sound base for leveraging additional funds through various government programs and many varieties of debt financing in the pri- vate sector. Since LEDCs seek to obtain financing and encourage a broad base of local community stock ownership with as few technical complications as possible, they must tread warily in order to fit within the exemptions to the registra- tion requirements under the Federal and State securities laws applicable to the sale of stock to the public, and also to provide full disclosure of the risks involved to their potential investors. Disclosure Problems Regarding the High-Ri.sk Situation and Unsophisticated Investors 28-2. The function of the Federal and State securities laws for protecting unwary or unsophisticated investors relates to LEDCs just as it does to industrial or commercial busi- nesses. Clearly, members of the community which an LEDC is developing and in which it is offering stock require and deserve the same protection which the Federal and State laws grant to members of the general investing public. Limited partnerships, if the limited partners are other than few, are also subject to the SEC laws. They are also subject to State blue sky laws. SEC and Blue Sky Law Requirements 28-3. In general, the Federal and State securities laws are applicable to the financing of and creation of community ownership in LEDCs. The most relevant Federal laws are the Securities Exchange Act of 1933 (the "Securities Act") and the Securities Exchange Act of 1934 (the "Securities Exchange Act"). State securities laws are sometimes re- ferred to as securities laws, broker-dealer laws, blue sky laws, and in some States they are a part of the banking or insurance laws. The sale of securities of an LEDC to members of the com- munity in order to create community participation and ownership of the LEDC involves different problems than would the sale of securities — such as nonvoting preferred stock, convertible debentures, or notes — to sophisticated investors. The latter issue of securities, designed as a vehicle for financing the LEDC, may be exempt from regis- tration under the Securities Act and under the State blue sky laws as a private placement. The sale of an LEDCs securities to members of a community is not exempt as a private placement; therefore, the securities must be registered under the Securities Act and the State blue sky laws, unless some other exemption from registration is available. If the issuance of stock by an LEDC does not fit within one of the exemptions from registration requirements of the Securities Act, the LEDC will become immersed in the highly complex and often expensive registration and report- ing requirements of the Securities Act and the Securities Exchange Act. The discussion of the various exemptions and require- ments of the Federal and State securities laws which follows is an attempt to show various means by which an LEDC can fit within existing exemptions and how to structure offer- ings and control procedures accordingly. EXEMPTIONS UNDER THE SECURITIES ACT 28-4. No provision in the Securities Act generally exempts securities issued by LEDCs from registration requirements of the Act. Accordingly, it is necessary to determine, with respect to each issuance of securities by an LEDC, whether one of the exemptions in the Securities Act is available to the LEDC. There are several significant exemptions from the coverage of the Securities Act, and certain types of trans- actions are not covered by the Securities Act. Private Placement of an Issue 28-5. An exemption which an LEDC might find particu- larly appropriate as a means of obtaining financing I but not for the purpose of creating community ownership) is the "nonpublic offering" exemption. Section 4(2) of the Securities Act exempts from the regis- tration requirements of the Act "transactions by an issuer not involving any public offering." The criteria used in determining the availability of the nonpublic offering (some- times called "the private placement" exemption) can make this a practical means of obtaining financing for an LEDC; it is ill-suited for the creation of community participation and ownership of the corporation. A private placement can take the form of the issuance of common stock, nonvoting stock, convertible preferred stock, notes, convertible deben- tures, warrants, or any other kind of security. (1) Advantages of This Approach. A private placement of securities is often used by industrial and commercial corpora- tions for many of the same reasons it would be used by an LEDC. That is: (a) It is inexpensive, uncomplicated, and speedy com- pared with a registered public offering. (b) It usually will not subject the issuing corporation to the complicated and costly reporting requirements of the Securities Exchange Act of 1934. (c) The purchaser of the securities, particularly if it is a financial institution such as a bank or insurance com- pany, may provide financial advice to the issuer in the future. 150 (d) Since a private placement is negotiated between le issuer and the purchasers, it can be tailored for the pecific purchasers, thus facilitating the financing. Moreover, since the Securities Act imposes no dollar mitation on the amount of money that can be raised in a onpublic offering, a private placement can be used to rovide all or substantially all of the capital required for le beginning of operations and later financing of an LEDC. (2) Standards for Qualification. The principal standards sed to determine the availability of the nonpublic offering xemption have, for the most part, been set forth in releases y the Securities and Exchange Commission (SEC), which dministers the Securities Act and the Securities Exchange iCt. The basic concept of private placement is that the urchaser of the securities can fend for himself and, accord- lgly, does not need the protection embodied in the regis- ation provisions of the Securities Act. The principal stand- rds are as follows: (a) Number of Offerees: The SEC has not set forth ny hard and fast rules as to the maximum number of fferees permissible in a nonpublic offering. Clearly, the :wer the offerees, the more likely it is that the nonpublic ffering exemption will be available. The SEC has made it lear, however, that the operative fact is not the number of urchasers but the number of offerees. The term "offerees" as been construed broadly to include each person with horn the issuer or an agent of the issuer may have dis- jssed the matter with a view to determining that person's lterest in the transaction. (b) Investment Intent of Purchasers: For an issuer to i/ail itself of the nonpublic offering exemption it is neces- iry that the purchasers of the securities being sold intend t the time of purchase to acquire the securities that are eing privately placed for investment. They also must repre- :nt in writing to the issuing corporation that they are ac- uiring the securities for their own account, for investment, nd not with a view to the distribution thereof. It should be oted that the mere representation of the purchasers is not rffkient; an "investment letter" is regarded as self-serving ad is not necessarily indicative of the actual intent of the urchasers. (c) Control Procedures: An effective way for the is- ler to police the transfer of the securities sold in a private lacement and, accordingly, to require the purchasers to old the securities "for investment" is to stamp each stock jrtificate (or debenture or warrant) with a legend to the allowing effect: "The securities represented by this certificate are ;ing held subject to the restrictions of the Securities Act of )33 and may not be transferred, sold, assigned, or other- ise disposed of without the prior written consent of the suer." The transfer agent (if any) for the issuer, or the officers the issuer who are responsible for effecting the issuance id transfer of the securities being held for investment, lould be ordered not to transfer those securities unless rected to do so by the management of the issuing >rporation. (d) Knowledge of the Issuer: Regardless of the small imber of offerees and the investment intent of all pur- lasers, the private offering exemption may not be available the offerees were not advised of all material facts regard- g the issuing corporation. If the purchaser has a close lationship with the issuer (for example, if an officer or incipal of the purchaser is a director of the LEDC) he ay be deemed to possess the requisite knowledge of the iDC's business. It often is thought wise to furnish each rchaser, prior to the sale, with up-to-date financial informa- m (if any is available) and a brief written description of the business, the history, the management (including re- muneration), and the capitalization of the issuer. The writ- ten description should contain an introduction that briefly and clearly sets forth the risks involved in the LEDC. (e) Nature of the Offerees: In all cases, offerees must be "sophisticated investors" able to fend for themselves. Financial institutions, insurance companies, certain universi- ties, mutual funds, certain investment partnerships, certain large corporations, and certain very wealthy individuals are generally considered sophisticated investors. An officer or key employee of the LEDC may also qualify as a sophisti- cated investor. Even after it has been determined that the private place- ment exemption is available for a particular issue of securi- ties, the buyers of the securities will be required to hold them for an indeterminate length of time. The reason for this requirement is that it is one of the criteria for determining the good faith of the purchaser's investment representation. The SEC has not set forth a hard and fast rule in this area — there is no minimum holding period and there is no safe rule of thumb. If the purchaser's circumstances have undergone a significant and unforeseen change (such as bankruptcy or serious financial need, illness, or death) and the holder must sell his investment letter stock to meet these unanticipated needs, the holding period for "investment letter" securities may be shortened. The type of purchaser is also relevant in this regard — for example, a person in the securities business is generally regarded as requiring a longer holding period than someone who is not in the securities business. In a recent study of the Securities Act and Securities Exchange Act conducted by the staff of the SEC (the "Wheat Report"), and in the rules proposed by the staff of the SEC to imple- ment the Wheat Report, certain changes were suggested in the restrictions on transferability of "investment letter" stock. The proposed rules are considerably more specific and detailed than those presently in effect. 1 Often the purchaser of "investment letter" securities will request the right to register the securities under the Securities Act as a means of disposing of the "investment letter" stock prior to the expiration of the required holding period. Regis- tration rights are commonly granted to the purchaser of securities in a private placement, but an LEDC would be ill-advised to grant any private purchaser of its securities those rights. If the purchaser could require the LEDC to register its securities under the Securities Act, all of the disadvantages to the LEDC of a registration statement (ex- pense, delay, and the fact that it would become subject to some of the provisions of the Securities Exchange Act) would only be delayed rather than avoided by the private placement. Intrastate Offering Exemption 28-6. Registration under Section 5 of the Securities Act is not required if securities are offered and sold in accordance with the intrastate offering exemption provided by Section 3 (a) ( 1 1 ) of the Act. Section 3 (a) ( 1 1 ) provides an exemp- tion from the provisions of the Act for: "Any security which is a part of an issue offered and sold only to persons resident within a single State or Terri- tory where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory." 2 1 See "Grist from Wheat — Trie New SEC Ground Rules for Venture Capital," 25 Business Lawyer 1001, April 1970. Explanation of Wheat report and how it changes present SEC regulations. "Public Sale of Control Stock and Private Investment Stock: The SEC's Proposed New Rules." 25 Bus. Law 1027. - Since the intrastate offering exemption is only available to an issue made solely within a single State or Territory, the exemption is not available in the District of Columbia, which is not defined as a "Territory" in Section 2(6) of the Act. 151 For an issuer to qualify to sell securities under the intra- state offering exemption, it must be incorporated in and be doing business primarily in the State in which the securities are offered and sold. To this extent LEDCs should be par- ticularly well qualified for the exemption. (1) Sales Limited to Residents. The most pertinent problem of eligibility for the intrastate offering exemption is the requirement that the offering be made only to residents of a single State or Territory. The exemption will be lost if any securities in the issue are sold to a nonresident even if such sales are not made through use of instruments of interstate commerce or the mails. Thus, one face-to-face sale of one share of stock of an issue to a nonresident will taint the entire issue and result in loss of its exemption. The SEC has denned "residence" to mean "domicile." Since domicile is a question of fact, based in part on the purchaser's state of mind, issuers must carefully screen each proposed purchaser to be sure that nonresidents are not included. (2) Restrictions on Resales. Even though the initial sales of securities are otherwise exempt from registration under the intrastate offering exemption, resales of such securities to nonresidents, if deemed to have been made during the initial distribution of the securities, will result in loss of the exemption. There is no fixed period during which the initial distribution is deemed to take place. However, there is au- thority to the effect that there is a presumption that the initial distribution is not complete for a one-year period. Therefore, issuers concerned with using the intrastate offer- ing exemption must control the distribution of their securi- ties to prevent the initial purchasers of the issue from reselling their securities in such a way that the entire issue is tainted. (3) Practical Steps to be Taken. The most practical means of protecting against loss of the intrastate offering exemp- tion is for the issuer to: (a) require that holders of its securities distributed under the exemption who wish to sell such securities must either sell them back to the issuer in a forced redemp- tion or, (b) sell them to a resident who has first been approved by the issuer. It should not be assumed that existing holders of the securities, even if the holders acquired their securities as part of the same issue, automatically qualify as purchasers in resales. Persons who qualified as residents at the time of the initial sales may have become nonresidents since that date. Therefore, the restrictions on resales should be absolute. Resale restrictions may be enforced by legending the stock certificates issued in the intrastate offering with a statement substantially as follows: "The securities represented by this certificate may not be sold to or purchased by any person not a bonafide resi- dent of the State of [ ], either directly or indirectly through a nominee. Any sale to and purchase by a person who is not a bonafide resident of the State of [ ], is invalid and of no force or effect." The issuer and its transfer agent, if any, should also be instructed not to transfer the securities until residence of the purchaser is confirmed. The intrastate offering exemption is fraught with fatal pitfalls which do not depend on the subjective intent or good faith of the issuer. Fortunately for LEDCs which may desire to make use of the exemption, avoidance of these pit- falls will probably be consistent with their general economic programs of encouraging community ownership and con- trol. Issuers may even wish to go beyond the requirements for the exemption by compelling security holders who be- come nonresidents to redeem their securities or resell then to approved residents. In any event, qualification of ai issue for the exemption will depend on recognition of these pitfalls and creation of procedures that will avoid them. A transaction that is exempt as an "intrastate offering' under the Federal securities laws is often not exempt fron registration under the State securities law. For a descriptioi of certain of those requirements see Section 28-21. Securities Issued by Nonprofit Corporations 28-7. Section 3(a)(4) of the Securities Act exempts fror the registration requirements of the Act "any security issuec by a person organized and operated exclusively for religious educational, benevolent, fraternal, charitable or reformatorj purposes and not for pecuniary profit and no part of th< net earnings of which inures to the benefit of any person private stockholders or individual." The reported cases am rulings under Section 3(a)(4) indicate that the only type o organization which can avail itself of the exemption is on< in which the investors can have no expectation or hope o economic gain as the result of their investment. Accordingly it is doubtful whether an LEDC that offers the hope o economic gain to its shareholders can avail itself of the non profit corporation exemption. A corporation which woul< qualify for an exemption under Section 3(a)(4) of thi Securities Act would seem to be a very undesirable vehicl for an LEDC, since the stockholders or other financial sup porters could hope for no pecuniary profit from thei investment. No Sale Distribution of Corporation's Stock 28-8. The distribution by a corporation of its own securitie for no consideration (cash, property, or services) is no covered by the Securities Act, since there has been no "sale of the security, and accordingly no registration is required A "sale" occurs upon the disposition (or agreement t< dispose of) a security for "value." The simplest method o distributing securities to a person or group of persons is ti give the stock away. However, stock that is given away fo no consideration raises problems under State law witi respect to the issuance of stock that is "not fully paid," an this means of transferring stock to members of the cor munity has serious limitations. USE OF REGULATION A BY AN LEDC 28-9. An LEDCs need for capital may be less than $300 000. Recognizing that full compliance with registration re quirements of the Securities Act for stock offerings of thi size could be expensive, Section 3(b) of the Act authorize the SEC to exempt certain securities from registration if finds that registration "is not necessary in the public intere; and for the protection of investors by reason of the sma amount involved or the limited character of the publi offering." Regulation A under the Act provides for an exemp tion from the Securities Act for offerings of $300,000 or lei made in compliance with the regulations. The LEDC mui use extreme caution to assure that only a maximum $300,000 of securities are offered and sold to the publii Advantages of a Regulation A Offering 28-10. Among the advantages of a Regulation A offerin to an LEDC is the ability of the LEDC to sell its securitu across State lines. Therefore, the LEDC need not won about the domicile of its offerees or purchasers or about an eventual resale of its securities to out-of-state residents. Another advantage of a Regulation A offering is that n ports are filed with the SEC's local regional offices whic 152 isist in filing procedures and completion of the various irms. Filing procedures have been relaxed so as to reduce e cost of raising capital. The reports filed need not be inted but can be typed and photocopied or mimeographed, dditionally, financial statements need not be certified. Although Regulation A is an exemption from the more :tailed registration requirements under the Securities Act, does not exempt the LEDC from provisions of the securi- ;s laws which prohibit fraudulent or misleading actions in ie sale of securities. (See Section 28-14.) The use of Regulation A is not available to all issuers of ock. For example, an LEDC will be disqualified from sing the Regulation A exemption if its affiliates, predeces- >rs, officers, controlling stockholders, or promoters have >mmitted certain violations of Federal securities law. iling Requirements J— 11. Regulation A requires the filing of a "Notification" >rm and an "Offering Circular" and clearance thereof by ie regional office before the LEDC can offer or sell its :curities. 3 The SEC has promulgated rules and provides forms hich must be followed closely in the preparation of these :ports. Copies of the necessary forms and the applicable :gulations are available on request from any SEC regional ffice. In addition, each office maintains a current library of xent filings which are public information and may be tilized as precedents in completing the various require- ients. 4 The Notification is intended to set forth information from hich the SEC can determine whether the LEDC will qualify >r Regulation A treatment. Among the information which requires are the names and addresses of the LEDC's pro- loters, directors, officers, controlling stockholders, under- riters, and counsel as well as information as to any litiga- on or investigation for securities law violations involving the EDC, its predecessors or affiliates, or any of the above amed persons. The Offering Circular, after clearance by the SEC regional Bee, must be furnished to anyone offered stock in the EDC. Its purpose is to disclose sufficient information about ie LEDC to allow an offeree to make an intelligent invest- ient decision. All of the Offering Circular's required disclosures, as con- ined in Schedule I to Regulation A, are considered mate- al and must not be reported in a false or misleading man- r. Additionally, there should be no material omission of formation requested by the Schedule. Among the informa- 3n required is a breakdown of the proceeds going to the EDC and a detailed explanation of how these funds will be >ed. If a plan exists to return funds collected on the occur- nce of any event, this also must be explained fully. In Idition, a complete description of the stock being offered, eluding the rights of a shareholder, is required. The LEDC's business operations (past, current, and pro- ved) must be described in detail. Projections of earnings id of potential success cannot be made in the Offering rcular, for these may be misleading. The LEDC's direc- rs, officers, and promoters must be identified, their back- ounds must be disclosed, and the salaries paid (and to be id) to the highest three are to be set forth. All trans- tions between the LEDC and any of such persons which ve occurred within the past 3 years must be set forth in tail, and any contemplated transactions of this nature ust be explained. Financial statements, including at a inimum a balance sheet and income statement, must be luded but need not be certified by an independent pub- accountant. The Notification and its exhibits (including the Offering Circular) is filed with the SEC regional office where the LEDC's principal business operations are conducted. Among the exhibits required is a consent to service of process, mate- rial agreements with underwriters and others, and financial statements. Due to the regional office's usual backlog a delay of 2 weeks to 2 months can be expected before final clear- ance on the offering is obtained. Once the Notification is received and studied, the SEC regional office will send a letter of comment suggesting amendments to correct deficiencies in the filing. At this stage in the filing process LEDC representatives can arrange to meet with a staff member of the SEC regional office to dis- cuss deficiencies and methods for their cure. Amendments to the Notification are then made to cure such deficiencies and to correct statements which have become inaccurate due to subsequent events. Amendments are filed in the same manner as the original Notification. When time is a crucial factor, this filing procedure can be accelerated by written request to the SEC regional office. Sale of Securities by Corporation 28-12. Once the Notification and Offering Circular are cleared by the SEC staff, the LEDC may offer and sell its securities only if an Offering Circular has previously been or is concurrently given to the person to whom the offer is made. After clearance of the material with SEC, advertisements for the security may be made, but they must be filed with the SEC regional office prior to use and must conform to standards set out in the SEC's ruling. An Offering Circular cannot be used for more than 9 months after the date of clearance with the SEC regional office. At that time, should the issue not be fully sold, a revised Offering Circular must be filed with the SEC regional office in accord with the previously described procedures and should be submitted well in advance of the 9-month ex- piration date, for it may be subject to delays as was the original. Additionally, the Offering Circular must always have true, complete, and current information. Should it become in- accurate or incomplete because of subsequent events, an amendment must be filed and sales must be halted until the amended Offering Circular is approved and distributed. No change may be made in the Offering Circular until such change is approved by the SEC regional office. In any case, semiannual reports must be filed with the SEC regional office after the offering is commenced, and a final report must be filed upon termination or completion of the offering. Simplified Registration for Smaller Offerings 28-13. If an LEDC has been organized for at least one year and has derived income from its operations during that time, a simplified accelerated form of registration may be avail- able, provided that the LEDC intends to offer $50,000 or less of its securities under the registration. Under this method of registration, although an Offering Circular is re- quired, it need not be distributed to persons to whom an offer is made or who purchase the security, and the informa- tion required may be submitted in a more condensed form. Since no Offering Circular need be distributed, the LEDC :i For a more detailed examination of Regulation A as an aid to the filing of a Notification and Offering Circular, see "Regulation A Under the Securities Act of 1933 — Highways and Byways" by Ezra Weiss in the New York Law Forum (March 1962). 4 See Appendix 28-A for information required to be included in a Regulation A offering circular. Additional information thereon can be obtained from the Securities and Exchange Commission. 153 can make any offer it wishes after clearance so long as it is not false or misleading, although advertisements are still subject to detailed limitations. The cost for such an offering to an LEDC is substantially less than with a full Regulation A registration. Sanctions 28-14. Even though a sale of securities may be exempt from the registration provisions of the Securities Act, all sales are subject to the so-called "antifraud" provisions of the Federal securities laws. Thus, Sections 12(2) and 17 of the Securities Act and Rule 10b-5 of the Securities Exchange Act prohibit misleading statements or fraudulent practices in the sale of securities. Violation of these provisions carry a number of sanctions: (a) The selling company and its management may be liable in damages to buyer of securities. (b) A defrauded buyer will be entitled to rescind his stock purchase and receive his purchase price back from the corporation. (c) The SEC may seek an injunction against the con- tinuation of the fraudulent practices. (d) Both the Securities Act and the Securities Exchange Act provide for criminal proceedings in the event of willful violations of those Acts. The criminal liability provisions of the Federal securities laws, together with the potential sale liability for violations of those Acts, obviously make it of the utmost importance that an LEDC and its officers and directors exercise great care to avoid making misleading statements or engaging in any fraudulent practices in connection with the sale of securities of an LEDC. Methods of Marketing and Costs of Placement of Regulation A Issues 5 28-15. The investment banker's role is that of financial inter- mediary between the issuer of securities and the investor. His commitments range from outright purchases of the issue, on the one extreme, to "best efforts" deals carrying very limited risks, on the other. Contacts between issuers and underwriters are made di- rectly or through an intermediary known as a "finder." In the case of an LEDC, its best approach may be through local cooperating accountants or lawyers, who can be asked to help locate an underwriter, and who in turn inquire among their associates about a reputable dealer. A professional finder's principal concern is his fee. This fee varies from a flat sum (usually 1 to 4 percent of the gross proceeds) to stock options, warrants, or some combination thereof. If he knows what houses are interested in particular issues and what kind of information the underwriters are looking for, he, more so than the principals, will be likely to induce the underwriters to initiate an investigation of their own. (1) Selecting the Underwriter. The investment banking industry is largely stratified. The largest firms head syndicates that underwrite the large multimillion dollar issues of giant corporations. Other established houses deal in smaller issues but seldom in amounts of less than a million dollars. With the possible exception of someone in a medium-sized firm who may respond to a personal contact, the placement of Regulation A issues are handled by the marginal firms. Often one or two (but rarely more) houses are involved in each issue. As a general rule, "shopping around" for the best deal is not recommended. If word were to circulate in the invest- ment banking field that a company was negotiating with two or more firms simultaneously, or trying to get firms to bid against each other, most good houses would quickly lose interest. Without assurance of getting the issue they would be unwilling to incur expenses of investigation. If a satis- factory agreement cannot be made with one firm, negotia- tions with another can be commenced. However, the chances of reaching an agreement diminish the more the issue "shopped around." (2) Negotiation of Terms. Issuers are dealing at a disad- vantage if they lack knowledge in such financial matters as determining the capital value of their own businesses, the types of underwriting contracts employed, and the wide range of terms. If expert advice is not readily available, prospective issuers should examine the terms revealed in Of- fering Circulars of earlier issues floated by various under- writers. Underwriters are frequently hesitant about accepting is- sues from unseasoned firms having untried management, products that may still be in the developmental stage, and limited if not poor financial records. If interested they will investigate the firm's financial prospects generally by inspect- ing financial data; by making a trip to the issuer's place of business; and by utilizing the professional services for credit ratings, for reports on the character of the principals, and on rare occasions for product and market analyses. Of the various criteria used the most vital element is the quality of management, especially in a small corporation where success or failure is so closely tied to the ability, imagina- tion, and initiative of management. Many investment bank- ers to some extent rely on their own experience and intuition in "sizing up" management. Emphasis on the expert man- agerial assistance available to LEDC-supported enterprises may help. (3) The Underwriting Agreement. Under "best efforts" arrangements, the underwriter agrees to use his best efforts to sell the issue but, if unsuccessful, is not obligated to pur- chase the unsold shares. If only a portion is sold, the under- writer receives his stipulated commission on the shares sold plus all or a portion of his additional expenses as may be provided for in the agreement. The major risk borne by the investment banker is the pos- sible loss of clients. He can temper this risk, if not remove it entirely, by inserting an "all-or-nothing" clause into the underwriting agreement. Such a provision would give the underwriter the right to return any funds received from the sale of the securities and to cancel the underwriting if the securities offered have not been fully subscribed to within a specified period, usually of 30 days. The LEDC should beware of investment bankers who have a lack of experience and a shortage of funds and who may offer their services on a "best efforts" basis. Even under a "firm commitment" such firms have little to lose in pulling out of an agreement at the last minute. One clause to be weighed carefully is a "market outs" clause which permits the underwriter to withdraw from the contract in the event of specific happenings. The scope of the "market outs" are often comfortably broad to allow cancellation when, in the underwriter's judgment, there have been adverse changes in general economic or market conditions. While the basic terms may be agreed on before filing the letter of notification with the SEC, final negotiations as to the offering price and the underwriting discount usually are not made until shortly before the clearance date of the offering. The period between the filing and the effective date is at least 10 days and may be as long as 2 or 3 months, during which time market conditions can change substan- tially. In an offering registered under the 1933 Act (as com- 5 In (he material presented in this section, the editors have drawn heavily on data contained in a study prepared by Professor Daniel Ounjian for the Federal Reserve Bank of Boston. 154 ared with a Regulation A offering), some investment bank- rs may issue a "red herring" or preliminary prospectus to feel out the market," and if the issue seems to lack appeal, mailer marginal houses may simply exercise their preroga- ve as provided in the "market out." The negotiations between the issuer and underwriter over the setting of an offering price, the amount of the total ffering, the number of shares to be sold, and the under- 'riter's fee. An underwriter would much rather sell more lares at a lower price. It is the widely accepted notion that le lower the price, the broader the market. Finally, under- 'riters seek a large quantity of shares to sell, because the r ider the distribution they can make, the easier will be leir task of maintaining an orderly "after-market." The amount of the offering is largely a matter of the finan- ial needs of the corporation. If the corporation can do what says it can do with the money it needs, future public fi- ancing will be more readily available and on better terms. 8 (4) Flotation Costs. In a recent study of commercially nderwritten common stock, for every dollar of gross pro- :eds paid by the public 16.5 cents went to pay underwriters, iwyers, accountants, printers, taxes, and other miscellaneous q)enses. The major part of the total was paid to under- riters who received commissions of about 12 cents on each ollar of common stock sold. In addition to their commis- ons the underwriters also received 2.2 cents per dollar of lies for expenses incurred. The remaining costs were borne y the issuers. The division of the various preparatory ex- enses between the issuer and the underwriter depends on te portion of the workload carried by each. Should the nderwriter fail to sell all (or some minimum stipulated roportion) of the offering, reimbursement for expenses ould likely be on a pro rata basis. (5) Options. As an inducement to accept and manage a ilatively small speculative offering, underwriters often insist i and obtain options to purchase a large block of shares in ie issuing corporation. Typically an underwriter will pur- lase warrants (at a penny each) which permit him to buy, : the issue price or at slightly graduated prices, a like num- ;r of shares during a period beginning a year after the com- etion of the offering and extending for 5 years. Some iderwriters, however, insist upon "bargain stock," i.e., stock jrchased prior to the public offering from the corporation • principal stockholders at a fraction of the offering price. he costs of such options, while not explicit, should not be inimized. The original stockholders together with the newly mnd co-owners will have a dilution of their earning Dtential." PPLICATION OF THE SECURITIES EXCHANGE ACT 1-16. It is important that if an LEDC has total assets ceeding $1,000,000, an effort be made to avoid having )0 or more shareholders. If the corporation has at least 10 shareholders and total assets exceeding $1,000,000 it ill be required, by Section 12(g) of the Securities Ex- ange Act, to register its securities under that Act. Regis- ition under the Securities Exchange Act, generally done i a Form 10, involves substantially similar disclosures id financial information as is required in a registration itement under the Securities Act. In addition, a corporation registered under the Securities cchange Act will be subject, among other things, to the oxy solicitation requirements and the reporting require- ents of that Act; its officers, directors, and 10-percent jckholders will be subject to the "short swing profits" ovision of Section 16(b) and the reporting requirements Section 16(a) of the Act. In the event that the LEDC does become subject to the Securities Exchange Act, it would seem to be highly desirable for the LEDC to retain an attorney who will be responsible for the corporation's compliance with that Act. 8 Antifraud Provisions 28-17. It is inevitable that in any business transaction one of the parties may become dissatisfied with the bargain. The possibilities of this occurring is greatly increased when stock is publicly held. Present experience is limited, but it seems probable that ownership by community persons of shares of new business ventures may increase the number of unhappy investors seeking redress because of the in- vestors' lack of experience in business affairs leading to unrealistic expectations. Although there are legal remedies available to the dis- enchanted investor under State blue sky laws as well as common law remedies, the major (and rapidly develop- ing) remedies are found in the provisions of the Securities Exchange Act of 1934.° This law was designed to supple- ment the Securities Act of 1933, 10 discussed above. The 1934 statute in a sense is designed in its entirety to prevent fraud. Broadly speaking, it seeks to prevent unfair advantage being taken of any person who is a party to a securities transaction. This is accomplished by many sec- tions of the Act, but particularly by Section 10(b) and Rule 10b-5 promulgated by the Securities Exchange Com- mission. 11 (1) Application of Rule 10b-5. Rule 10b-5 provides a basis for a civil action in any case involving the purchase or sale of a security where one party has defrauded another and an "instrumentality of interstate commerce or of the (i See "The Public Offering and a Quest for Alternatives," 23 Vand. L.R. 41, December 1969. This article analyzes the advantages and disadvantages of going public in the context of BarChris, Globus, and Texas Gulf Sulfur. See also "Going Public — Practice, Procedure, and Consequences," 15 Vill. L.R. 283, 1970. Article focuses on sec- tic ns cf Securities Act of 1933 dealing with registration, pros and cons cf going public. Practising Law Institute, On Going Public, 1970. " See "The Regulation of Options and Warrants," 45 LAB Bud 145, February 1970. Discusses the seven sections of the SEC Regulations governing the issuance of stock options and warrants. N See Securities Regulation Sourcebook, 1969-1970 edition. Com- piled by R. L. Knaus. Practicing Law Institute. Has basic securities acts and regulations and a selection of most of the forms. '■' 15 USC 78a et seq. 10 15 USC 77a et seq. 11 Section 10(b) provides: "It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange — "(A) To effect a short sale, or to use or employ any stop-loss order in connection with the purchase or sale, of any security registered on a national securities exchange, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors. "(B) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or descriptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors." Rule 10b-5 provides: "It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, cr of the mails, or of any facility of any national securities exchange — "(1) to employ any device, scheme or artifice to defraud, "(2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, or "(3) to engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security." 155 mails" is used. 12 It is clearly applicable to private trans- actions. 13 Fundamentally Rule 10b-5 is designed to provide the investor with protections that might not otherwise be avail- able. The Rule operates to require disclosure by prohibit- ing misrepresentations and nondisclosure of material in- formation. It also prevents "insiders" from misusing secret corporate information by trading in securities. (3) Actual Misrepresentations. As a rule designed to pre- vent misrepresentation it has been found by the courts to have been breached by acts such as furnishing: (a) False financial information. (b) False statements that named well-known persons would be involved in the active management of the company. (c) False statements that orders or business was to be received from major sources. (d) False statements that the proceeds of the sale of the securities would be used for specific purposes. (4) Concealment or Omission of Material Facts. Not only does the rule prohibit false statements, but it makes illegal any misleading statements resulting from concealment or omission to furnish material facts. A material fact is infor- mation that can be reasonably expected to affect the market value of a security and influence a decision to buy, sell, or continue to hold a security. Some of the types of conduct held by the courts to con- stitute concealment in violation of the rule are: (a) An insider purchasing stock from minority share- holders without disclosing information about improved earnings. (b) Failure to disclose increased inventory value. (c) Failure to disclose negotiations to sell or a con- tract to sell corporate assets. (d) Failure to disclose pending product developments. (5) Insider Trading. An insider is a person who through his fiduciary relationship with the corporation has knowledge of nonpublic material information about the company. Clearly officers, directors, employees and major stockholders of the company are "insiders." If the insider has knowledge of material, nonpublic corporate data, he must either dis- close the information when he engages in a transaction involving the company's securities or refrain from trading or recommending the security. If disclosure would constitute a breach of his corporate obligation, no disclosure — and thus no securities transaction — can take place. In the Texas Gulf Sulphur Co. case, for example, corporate officers were held to have acted illegally by placing orders to purchase stock prior to publication of information concerning sig- nificant ore strikes. 14 (6) Remedies. Any person injured by a violation of Rule 10b-5 may bring an action for damages against the defraud- ing party and his associates. Regardless of the form of action in which the violation of Rule 10b-5 is raised, it must be brought in the Federal courts, which are given exclusive jurisdiction in cases of violations of the Securities Exchange Act. STATE REGULATION OF STOCK ISSUES 28-18. The "blue sky laws" are the securities laws in effect in all States except Delaware. These laws seek to protect the State's public investors through ( 1 ) regulation of persons who engage in the securities business; (2) regulation of activities conducted in conjunction with securities trans- actions, including the solicitation of offers to buy and sell and purchases and sales; (3) registration of securities to be offered, sold, and purchased; and (4) broad antifraud pro- visions implemented by a wide range of sanctions including administrative investigations, judicial proceedings, and th( imposition of statutory damages in civil proceedings. I should be. noted that regardless of the fact that an issuance of securities may be exempt under the Federal securitie; laws, it may be subject to regulation under State law. The various State blue sky laws are notable for their lad of uniformity as to both substantive and procedural matters Additionally, there is a wide variation in the administratior of the statutes from State to State and, in some cases, withii the State. Within the past 10 years about three-fifths of the States have adopted a uniform statute (the Uniform Secu rities Act) which has been changed by each of such State; to meet certain requirements. However, no two blue skj laws are identical, and it remains necessary in each instancf to carefully review the appropriate State's blue sky law prior to any solicitation or sales of securities by the LEDC The following discussion generally introduces the principa aspects of State regulation which might relate to an LEDC and in no instance is it meant to be an all-inclusive discus sion. The examples given are based on specific premises and it will be necessary to individually check the appropriate statute for each situation as it arises. Broker-Dealer Registrations 28-19. A broker, dealer, or broker-dealer, the name de pending upon which State's blue sky law one looks at, is person or organization which engages in the buying o selling of securities or the solicitation of purchases or sale! of securities. Most of the States have more narrowly definec the term as a person or organization who engages in sue! activities as its principal business. (1) Must the Corporation Register? No State requires ai LEDC which sells its own securities to register as a broke solely for the purpose of selling such securities exclusively to brokers duly registered in the State. Therefore, the LEDC should make an effort to contact a registered broker ant attempt to arrange to have such broker sell its securitie for it. Where it is impossible or impractical for the LEDC to arrange to have a registered broker or dealer sell it securities in a particular jurisdiction, the LEDC must deter mine whether the applicable blue sky law requires it tc register as a broker in order to sell its securities. Whethe an LEDC which sells its own securities is a broker depend entirely on the definition of that term in the State's blui sky law. Each blue sky law defines, as a part of the law the term "broker." In some cases where the LEDC would normally have t< register as a broker to sell securities, if the LEDC's secu rities are exempt from registration for one of the reason discussed below, the LEDC may not need to register as broker in order to sell its securities in that State. However in a small number of States, even when the LEDC's secu rities are exempt, it will be necessary for the transaction in which the securities are to be issued to be exempt for th registration provisions of that State's blue sky law to b inapplicable. An LEDC can determine if such an exemptioi is available by checking the broker registration provision and the respective exemptions provisions, if one is appli cable, to determine if a person who sells pursuant to sue! exemption is also exempt from the broker registratioi requirements. 12 The rule will be applicable to an intrastate transaction if th instrumentalities of interstate commerce, such as the telephone, ar used. Boone v, Batigh, 308 F. 2d 711 (8th Cir. 1964). IS Hooper v. Mountain Slates Securities Corp., 282 F. 2d 195 (5t Cir. 1960), cert, denied, 365 US 814 (1961); Kardon v. Nation Gypsum Co.. 73 F. Supp. 613 (E.D. Pa. 1947). 1* See S.E.C. v. Texas Gulf Sulphur Co., 258 F. Supp. 262 (SDNH 1966). 156 The principal exemption from broker registration which 'ill be available to most LEDCs arises from the definition f a broker. Since the LEDC is selling its own securities it lay be deemed to be an "Issuer." An Issuer is exempt •om registration as a broker in most States, including all tates which have adopted the Uniform Securities Act. additionally, in many of the remaining States, an Issuer sgistering as a broker is exempt from a number of the lore onerous registration provisions such as fingerprinting f officers and other personnel and the necessity of having ich persons take qualifying examinations. (2) Procedures for Registration. Once it is determined that te LEDC must register in order to offer its securities in le State, the appropriate State blue sky commission should e contacted for supply of the requisite registration forms, 'nlike the registration of securities, broker and issuer regis- ation forms have not been standardized, and each State squires submission of its own groups of forms, although le same information is usually required. These applications sually require a listing of officers, a brief resume of their rincipal occupations for the past 5 to 10 years, information 'ith respect to any criminal convictions of such officers and stters of recommendation, as well as the submission of a irety bond, usually in the amount of $5,000 and $10,000. In many States where the LEDC will have to register as broker it may also have to register at least one of its fficers as an agent or salesman. Although such registration rocedure is similar to registration of the LEDC as a broker rid should be completed simultaneously with such registra- on, one important difference is that most States require le agent to take an examination. However, in such a case waiver to the requirement will probably be granted by the ppropriate State blue sky commission, if requested, as a :sult of the limited activity such agent will engage in as n agent. 15 ecurities Registration Exemptions 8-20. In addition to the registration requirements for secu- ties imposed by the Federal Securities Act of 1933, similar gislation has been passed by each State except Delaware, lost persons do not fully appreciate the breadth of the lue sky laws, which usually apply whenever there is a sale f a security. Many of these statutes are obscure and, as a suit of loose draftsmanship, apply with the same vitality the small offering by an LEDC as to an interstate offer- g by a large corporation. Unless the particular blue sky w grants an exemption to the offering and sale of the curity. some compliance is necessary in each instance, compliance is omitted, potentially disastrous civil and iminal liabilities may be created. The blue sky law requires, as a general rule, registration securities in order to protect the public from misleading fraudulent claims as an inducement to their investment, ealings of any nature, including solicitations, involving a curity are generally prohibited until statutory registration quirements have been met. The manner in which such gistration is accomplished varies widely from State to ate and will be discussed very briefly for certain types of ferings. However, since registration may be quite costly. Tie-consuming, and complex, if registration can be avoided t the availability of an exemption in the applicable blue y law, such exemption should certainly be utilized. Blue sky laws have exempted from registration require- ents certain securities and transactions which by their ture do not carry with them the same degree of risk or aud on potential investors which might otherwise neces- ate registration for protection of the public. This section will discuss several of the more general exemptions from the registration requirements which may apply to an LEDC. Examples in this discussion are for illustration only and are selected from only a few representative States, since a detailed State by State analysis is beyond the scope and needs of this discussion. Some degree of uniformity is to be found in State legislation due to the adoption by most States of the Uniform Securities Act. However, many States have chosen to modify in minor detail the provisions of the Uniform Act, thereby rendering the Uniform Act not as uniform as would be expected. (1) Private Placements. Most States exempt offerings which are limited to a small number of offerees or buyers; small private offerings are less likely to work a fraud upon purchasers who are likely to know the issuer, its qualifica- tions, and its background, and who are thus in a position to accurately evaluate the security offered. Many States exempt an offer or sale to any institutional buyer or to a registered broker. Institutional buyers usually include banks, savings institutions, trust companies, insur- ance companies, investment companies, pension or profit- sharing trusts, and other financial institutions. Many States also provide an exemption for transactions pursuant to offers which are made to a limited number of persons. The Uniform Securities Act exempts such trans- actions if offers are made to not more than 10 persons within a 12-month period, if the offeror believes that the buyers are purchasing solely for "investment purposes," and if no commissions are paid. Many States which have adopted the Uniform Act, however, have modified this provision. Massachusetts and Wisconsin have no such exemp- tion; Indiana and Washington permit offers to 20 persons within the 12-month period. Most States have adopted similar variations of the exemption. However, there is a wide variation between each State, and some States may require the filing of simplified registration forms in order to gain the exemption. (2) Minimum Capital Exemption. A few States grant an exemption if the aggregate offering price of the securities to be issued does not exceed a specified amount. Since the Uniform Securities Act contains no such exemption, there are few instances to be found. In New York an offering which seeks to raise no more than $40,000 and which is made to a group composed of the issuers' officers, directors, or other controlling persons, is automatically exempt with- out filing an Offering Prospectus. The same applies if an offering is made to a group where a family or long-time business or personal relationship exists between one or more of the directors, officers, etc., and every member of the group. (3) Nonprofit Organizations. The Uniform Securities Act exempts a security from registration where the issuer is organized and operated not for private profit but exclusively for religious, educational, benevolent, charitable, fraternal, social, athletic, or reformatory purposes, or as a chamber of commerce or trade or professional association. Although there is some variety as to the particular purposes enumer- ated, almost all States, whether or not they have adopted the Uniform Act, have provided for a similar exemption. In amplification of the requirements that the issuer be a nonprofit organization and that it operate for specific pur- poses most States require that to be eligible for the exemp- tion "no earnings of the issuer may inure to the benefit of a shareholder or any other individual." Thus, an LEDC which has community ownership of its stock may not be eligible for this exemption. IS See Guides for Preparing and Filing of Registration Statements November 26, SEC Securities Act Release #4936, December 9, 1968. 157 Additionally, a number of States further qualify the ex- emption. Missouri allows the exemption only if written notice thereof is given 30 days before the sale. In New York the exemption applies only to the Further State Notice requirement, thus still necessitating the filing of the State Notice and the Registration Statement. (4) Exemption for Nonprofit Development Corporation. Several States recently have enacted exemptions specifically designed for use by nonprofit development corporations. As an example, Michigan will exempt any offer or sale of a security by a nonprofit development corporation formed in Michigan, if the primary purpose of the corporation is to promote and assist the growth and development of business enterprises in the area covered by its operations. New York provides that exemption from or a modification of the prospectus requirements may be granted upon appli- cation by a community organization. Virginia provides that its blue sky commission may exempt any security that it finds is to be offered and sold as a part of a community undertaking to attract new business or industry to the community, if it is sponsored by a local industrial develop- ment corporation or by other groups of representative local businessmen and it is to be sold mainly to persons inter- ested in development of the community. This exemption is a new concept in the blue sky laws and experience with it is limited. It is not clear that the exemption would be available to an LEDC where com- munity members may profit through stock ownership. On the other hand, a nonprofit LEDC may be eligible for this exemption as well as for the exemption discussed in (3) above. Registration Procedures 28-21. Unless an exemption is available under the appli- cable State blue sky law, the LEDC must register its secu- rities before it may offer and sell them under the pertinent State statute. (1) Interstate Offerings. If the LEDC is filing a registra- tion with SEC under the Securities Act of 1933, registration of its securities in the various States is accomplished by filing a Uniform Form to Register Securities (Form U-l). A copy of the Prospectus or Offering Circular is attached to the form. The form may be obtained from any of the blue sky commissions and is accepted in most States. However, Massachusetts, New Hampshire, New lersey, Pennsylvania, and Virginia require a simple registration form. In Con- necticut, Delaware, and New lersey, registration of these securities would not be necessary under the circumstances. The information required by Form U-l is self-explanatory and the form can be completed in a matter of minutes using the instructions on the form as a guide. (2) Intrastate Offerings. The registration procedures fol- lowed in each State are quite different whsn the securities are not concurrently being registered with the SEC. In such a case procedures vary widely from State to State. Each State has its own forms, which are available from the State blue sky commission. They must be completed in detail and usually must be filed with the form of prospectus required by that State. Even after the LEDC files the required forms and pro- spectus, most States require final approval of the submitted prospectus prior to allowing the LEDC to make offers oi sales therein. However, some States allow the LEDC to sell its securities after a specified waiting period unless the State's blue sky administrator objects to the contents of the submitted prospectus. Depending on the State, advertise- ments can usually be made in connection with the offering, but they must be consistent with the prospectus and must be filed with the blue sky commission prior to publication, In any case, the LEDC should be fully informed of all applicable statutes and regulations of the appropriate blue sky commission prior to any filing therein. It should feel free to telephone or arrange a conference with the staff of the commission prior to filing its application therewith in ordei to resolve any unanswered questions. Each State's commis- sion is used to answering such questions and can be mosl helpful in amplifying its law and regulations and in speed- ing the processing of the registration application. Appendix 28-B outlines the types of disclosures requirec for intrastate offerings under a typical State blue sky law BIBLIOGRAPHY 28-22. The following reference materials give additional information oi stock issues: Commerce Clearing House, Federal Securities Law Reporter. Gadsby. Federal Securities Exchange Act of 1934. Loss, Louis. Securities Regulation, Little, Brown & Co. 2nd ed. 2 vols. 1961. McCormick. Understanding the Securities Act and the SEC American Book Co. Securities Regulation Source Book, 1969-1970 edition, Compilec Corporate Law and Practice Sourcebook, Practising Law Institute Compilation of basic securities acts and regulations as well as in terpretive releases under these acts. "Secondary Sales by Control Persons and Private Purchaser! Under the Securities Act and the Wheat Report," 45 Los Angele B.A. Bull. 105. January 1970. Discussion of how and when to sel after client has acquired securities in a private placement from th( issuer or a controlling person of the issuer. "Dealings Between Closely Held Corporations and Their Stock holders," 25 N.Y.U. Tax L.R. 403. February 1970. Practising Law Institute, New Trends and Special Problems Unde the Securities Laws, 1970. "Recent Developments in Securities Regulation." 11 Boston Col lege Industrial and Commercial Law Review 242. 272. February 1970 How To Go Public: An Introduction to the Securities Laws Corporate Law and Practice Course Handbook Series No. 31 (B4-2544), Practising Law Institute, New York, N.Y. 158 section 29 INSTITUTIONAL SOURCES OF LONG-TERM LOANS rivate Sources of Long-Term Financing J— 1. One of the most critical needs of the nonprofit, nited-profit, or profitmaking Local Economic Development ompany is to obtain low-interest, long-term capital for its Derational and project needs. Private sources for such financing include insurance impanies, commercial banks, savings and loan associations, ■undations, industrial corporate lenders, union pension nds, or community cultural, religious, and charitable or- inizations. Government sources include Federal, State, and cal government agencies and programs. Quasi-govern- ental sources include national housing partnerships. 1 On behalf of the low-income community the LEDC will ant to negotiate the detailed terms of its financing with ivate institutional lenders (as well as with Federal, State, id local government agencies that provide long-term lancing 2 ) so as to meet its immediate and long-term .pital needs with a minimum of restrictions on its opera- )ns by the lender. The LEDC must remain financially :xible in order to deal with the diverse problems of low- come areas. Historically, funds have been extremely scarce for financ- g enterprises in low-income communities. 3 An LEDC will )t be able to raise capital in the securities market as easily could an industrial corporation with substantial assets id revenues. An LEDC may similarly have difficulty in taining long-term financing from institutional lenders, rticularly at early stages of its growth when its manage- ent and performance records are not known. Although financing available for LEDCs and minority siness enterprises has been relatively scarce, many finan- il institutions state that they will make available sufficient nds upon a finding of effective management and proper llateral. The LEDC can borrow money directly or act for sinesses in its area to assist in arranging long-term loans, d furnish legal, financial, and technical expertise to ac- mplish these objectives. The extent to which private lending institutions will en- ge in lending to LEDCs will probably depend on ( 1 ) the fficiency of their available funds, (2) the cost of money relation to credit demands, (3) alternative investment portunities at the time of a financing, (4) legal restrictions such financing, (5) management capability, and (6) jnomic and profit feasibility. To indicate the lending capacity of several of these institu- ns, the amount of general mortgage loans to be made by :m in 1970 has been projected as follows: 4 Billion ltual savings banks $62.2 yings and loan associations $149.2 Total resources of commercial banks have been projected increase from $468 billion at the end of 1969 to $510 lion at the end of 1970. Total assets of mutual savings banks have been projected to expand from $76 billion in 1969 to $83 billion in 1970. 5 Types of Institutions 29-2. Private sources of long-term (over 10 years) financing for LEDCs can provide ( 1 ) operational and construction loans to finance small building and rehabilitation projects and (2) long-term mortgage loans to finance acquisition and construction of industrial and housing properties. Such institutional lenders available for such financing include: commercial banks, mutual savings banks, savings and loan associations, life insurance companies, pension funds, individual and corporate lenders, labor union general welfare funds, religious organizations and associations, foundations, 7 university and college endowment funds, philanthropic community organizations, small business in- vestment companies, K mortgage companies, chartered credit unions, and face amount investment companies. It has been estimated that this group of institutional lenders account for perhaps 80 to 90 percent of mortgage loans now being made. Commercial banks, mutual savings banks, savings and loan associations, and life insurance companies have tradi- tionally been regarded as the major source of mortgage loans. Long-term loans to LEDCs minority enterprises, and other business structures (such as Massachusetts busi- ness trusts and partnerships) have been made in large part through FHA-insured mortgage loans, pursuant to conven- tional and FHA-insured mortgage loan agreements and documentation. Such mortgage loans have been made primarily for con- struction of moderate- and low-income housing units and for purchase, refinancing, and rehabilitation of multifamily housing, principally with FHA-insured financing. Conventional loans without insurance for rehabilitation have been difficult to obtain in some areas since rehabilita- tion is most necessary in areas of special deterioration where the lending risk is higher, but private institutional or govern- ment programs for interest subsidy, loan insurance guaranty, and pooling of risks by banks are intended to promote private financing by reducing the risks involved. A limitation on banks as a source of debt financing is a reluctance to participate in long-term investments which are 142 U.S.C. 3931 (1968), U.S. Code Cong, and Adm. News, 90th Cong., 2nd Sess. 2873 (1968). - See Sections 26 and 27. 8 Testimony of Counsel for New York Urban Coalition in Hearings Before Senate Small Business Committee, 90th Cong., 2nd Sess., 174 (1968). See also 83 Harv. L. Rev. 1558, 1627-1629 (1970). 4 First Annual Report on National Housing Coals, pursuant to pro- visions of the Housing and Urban Development Act of 1968, January 23, 1969, pp. 67-80. 5 Ibid., p. 65. '• See Section 25. " See Section 24. * See Section 10. See also 83 Harv. L. Rev. 1558, 1637-1640 (1970). '■> First Annual Report on National Housing Goals, page 55. 159 frequently the most critical need of LEDCs. Insurance com- panies usually lend for longer terms than banks but insur- ance companies, like banks, ordinarily require solid col- lateral, whereas inventory and accounts receivable may be all the LEDC may have available for such purpose. THE INSURANCE INDUSTRY COMMITMENT 29-3. On September 13, 1967, some 163 insurance com- panies (representing 90.6 percent of the assets of the life insurance business in the United States) pledged a $1 billion investment commitment to help long-term financing for rehabilitation of low- and moderate-income housing and for job-creating services in the inner cities. 10 This commitment was expanded to $2 billion on April 15, 1969; $1.4 billion had been either loaned or committed as of September 1970. In the first billion-dollar program, insurance companies financed projects in 227 cities in 42 states, the District of Columbia, and Puerto Rico including 63,000 units of hous- ing. 11 The investment commitment was based on the follow- ing investment criteria for the insurance industry con- sortium: 12 (1) The investment must be one which because of its type, location, or risk would not ordinarily be financed under normal lending practices of life insurance companies. Normal credit standards of life insurance companies would probably not be met. (2) Investments may carry government guarantees or insurance of principal (for example, FHA mortgages or loans under State or local economic development programs) unless such guarantees are not deemed necessary in the judgment of the lender. Because of the availability of government insurance, such loans should carry interest rates no higher than the regular market rates for mortgages on properties within the normal operations of life insurance investments. (3) Location. Investments may be made in urban com- munities of any size that are seriously in need of revitaliza- tion. However, it is expected that emphasis will be placed on major metropolitan areas, which, if the criteria apply, could be outside the corporate limits of a city. (4) Housing. Housing investments may include the following: low- and moderate-income housing in city core areas, low- and moderate-income housing outside city core areas, provided they are primarily designated to provide housing for people now residing in city core areas. Housing investments may be for new or rehabilitated housing, for single or multiple occupancy. (5) Job-Creating Enterprises or Services: (a) Investment may be made to help retain or pro- vide jobs and/or services which will benefit those residing in city core areas. (b) Types of property that may be considered in- clude, but are not necessarily limited to, the following: factory or other industrial facilities, warehouses, hospitals, nursing homes, medical buildings or doctors' clinics, retail or service facilities, public service offices, educational facili- ties, laundry processing plants, wholesale bakeries. Participating Companies 29-4. Further information about the insurance companies' investment commitment can be obtained from the Communi- cations Division, Institute of Life Insurance. 13 A list of names and addresses of participating insurance companies that have made investments under the first and second billion-dollar programs is available from the Institute. Names of officers of individual insurance companies with whom communication is necessary for discussion of a finan< ing may be obtained there. Requests for further information with respect to financin a particular project can be directed to the Urban Clearin House, Life Insurance Association of America. 14 Negotiations of the specific terms and details of a partict lar financing must, of course, be conducted through discus sions between the borrower and the individual insuranc company. Forms of Investment 29-5. The participating insurance companies have entere into several forms of financing. (1) Urban Housing Investments. Urban housing inves ments by insurance companies, under this program, ha\ included three primary areas of activity: 15 (a) Federal Housing Administration (FHA) rent-su] plement housing projects which range in size from aboi $50,000 to $2 ! /2 million or more. These are 40-year mor gages with FHA insurance, under Section 221(d)(3) the National Housing Act to supply rental housing to lov and moderate-income families, through use of market ra (MIR) and below market rate (BMIR) mortgage loai under Section 221(d)(3) of the National Housing Act 1961, 10 as amended, and more recently through the Sectic 236 interest payment assistance program of the Housing ar Urban Development Act of 1968, as amended, and Sectic 221(h) of the National Housing Act. 17 (b) FHA Section 203(b) insured and Veterans Admii istration guaranteed mortgages on 1-4-family houses f( low- and moderate-income families, where the property in an older, blighted neighborhood in an inner city are (c) Non-insured loans on low- and moderate-incon housing, either in the form of rental housing projects 1-4-family homes occupied by the owner. (2) Direct Loans to LEDCs and Nonprofit Sponsors. Tf insurance companies have also made a limited number direct loans to LEDCs and nonprofit sponsors of urbz rehabilitation projects. The varying forms of collater required for these loans include assignment of manageme: fees from real property management contracts. (3) Purchase of Equity and Debt Instruments of LEDC (a) Equity Interest. Subject to Federal and State sec rities law, and State insurance law restrictions, insurani companies have also purchased the equity common stock LEDCs and of minority enterprises such as banks ai industrial corporations. (b) Convertible Securities. Subject to the above I ferred-to restrictions, institutional lenders may also bi convertible securities of an LEDC, thus acquiring a potenti for equity ownership. Such purchases of an equity intere are not frequent in view of (i) a number of State statuto limitations on the type of securities institutional lende may purchase; (ii) the interest of some institutional inve tors in buying an equity interest only in rapidly movii growth income companies; and (iii) a reluctance to contn 10 $1 billion Urban Investment Program of the Life Insuran Business, statement prepared by Life Insurance Association of Amerii March 1969. See also Conroy, "What the Insurance Companies Doing in the Ghetto," 25 Bus. Law. 27, Sept. 1969 Special Issue. n Statement by the President of the United States, April 15, 19( i- First Annua! Report on National Housing Goals, page 2. IS Institute of Life Insurance, 277 Park Avenue, New York, N. 10017 (phone: 212 922-4976). M Life Insurance Association of America, 277 Park Avenue, N York, N.Y. 10017. i"' First Annual Report on National Housing Goals, page 4. 10 12 U.S.C. 1715 1(d)(3) (Supp. II, 1967). i" 12 U.S.C. 1715 1(h) (Supp. II, 1967). For a detailed discussi of these programs, see Section 18. 160 through ownership of voting common stock, an LEDC in a low-income area where community resentment may exist. If lenders wish to avoid voting control, they could buy nonvoting common stock, fractionally voting common stock (for example, class A common that is entitled to only a fraction of the vote of Class B common), or preferred stock, with initial voting privileges if dividends are not declared withn a fixed number of years. In addition, different classes of voting stock could be entitled to elect different numbers of directors. Voting privileges of the stock to be issued, as well as asset preference and dividend policy would, of course, have to be in accord with State corporate law requirements. (c) Notes and Debentures. The institution lender may purchase notes, debentures, or convertible debentures issued by LEDCs. LEDC notes purchased by institutional lenders usually have a maturity of at least 10 years with interest at the market rate or slightly less. Certain significant terms of a note agreement between an institutional lender and an LEDC are summarized in Section 29-16. (d) Restrictions on Use of Proceeds. Under many loan agreements, use of proceeds is restricted to public bene- fit uses. For example, such a loan agreement was made in February 1968 between an insurance company and a cor- poration developing low- and middle-income housing and furnishing sponsors of such projects with organizational and architectural services. The loan agreement provided that the borrowing corporation "covenants that it will use the net cash proceeds received from the sale of the notes to finance the development of low- and middle-income housing projects under the National Housing Act, as amended." The interest on this 15-year loan was 7 percent, but a contingent interest jrovision in the agreement required the borrower to pay an idditional interest payment at the end of each fiscal year of 5 percent of annual gross income from management and :onsulting fees until 1979 and then 3 percent of such annual jross income until 1983. Another loan by an insurance company was- made on i ten-year note at 6 percent interest to a Massachusetts Trust operated by Boston black citizens. Proceeds of the oan were for the specific purpose of financing "the acquisi- ion, rehabilitation and management of the low- and noderate-income rental properties" in a particular urban enewal area of Boston. Another loan was made by an insurance company to a lonprofit institution established for housing improvement. The note agreement required the borrower to deposit the >roceeds from its sale of 10-year 5-percent senior notes in a ;pecified bank account in the joint name of the lender and he borrower; the borrower could draw from said account or certain enumerated purposes including the purchase of :ertificates of deposit or government securities which might >e pledged with other institutional lenders as collateral for mortgage loan. (4) Deposits in Minority-Owned Banks. Insurance com- anies have also used their depositing power to make funds vailable to the low-income community through deposits minority-owned banks for borrowing directly by ghetto usinesses and by appointment of such banks as mortgage orrespondents to increase availability of the lender's assets. rocedurcs That Induce Insurance Company Investment 9-6. Several Federal programs serve as inducements for surance companies to provide long-term financing for mall businesses. (1) Participating Loan or Guarantee Approach. The in- rance companies participate with other insurance com- anies, with commercial banks, and with the Small Business Administration (SBA) in making long-term, low-interest loans with relaxed collateral rules to small businesses under the SBA loan participation or guarantee program. Borrowers include LEDCs and LEDC-supported enterprises, especially those that qualify under Section 502 of the Small Business Investment Act of 1958, as amended. In an immediate participation loan, either the participat- ing private lending institution or SBA makes the loan and the other participant purchases its agreed percentage of the loan immediately upon disbursement. In a guaranteed loan, the lending institution makes and disburses the entire loan. SBA agrees that upon default it will purchase an agreed percentage of the unpaid balance of the loan within a stated period. In either an immediate participation or guaranteed loan, SBA cannot provide more than 90 percent of the outstand- ing balance of the loan. No agreement to participate establishes any preference in favor of the lending institution participating in a loan with SBA except in accordance with the Simplified Early Ma- turities Participation Plan. In guaranteed loans, SBA makes a charge to the lending institution. The participation charge, which shall not be borne by the borrower, is Va of 1 percent per annum on the part of the loan which SBA is obligated to purchase. After SBA has purchased its guaranteed part of the loan, interest on SBA's share will not exceed 5Vz percent per annum. SBA's maximum share on a regular business participation loan is limited to $350,000 or not in excess of 90 percent per loan for a maximum loan maturity of 25 years for a construction loan and 15 years for an equipment loan, with collateral consisting of one or more of the following: mort- gage on land, buildings, machinery, equipment; assignment of warehouse receipts for marketable merchandise; assign- ment of certain types of contracts. This participation program has been widely used by in- surance companies and banks to spread the risk of financing. In turn, small business borrowers benefit from the participa- tion program because they obtain needed credit not other- wise available from a single institution on desirable terms. The LEDC benefits because economically viable small busi- nesses result in increased community prosperity. An LEDC may be able to encourage institutional lenders to participate by guaranteeing that part of the financing not covered by SBA. For discussion of possible guarantees by the LEDC, see Section 30-23. (2) Mortgage Financing in Reliance on the Credit of the Tenant. (a) Small Tenants Secured by Lease Guarantees: Title IV of the Small Business Investment Act of 1958, as amended, permits SBA or a participating private institutional lender to guarantee rental payments under leases of com- mercial or industrial property by small businesses; the leases must be for a minimum of 5 years and a maximum of 20 years; direct SBA lease guarantees are orrly available for leases of 15 years or longer. Lease guarantees, if available for shorter periods, must be by SBA participation policies written by private insurance companies. 18 Lease guarantees enable small businesses to rent space in prime business loca- tions that might otherwise be available only to tenants that have an AAA credit rating, which requires a net worth of $1 million. 19 l g Eighteenth Annual Report of the Senate Select Committee on Small Business, 90th Cong., 2nd Sess., 7 (1968). Lease Guarantee Booklet prepared by Small Business Administration, October 1968. 1" For a detailed discussion of the lease guarantee program, see Section 32. 161 (b) Reliance on the Credit of an AAA Tenant: By relying on a lease from an AAA tenant as primary col- lateral, mortgage financing can be used by an LEDC to acquire ownership of land and an existing building. The technique of sale and leaseback of the real property was used in the purchase of a major retail store (F. W. Woolworth) in Harlem, New York. The land and store were sold to a limited partnership (could have been to an LEDC), one of whose partners was an investment banking firm. The partnership obtained first mortgage financing from the Equitable Life Assurance Society as part of its par- ticipation in the $2 billion life insurance commitment previ- ously mentioned. Additional mortgage financing was ob- tained from a major labor union. Subject to a 20-year lease- back to the original owners, the land was then conveyed to a Harlem church that has a committee of black citizens serving as trustees to advise on use of the property income. SECURITY AND COLLATERAL REQUIREMENTS 29-7. Collateral requirements for a long-term loan to an LEDC or an LEDC-sponsored minority entrepreneur will vary depending (i) on the type of loan (whether bank, savings and loan, or insurance company mortgage loan, 20 conventional or federally insured) and (ii) on the attitude and economic power of the lender (subject to State banking, insurance, and corporate laws, Uniform Commercial Code provisions, and other statutory provisions relating to secured financing; Federal banking and housing laws; Federal grant- in-aid statutes; and other Federal and State laws). Subject to restrictions in State or Federal banking or State insurance laws, lenders may negotiate with respect to the precise type and amount of collateral. The course of such negotiations depends on (i) integrity and financial strength of the borrower and likelihood of repayment; (ii) need and available assets of borrower; and (iii) the policies of the government or private institutional guarantor or insurer. Real Property 29-8. Collateral consisting of real property may include any of the following: ( 1 ) Land and improvements — fee title, leasehold in- terest, mortgage, leases, rentals, options, and executory contracts. (a) Type of security instrument: (i) mortgage, (ii) deed of trust, indenture of trust, deed to secure debt, (iii) land contract (purchase-repurchase agreement), (iv) assign- ment of leases, rents, management fees, and other income- producing instruments. (b) Financing statement covering fixtures, equip- ment, and improvements to realty under Uniform Commer- cial Code and Recording Acts. Personal Property 29-9. The legal problems surrounding use of personal prop- erty as collateral for a loan and relationships between parties to the secured financing are reviewed in Section 31. State statutory and common law requirements with re- spect to secured financings and the perfection of interests in personal property will, of course, differ. However, a brief list of frequently used types of personal collateral, with some statutory references, is presented below. (1) Inventory, Machinery, and Equipment. (a) Chattel Mortgages: State personal property law. Article 9, Uniform Commercial Code. State corporate law on stockholder consent. Bulk Transfers Act. Article 6, Uniform Commercial Code. Factor's lien statutes. (b) Bill of Lading: Article 7, Uniform Commercfal Code. Federal Bills of Lading Act, 49 U.S.C. 81. Uniform Bills of Lading Act as adopted in various States. (c) Letters of Credit: Articles 5 and 9, Uniform Com- mercial Code. (d) Warehouse Receipts: Article 7, Uniform Com- mercial Code. (e) Acounts Receivable: Article 9, Uniform Commer- cial Code. Definition of accounts receivable, form of financ- ing statement, filing requirements, applicable law, where and how to file, accounts receivable loan or purchase agree- ments, collection problems, policing of accounts. Perfection of security interests and priorities. (f) Trust Receipt: Article 9, Uniform Commercial Code. (2) Assignment of Private and Government Contracts. (a) Consideration of terms of contact and govern- mental statute and regulations. Local statutes on requisites for notice and consent, filing of assignment and notice thereof, restrictions on assignment. Notice to contracting officer and/or surety. Federal Assignment of Claims Act of 1940, as amended, 31 U.S.C. 203. (3) Chattel Lease. Loan secured by assignment of rentals. Article 9, Uniform Commercial Code. LEGAL RESTRICTIONS ON INSTITUTIONAL LOANS 29-10. A range of Federal and State statutes restrict the institutional lender in the general lending policy with respeci to the types and size of its investment. For negotiating pur- poses, the LEDC's lawyer should know what limitations are imposed on the institutional lender. Certain banking and insurance law restrictions are discussed below. Federal Banking Law 29-11. National banks can make loans secured by first liens on improved real estate in fee simple including leasehold; under a lease which does not expire for at least 10 yean beyond the maturity date of the loan. However, subject tc certain specific exceptions, Federal banking law 21 restrict! such loans to an amount not in excess of 50 percent of th< appraised value of the real estate offered as security anc for a term not longer than 5 years. The three major exceptions to this rule are: ( 1 ) The loan may be for up to two-thirds of appraisec value and for not longer than 10 years if it is secured b; an amortized mortgage, deed of trust, or other such instru ment under which the installment payments are sufficient t( amortize 40 percent or more of the principal during thi term of the loan, or (2) The loan may be for up to two-thirds of appraisec value and for not longer than 20 years if secured by ai amortized mortgage, deed of trust, or other such instrumen under terms of which the installment payments are sufficien to amortize the entire principal within a period of not mor than 20 years, or (3) The loan may be for up to 80 percent of ap praised value and for not longer than 25 years if the loa: is secured by an amortized mortgage, deed of trust, other such instrument under terms of which the installmen payments are sufficient to amortize the entire principa before its maturity date. Certain federally insured res estate loans under Titles II, IV, Title VIII, section 8, Titl I and Title IX of the National Housing Act, and certai 20 See "The Mortgage Banking Process and Single Family Residenc Loans," 7 Houston Law R. 70, September 1969. Article concerns description of the mortgage banking process, legal relations create by the process, the effect of bankruptcy. -'i 12 U.S.C. 371. . 162 ther Federal acts are exempted. The 1968 Housing Act Iso permits national banks to continue to purchase partici- ations in existing mortgages. The above limitations do not apply to loans having ma- arities of less than 36 months made (i) to finance con- traction of industrial or commercial buildings if a finan- ially responsible lender has agreed to advance the full mount of the bank's loan upon completion of the build- lgs, and (ii) to finance construction of residential or farm uildings, provided that such loans or investments in such )ans may not exceed an aggregate amount in excess of 00 percent of the banking association's actually paid-in nd unimpaired capital plus 100 percent of its unimpaired urplus fund. Loans are not real estate loans within the meaning of le restrictions outlined above: (i) if the bank looks for jpayment to the borrower's general credit standing and arecast of income, with or without security, or ( ii ) if the sociation relies on other security as collateral, or (iii) : , in either case, the association wishes to take a mortgage, eed of trust, or other instrument on real estate as a pre- aution against contingencies. 'ederal Home Lean Bank 9-12. With respect to investment of surplus funds, the ederal Home Loan Bank Act States : 2 - "Such part of the assets of each Federal Home Loan ;ank (except reserves and amounts provided for in sub- :ction (g) to this section) as are not required for ad- ances to members or nonmember borrowers, may be in- ested, to such extent as the bank may deem desirable and abject to such regulations, restrictions, and limitations as lay be prescribed by the board, in obligations of the Inited States, in obligations, participations, or other instru- lents of or issued by the Federal National Mortgage isociation, or the Government National Mortgage Associ- tion, in the stock of the Federal National Mortgage Asso- iation and in such securities as fiduciary and trust funds lay be invested in under the laws of the State in which the ederal Home Loan Bank is located." See also loan restrictions on Federal Savings and Loan associations. 23 Jew York State Restrictions on Bank Loans 9-13. New York Banking Law provides generally 1 ' 4 that o bank or trust company may lend to any person (includ- lg a corporation) an amount in excess of 10 percent of ich bank's capital stock, surplus fund, and undivided rofits. With certain exceptions, loans to other persons may equal at not exceed 25 percent of the capital stock, surplus fund, id undivided profits, provided such loans either in whole r in part (in any event that part thereof in excess of 10 sreent of such capital stock, surplus fund, and undivided -ofits) are secured by collateral having an ascertained arket value, or otherwise having a value as collateral as >und in good faith by an officer of such bank or trust impany, of at least 15 percent more than the excess of ich loans over 10 percent of such capital stock, surplus ind, and undivided profits. This limitation does not apply here the United States, or Federal agency, New York ate, or a municipality guarantees the payment of princi- il and interest, or where cash not subject to withdrawal collateral, and other limited circumstances. Generally, no bank or trust company may make a loan Don the security of real estate: ( 1 ) if such real estate is unimproved, in excess of /o-thirds, if such real estate is improved by a building or buildings, or is to be improved by a building or build- ings in the process of construction, in excess of three- fourths, and if such real estate is improved by a single family or two-family residence, in excess of four-fifths of the appraised value of such real estate, or in an amount which added to the amount unpaid upon prior mortgages, liens, and encumbrances upon such real estate exceeds the foregoing respective proportions of such appraised value; provided, however, that in respect of loans made upon the security of real estate improved by a single-family or two- family residence in excess of three-quarters of the appraised value thereof, the total unpaid principal amount of such loans when added to the amount unpaid upon prior mort- gages, liens, or encumbrances upon such real estate shall not exceed 10 percent of the maximum amount of real estate loans permitted to such bank or trust company; (2) in an amount which when added to the amount unpaid upon prior mortgages, liens, and encumbrances upon such real estate exceeds 10 percent of the capital stock, surplus fund, and undivided profits of such bank or trust company; (3) when the total value of all real estate held by such bank or trust company, other than real estate referred to in New York Banking Law 98(1) (a), and of all loans by such bank or trust company upon real estate security ex- ceeds, or by the making of such loan will exceed (i) 15 percent of the total assets of such bank or trust company or 60 percent of the amount of the time and savings de- posits thereof, whichever is the greater, if its principal office is located in a borough having a population of more than 1,500,000; or (ii) 40 percent of the total assets of such bank or trust company or 60 percent of the amount of the time and savings deposits thereof, whichever is the greater, if its principal office is located in a village having a population of 2,000 or less; or (iii) 25 percent of the total assets of such bank or trust company or 60 percent of the amount of the time and savings deposits thereof, whichever is the greater, if its principal office is located elsewhere in the State. New York State Restrictions on Investments of Insurance Companies 29-14. Under Section 79 of the New York Insurance Law, before investing any of its funds in any other class of se- curities or type of investments, every domestic insurer must, to the extent of an amount equal in value to the minimum capital required by law or the minimum surplus to policy- holders required to be maintained by law for a domestic stock corporation authorized to transact the same kinds of insurance, whichever amount is greater, invest its funds only in specified classes of securities. Forty percent of the total amount of the required minimum capital investments may consist of State bonds and mortgage loans or deeds of trust on property located in New York as specified in paragraphs (a) and (c) of subsection 6 of Section 81 of the New York Insurance Law. Section 80 provides that after satisfying the requirements for minimum capital investments specified in Section 79: (1) Any domestic life insurance corporation may in- vest its funds in, or otherwise acquire, or loan upon, only the very limited classes of securities or types of investments specified in Sections 46(«), 79, 81, 82, and 83, and subject to the limitations therein contained; and (2) Any domestic insurer, other than a life insurance company or a fraternal benefit society, may invest any por- --' 12 U.S.C.A. 1431(h). ^ 12 U.S.C.A. 1464(c). -i Banking Law, Sect. 103. 163 tion of the remainder of its funds in, or otherwise acquire, or loan upon, only the classes of reserve investments as specified in Section 81, unless it shall at all times have and maintain cash and such reserve investments (including its minimum capital investments), free from any lien or pledge, which, when valued in accordance with the provisions of this chapter, shall be at least equal in amount to 50 percent of the aggregate amount of its unearned premium and loss reserves as shown by its last sworn statement, annual or quarterly, on file with the superintendent. Any such insurer which has investments fully complying with the above requirements may acquire investments eligible under the provisions of Section 85." (See also Chapter 190, N.Y. Laws, 1969 Regular Session for certain new insurance in- vestment restrictions, effective September 1, 1969.) Section 81 sets out the various classes of reserve investments and includes corporate obligations of various classifications, pre- ferred or guaranteed stocks or shares, and mortgage loans. (See particularly Sect. 81(13).) LEGAL STEPS IN SECURING FINANCING 29-15. Most institutional loans to LEDCs or small busi- nesses involve the negotiation of certain principal terms. A term sheet is usually drawn by the institutional lender following resolution of major items. Terms to be Discussed 29-16. The LEDCs lawyer should be prepared to discuss each relevant point listed below in terms of the practical realities of the business venture to be financed, both with respect to the basic terms of the loan and the more detailed covenants and restrictions in the loan agreement. Careful advance preparation can help smooth the negotiating path. A review of the provisions of the agreement set forth in Exhibit 19-A would be useful to the lawyer in preparation for negotiations. (1) Participants: Will the lender be a single bank? An insurance company? A group of such lenders? Will the loan be a direct loan or immediate or deferred participating loan? Will there be a guarantor, either private institutional lender or governmental guarantor? (2) Nature of Borrower: See section on Banks. (3) Use of Proceeds: Will proceeds of loan be used as seed money, working capital, for interim financing, or for long-term project needs, such as construction? Will use of proceeds be restricted as to a specific purpose and/or will funds be required to be placed in a specific deposit or form of investment, that is, government bonds or certificates of deposit? (4) Amount of Loan: Will loan be a participating loan with a Federal agency, such as the Small Business Admin- istration, which has a statutory limit on the amount of its participation? Federal and State banking law and State in- surance law impose restrictions on the amount of loans which can be made by banks and insurance companies and the type and amount of investment and upon certain type of underlying collateral. (5) Interest Rate: Will interest rate be fixed or vary as a percentage above or below the prime rate? Will addi- tional contingent interest be charged based on a percentage of annual income of the borrower? Will payment of interest be deferred until a certain date? Consideration of usury statutes. (6) Maturity. (7) Take-down. (8) Terms of Repayment: Will the loan be paid in periodic installments, terms of prepayments required o optional, with or without premium? Will there be a sinking fund and optional or mandatory redemption of the security of the borrower? (9) Security to be Given by Borrower: Will loan b< secured or unsecured and nature of collateral? Applicabilit of Uniform Commercial Code, banking and insurance law etc., with respect to nature of and security interest collateral. (10) Convertibility Rate of Convertible Security o Borrower. (11) Dilution Protection: Restrictions on activities o borrower to prevent dilution of lender's equity interest. (12) Net Working Capital Maintenance. (13) Restrictions on Dividends and Redemption O securities. (14) Additional Indebtedness. (15) Insurance. (16) Entering into of Leases and Contracts. (17) Loans and Advances. (18) Restrictions on General Activities and Investment of Borrower. Provisions in Loan Agreement 29-17. Loan agreements to be entered into by LEDCs ma include certain covenants, representations and warrantie by the borrower to be found in summarized form here an more fully set forth in Appendix 29-A. Many of the cove nants, representations and warranties may be expanded o diminished by negotiation between the borrower and th lender on an ad hoc basis, depending on the attitudes an economic strength of the borrower and the lender. (1) Some typical covenants by borrower: (a) Authorization of Issue of Note: Representatio that borrower has authorized issue and sale of the promii sory note, including principal amount, date of issue, mi turity date and interest. Purchase and sale of note. Cond tions to purchase. Opinions of counsel. (b) Use of Proceeds: Representation that borrowe will use proceeds received from the sale of notes solely finance certain types of projects or will use such funds working capital, etc. Provisions for payment, prepaymen (c) Organization and Existence: Representation borrower as to organization, qualification, and good stanc ing in the State of incorporation and capitalization borrower. (d) Business and Properties: Description of the bus ness of borrower, the jurisdictions in which it and/or i subsidiaries conducts business. Representation by borrow! that it has good title to all of its securities subject to n encumbrance (with exceptions set forth). (e) Financial Statements: Borrower will deliver ai dited and/or unaudited financial statements for a specific period, which fairly present the financial position of bo rower at the respective dates thereof in conformity wil generally accepted accounting principles applied on a coi sistent basis. (f) Changes in Condition: Borrower represents th since date of last financial statement no material adver change in the business has occurred. (g) Title to Properties: Borrower represents that ,has good and marketable title in fee to all real proper (with exceptions set forth) and good title to all person property reflected in the most recent balance sheet. (h) Franchises: Borrower represents as to its posse sion of franchises, permits, licenses, patents, trademark and trade names. (i) Litigation: Borrower represents that there is 164 action, proceeding, or investigation before any court or government agency pending, or to borrower's knowledge, threatened which may result in any judgment, order, decree, or liability having a material adverse effect upon the busi- ness. (j) Tax Returns: Borrower represents that it has prop- srly filed all U.S. and foreign. Federal, State, local, and other tax returns required by law to be filed by it and all taxes shown to be due and all assessments have been paid. (k) No Default of Legal Obstacle: Borrower repre- sents that it is not in default of its charter or by-laws or in violation of any applicable law or in breach of any agree- ment to which it is bound and that execution of the note agreement will not result in any breach or default of such. Borrower also represents that it has adequate powers to authorize execution and performance of the agreement. (1) Securities Act of 1933: Borrower represents that it will take no action which would subject the offering of notes to the Securities Act of 1933, as amended. (m) Foreign Direct Investments: Borrower represents that it is not, and after giving effect to the issuance and sale of the note, will not be subject to foreign direct in- /esment regulations or the interest equalization tax. Bor- -ower represents that it is a "United States Person" and tvill not apply the proceeds of the note to the "acquisition" jr "stock" of a "foreign issuer" or "debt obligation" of a 'foreign obligor" as such terms are defined in the Interest Equalization Tax Act which would subject the acquisition Df the note to such tax. (n) Federal Reserve Board Regulation G: Borrower •epresents that none of the proceeds will be used for the Durpose of purchasing or carrying a registered equity se- :urity (as defined by Regulation G) (12 CFR 207) or for :he purpose of reducing or retiring any indebtedness which ,vas originally incurred to purchase a registered equity security or for any other purpose not permitted by Regu- lation G. (o) Government Regulation: Representation by bor- rower that the Company is not subject to regulation or the xansaction subject to Government approval under specific Federal statutes. (p) Capital Stock: Borrower represents its authorized and outstanding capital structure. (2) Some typical affirmative covenants by borrower: (a) Punctual payment, (b) Contingent interest to be paid in iddition to fixed interest in some agreements, (c) Conduct )f business and corporate existence, (d) Adequate insur- mce. (e) No adverse judgments, (f) Maintenance of and jreservation of properties and leases, (g) Payment of taxes, (h) Financial statements to be furnished, (i) Permit in- spection of property and books, (j) Furnishing of informa- :ion to lender on quarterly reports and annual statements. (3) Some typical negative covenants (restrictions) on sorrower: (a) Indebtedness and liens. Without permission of lender, borrower will not incur any additional long-term debt other than mortgage debt on construction projects and guarantees in connection with project. Restrictions on liens. Additional senior debt ranking pari passu with this issue. Restriction on short-term indebtedness to $[ ]. (b) No additional projects but those currently planned until 197[ ]. (c) Declaring or paying of dividends and distribu- tions during any fiscal year not in excess of 50 percent of net income earned during previous fiscal year, (d) Working capital — current assets to be maintained at 125 percent of current liabilities, (e) No pledges and no payment of cer- tain indebtedness, (f) No merger, consolidation, or sale of assets, or disposition of shares of subsidiary, (g) Limitation on advances, loans, and substantial investments, (h) No sale of stock, (i) No lease rentals, (j) No sale and lease- back by borrower or subsidiary, (k) No sale or discount of receivables. (1) Limitation on entering into certain con- tracts and entering into different types of business. (4) Events of default. (5) Expenses and indemnification. (6) Ownership and control to remain in existing share- holders. (7) Other covenants: (a) Where borrower has or will have nonexempted publicly offered securities, a right of the purchaser to register, and/or piggy-back registration under the Securities Act of 1933, as amended, (b) Dilution protection. Procedural Steps in Obtaining Financing From Lender 29-18. While procedures for an LEDC to obtain long-term financing will vary substantially from case to case, certain specific steps will generally be taken. ( 1 ) After analyzing its capital needs and obtaining legal and financial advice (possibly from financial institutions which may have representatives on its board), the LEDC will decide the most advantageous way to raise long-term capital at the lowest cost with minimum restrictions from private and/or government sources. Consultation with and/ or sale or placement of LEDC securities by an investment banker may follow. (2) Assuming the LEDC decides to borrow, it will pre- pare a loan proposal and submit it to the institutional lender or lenders. Negotiations will follow with the lender and/or governmental agency as to the terms and participa- tion, and/or the security by private and governmental institutions. (3) Preparation of term sheet of loan and approval by lender of financing. (4) Lender's commitment letter to borrower is issued. (5) Loan Agreement is drafted, usually by lender, and additional terms are refined. Careful study of all provisions by LEDC and its counsel. Closing documents are prepared and security interests prepared for filing. (6) Closing, with exchange of documents and issuance of funds to borrower. 165 Section 30 COMMERCIAL BANKS AS A SOURCE OF SHORT- TERM AND MEDIUM-TERM LOANS USE OF COMMERCIAL BANK FINANCING 30-1. Previous sections discussed leveraging in general and described leveraging possibilities through a number of gov- ernment programs. This section discusses leveraging through the use of com- mercial banks. After describing commercial bank financing in general, three different approaches for increasing the availability of such funds are suggested: (1) setting up a bank pool arrangement; (2) setting up a group of outside guarantors; and (3) loan guarantee approaches for an LEDC. Forms of Financing Available 30-2. Commercial banks normally make short-term and medium-term loans. The short-term loans are usually for seasonal working capital purposes. The medium-term loans (from 1 to 7 years) are for more permanent financing needs. 1 Medium-term loans usually require periodic (annual, semiannual, or quarterly) amortization that either extin- guishes the loan by maturity or at least reduces it to a per- cent of the original advance. If only a small part of the loan is amortized during its life, it is said to have a "balloon maturity." These loans may carry a moderately higher interest rate than an evenly amortized loan. The commercial banker's decision to grant a loan to an LEDC or a minority entrepreneur is based on an analysis of the borrower's ability to repay. Therefore the availability of a commercial bank loan is generally said to be based on three criteria: Character, Capacity, and Capital. Character refers to the personal integrity of the prospec- tive borrower, his intention to meet his obligations to the bank without default of any kind. Capacity measures the managerial ability of the prospec- tive borrower — his ability to use wisely and efficiently whatever funds the bank may advance. Capital is the measure of the borrower's own resources to which the loans of the banks will be added — the plant and equipment already owned, its location, its layout, the nature and extent of the markets in which the borrower sells. To make such bank financing more readily available to an LEDC or LEDC-sponsored enterprises, loan applications should go as far as possible in conforming with customary bank requirements. Since every lending situation is different, different supporting documents will be required by different banks. The following list indicates some of the information a bank needs as a basis for making loan decisions: 2 ( 1 ) Business Prospectus — basically describes the busi- ness and methodology of achieving the borrower's goals. Prospectus can be brief, perhaps a few pages, outlining the business opportunity. (2) Financial Statements — provide a measure of the capital of the business. (3) Estimates of Fund Requirements — to determine financing necessary to operate the business. (4) Projections — to properly structure a loan it is necessary to evaluate the projected cash flow of the venture. (5) Resume of Principals — to evaluate character and capacity of the principals. (6) Business References — to evaluate character and capacity of the principals. (7) Personal Financial Statements — to evaluate char- acter and capital of the principals, by reviewing their per- sonal savings and personal debts. (8) Copy of U.S. Individual Income Tax Returns of Principals — to evaluate financial capacity and worth of principals. (9) Copy of Business Tax Returns — to measure the capital of the business. (10) Incorporation Papers, Partnership Certificate, or Certificate of Doing Business, Material Contracts on Agree- ments — to evaluate the capacity to do business. (11) Copy of Lease or Promise to Rent — to evaluate the capacity to do business. (12) Copy of Any Licenses Needed to Operate — to evaluate the capacity to do business. Many banks recognize that conventional banking criteria cannot be rigidly applied if banks are to make a contribu- tion to minority economic development. Some banks have developed special forms and provisions for "submarginal" loan applicants. 3 What has been set forth above, however, can serve as a guideline for LEDCs as to what most banks would like to see as a basis for a conventional lending situation. Since much of this information will not be available in many cases, it has been stated that if banks are to play a meaningful role in ghetto financing, they must place the major emphasis in judging a loan request on the character of the borrower. The loans must be considered primarily "people" loans in which the most significant criterion in determining the ability to repay is the character of the person or institution to whom the bank is lending funds. Necessity for Guarantee 30-3. A borrower will usually be required to provide a lender with a guarantee by a third person when the bor- rower does not have sufficient capital funds to justify the amount of the loan requested or has not operated long enough to demonstrate his ability to repay the loan. 1 See Freiberg, "What the Banks Are Doing To Provide Capital," 25 Bus. Law., September 1969 Special Issue at 37, 38-39. See also Funk, "Legal Techniques Available for Obtaining Funds," 25 Bus. Law., September 1969 at 13, 18. - See Section 21 for discussion of the preparation of financial state- ments by LEDCs. The LEDC staff, volunteer consultants, or such organizations as ICBO should be turned to for assistance in preparing a loan application for a new enterprise. 3 Weston, "Economic Development Corporations," 25 Bus. Law., September 1969, Special Issue, at 219, 223. 166 No blanket rule can be given as to what amount of capital will be considered sufficient to justify an unguaran- teed loan. If existing debts of the borrower plus the amount of the proposed loan (less the amount of existing debt to be repaid out of the proposed loan) are less than 150 per- cent of the capital of the borrower, most lenders would probably consider the capital as sufficient. Unless the busi- ness were extremely risky, many lenders would probably go further than this and allow liabilities to equal 200 per- cent or less of capital. However, if the business were con- sidered to be extremely risky, even the 150 percent figure would probably not be enough. Similarly it is difficult to be specific as to what will be considered sufficient capacity of the borrower's management to justify a loan. It should be noted that in conventional circumstances most lenders would only consider 4 or 5 years of continuous operations with profits increasing each year as persuasive evidence of sufficient capacity. However, the lender may be favorably impressed if the borrower is re- ceiving one or more forms of management assistance from an LEDC or similar organization. (See Section 4.) SETTING UP A BANK POOL ARRANGEMENT 30-4. Local banking pools or consortiums can play a vital role in making bank loans more readily available to poten- tial entrepreneurs in low-income communities. The main purpose of such a pool is to provide a period of transition during which a record of successful transactions can de- velop between minority entrepreneurs and banks within the eommunity. Such a record would make the pooling of risks Dn bank loans to minority entrepreneurs less and less needed as time goes on. One cooperative approach to serve both the interests of established lending institutions and the community interest in promoting entrepreneurship has been taken by the Job Loan Corporation in Philadelphia. Since this approach could be applied in many other communities, the background and mechanics of the Job Loan Corporation are set forth in detail below. Establishing a Service Organization to Make a Commercial Cooperative Loan Fund Work 30-5. Community leaders in Philadelphia recognized the need to make bank loans less difficult to obtain for entre- preneurs in low-income communities. A cooperative loan fund service organization seemed the best approach. It was initially planned that the organization (later named the Job Loan Corporation) would itself borrow from banks, and in turn make loans to entrepreneurs. How- ever, this approach was discarded in favor of the present procedure whereby the minority businessman applies ini- tially to the Job Loan Corporation (JLC). After JLC re- views and approves his application, the loan is made directly to the borrower by the participating bank of his choice. Such a plan accomplishes several things: (1) It estab- lishes a relationship between the borrower and the bank which in the past had rarely existed. (2) It establishes the loan on the books of the bank and makes the bank respon- sible to the borrower and vice versa. (3) By having direct bank participation, it obviates the necessity of JLC borrow- ing funds from the bank and relending them to the entre- preneur. To do so would make JLC a conduit that would increase the cost and add no special value. Implementing the Concept 30-6. When the tentative plan had been worked out after a number of conferences with the State Secretary of Bank- ing, the presidents of the eight major commercial banks in Philadelphia were invited to meet to discuss the idea. Out of this meeting came a commitment for an initial sum of $2 million to create a Job Loan Corporation loan fund. Since being formed, the banks have increased their com- mitment by an additional $3 million; as loan demands in- crease, further requests will be made to the banks. Each bank's commitment is based on the percentage which its capital bears to the total capital of all eight banks. 4 Since April 1, 1970, the Small Business Administration has worked out an arrangement with JLC for a blanket guarantee of 50 percent of all loans made by JLC. This is in addition to its regular program of minority entrepreneur- ship loans. Under this blanket guarantee program, when the loan application papers are processed for the bank's approval a set is sent to SBA for its review. Within five working days SBA gives its approval and there is an automatic guarantee of 50 percent of the loan. This procedure has permitted the banks to stretch its funds that much further. Agreement by Commercial Banks to Pool Losses 30-7. When it was decided that the banks were to make the loans directly, it was also agreed that the eight banks would participate in any uncollectible loans in proportion to the ratio that one bank's capital, surplus, and undivided profits bear to the total capital position of all eight banks. Thus, no bank is overly committed and all share propor- tionately in the business and in the losses. A blanket loan guarantee entered into by JLC and each of the eight banks spells out the terms and mechanisms for participation by each bank. (See Appendix 30-A.) Interest Rates and Term of Loan 30-8. The banks agreed that individuals would pay 6 per- cent simple interest on the outstanding balance and corpo- rations would pay from IVi to 8 percent. The lower interest rate reflects not only the bank's contribution to the com- munity but the reduction in the bank's costs for processing such loans and the benefits of pooling the losses. With the prime rate up, the banks individually have increased the interest to $4 per $100 add on. The increase came in February 1969, after the prime rate rose to 7 percent. Loans have been made for terms up to seven years. In most cases, the loans are made without any equity required by the entrepreneur so that the entire business operation has been financed by the bank loan. Sources of Funds for JLC Operations 30-9. An initial grant from the Economic Development Administration of the U.S. Department of Commerce of $93,000 over a 2-year period paid for part of the adminis- trative costs. The remainder of the capital required for administrative costs was filled by a $50,000 equity invest- ment in JLC by the Southeastern Pennsylvania Develop- ment Fund. 5 Other nongovernmental sources of financing for such a corporation can be more readily tapped if the corporation has qualified for 501(c)(3) or 501(c)(4) status with the * The participating banks are: Central-Penn National Bank, Con- tinental Bank and Trust Company, Fidelity Bank, First Pennsylvania Banking and Trust Company, Girard Trust Bank, Industrial Valley Bank and Trust Company, Philadelphia National Bank, and Provident National Bank. 3 The Southeastern Pennsylvania Development Fund is a Pennsyl- vania development credit corporation. The Fund makes loans to businesses unable to obtain long-term loans for working capital, machinery, and equipment from conventional sources and recognizes the need for short-term loan assistance to the minority entrepreneur. 167 U.S. Internal Revenue Service. JLC has now qualified as a 501(c)(3) corporation and is able to obtain the funds for administration and program cost from individuals. As a 501(c)(3) corporation, its certificate of incorporation has broadened its scope of operation to include more than lending money, and it can involve itself in venture capital and real estate operations. On July 1, 1970, a subsequent grant by the Economic Development Administration was made for the operation of JLC in the amount of $60,000. In addition to the sums made available by the Southeastern Pennsylvania Develop- ment Fund for administrative purposes, the commercial banks share proportionately in the administrative costs over and above those provided by EDA. Forms of Community Representation on Board and Staff of Corporation 30-10. JLC is incorporated as a Pennsylvania business corporation. Its certificate of incorporation states: "It shall have unlimited power to engage in and to do any lawful act concerning any or all lawful business for which cor- porations may be incorporated under the Business Corpo- ration Law, particularly to lend money but not in such a manner as to subject the corporation to the regulation of the Department of Banking." The by-laws provide for a 17-member board of directors. Eight directors are officers of a banking institution; eight are engaged in busines or community affairs (and in prac- tice represent the black and Spanish-speaking communities); and one is an officer or director of the Southeastern Penn- sylvania Development Fund. The term of office of a director is limited to 2 years. The chairman is a member of the black community; the president represents the Development Fund; the executive vice president, a woman, and three vice presidents, all black, constitute the professional staff of the organization. Day-to-Day Operations 30-11. Potential minority businessmen are referred to JLC by civic organizations, lawyers, ministers, black community organizations, members of JLC's board of directors, and the banks in the 5-county Philadelphia area. An applicant must present background information, ref- erences, and a proposal for a specific project. If the appli- cant proposes a project which is well conceived, provides a needed service or product, benefits the community, and has a reasonable chance to succeed, his credit and personal references are checked. He is then interviewed by a JLC loan officer. A field representative then investigates the area around the proposed business site. Loans of up to $25,000 can be approved directly by JLC loan officers. Larger loans, and any turned down by the lending officers, are reviewed by the executive committee of the board of directors. This executive committee is des- ignated from among the board members with equal repre- sentation of bank and community designees. In reviewing loan applications, JLC does not apply fixed or traditional credit standards. Motivation, determination, knowledge of the particular business, and prospects for success weigh more heavily than credit rating, past per- formance, and collateral. If an individual's credit back- ground is somewhat clouded, an effort is made to determine the cause of the poor record. Was it because of unfortunate or unavoidable circumstances or simply a lack of effort or desire to repay? Unless the poor record was caused by the latter reason, the applicant would probably be given further consideration. In effect, JLC gives positive consid- eration to blacks and Puerto Ricans who show promise fo: business success but who cannot get financial help elsewhere When the loan is approved by JLC, the applicant is givei the opportunity to choose the participating bank with whicr he wishes to do business. JLC then sends an "authorizatioi letter" to the designated bank. This letter explains the de tails of the loan, serves as a guarantee (under a blanke loan-guarantee agreement signed by the participating banks] to the bank which will make the loan, and lists the docu mentation and collateral which must be obtained by the bank in order to make the guarantee binding. JLC generallj guarantees 100 percent of each loan. After the "authorization letter" has been received, the bank grants the loan directly to the applicant. Banks gen erally follow the dictates of the "authorization letter" anc are required to service the loan. In only few cases has i bank refused to make a loan in accordance with the JLC authorization letter. But in each case, the wishes of the bank were respected and the loan applicant was referrec to another bank. Rejection of Loan Application 30-12. A number of loans have been turned down by JLC in cases where applicants could get funds directly from banks or other sources, such as the Small Business Admin istration. Finally, loan requests must be refused if ventures are judged too risky even by the JLC standards described above When JLC finds that it is unable to grant a loan, i counsels with the turned-down applicant, discusses fully the reasons for rejection of the application, and explores possi bilities for the loan being granted under different circum stances. Delinquency and Defaults 30-13. If a loan becomes delinquent, JLC is notified so that it can contact the borrower and assist the bank as much as possible in curing the problem. If the loan deteriorates to the point where it is considerec uncollectable, JLC repurchases the loan from the bank anc all the participating banks then share proportionately in the loss. 7 Business Assistance 30-14. Many borrowers from the JLC fund lack the ac counting, legal, and financial background necessary in to- day's complex business world and do not have access to or cannot afford the outside technical assistance needed to get their businesses started. To cope with this problem, the Philadelphia Bar Association, the Philadelphia Institute of Certified Public Accountants, and the Chamber of Com- merce of Greater Philadelphia have offered free or inex- pensive technical assistance to loan recipients. In the case of accounting services, the Philadelphia Insti- tute has established a committee to work with JLC to pro- vide bookkeeping and accounting services at a minimal cost to businessmen who do not have their own accounting services. In addition, JLC is now working with graduate schools of business to use graduate students to assist the entrepreneurs in their day-to-day financial recordkeeping. One of JLC's three vice presidents is a black Certified Public Accountant and is on the staff providing assistance to the entrepreneurs in the preparation of loan applications and the entrepreneurs' day-to-day operations, working with the entrepreneurs' accountants. In addition, he conducts l! See Section 5. " See Section 30-7. 168 workshop sessions during the night to give the entrepreneur an awareness of the bookkeeping and accounting problems he must face. The rates charged to proprietors and partners is, by mutual agreement, 7 percent simple interest. The rate to corporate borrowers is 8 percent simple interest. Long-Term Commercial Mortgages 30-15. JLC has also developed a real estate mortgage loan program. Seven mutual savings banks and mutual life in- surance companies have agreed to make available for JLC borrowers an aggregate sum of $2 million for long-term financing (for terms up to 15 years). 8 Commercial Real Estate Mortgage Lending Procedure 30-16. Applicants for a commercial mortgage loan may come from many sources. Primarily they are referred to JLC by commercial banks or by other outside sources. These applicants must qualify under JLC standards as better than average risks for a new business enterprise. If it is necessary or desirable that a commercial mortgage be a part of the new business financing, JLC will prepare an SBA partici- pation application for the applicant, which will be forwarded to the lending institution with an appraisal made by one of the accepted appraisers at the expense of the applicant. The work done by JLC in preparing the loan application consists of the following: The applicant is interviewed by a JLC representative. A JLC representative visits the site to evaluate the proposed location. If necessary, JLC attempts to obtain assistance from experts in the applicant's commercial field for perusal of the property and the proposal. JLC makes a character check and the commercial bank provides a credit check of the applicant. The Insurance Company of North America also makes a character and credit check of each applicant for term life insurance on the commercial loan. When the completed SBA forms are received from JLC, the mortgage lender reviews the application, makes a second "in house" appraisal if required, and determines if the loan is acceptable with an SBA guarantee. If the finding is affir- mative, the lender completes SBA Form No. 751 and sub- mits the application to SBA. When received by SBA, the application receives immediate attention and an answer is returned to the lending agency within 10 working days of receipt of the application. After approval of the loan, a settlement is held, at which time title to the property changes hands and the bank or insurance company provides at settlement a check covering its part of the mortgage loan. In probably all cases, the commercial bank is also represented at the settlement and tenders a check for the balance of the purchase price for the property. At the same time, the commercial bank may take advantage of having the parties all in one place to complete a settlement of the commercial loan. After the commercial mortgage loan has been made, JLC has no further part to play in the relationship between the commercial mortgage lending institution and SBA on that particular case. However, in nearly all cases, JLC will have extended a guarantee to a commercial bank for the same applicant and its interest will be continuing during the life of that loan (5 years in most cases). JLC attempts to follow the case and to provide management and other assistance when needed by the applicant. Mortgage loan applications are first apportioned to the lenders at random. After each lender has one accepted loan, further loans are assigned in accordance with the propor- tionate share of each lender's assets to the total sum of the mortgage pool. Quarterly reports of outstanding loans and commitments are furnished by JLC. JLC Fulfills a Temporary Need 30-17. JLC is a temporary organization, designed not to remove from the banks their responsibility for making the loans or judging credit but to demonstrate to them how risky loans can be made with a minimization of the risk. Through their participation, the banks, even smaller ones, now have personnel who are being trained in this type of loan activity. SETTING UP A GROUP OF OUTSIDE GUARANTORS 30-18. A possible approach to make bank loans more read- ily available without a formal loan-guarantee fund financed and administered by the Local Economic Development Company utilizes the goodwill and financial resources of a small group of philanthropically minded citizens. These in- dividuals may be willing to serve as guarantors if proper mechanisms for such group guarantees can be carefully prescribed. To facilitate setting up a group of outside guarantors to assist in developing new business enterprises, three basic entities are involved in the structure: (1) a 501(c)(3) or- ganization; (2) a credit pool; and (3) a commercial bank or banks. (1) The 501(c)(3) organization is the vehicle for mak- ing funds available to prospective entrepreneurs who do not have and are unable to obtain capital or credit to estab- lish proposed business enterprises. The organization governs and administers the use of a composite line of credit to obtain funds for establishing the proposed businesses. The organization obtains guarantee agreements from members of the credit pool as collateral for bank loans that may fall into default. (2) The credit pool may consist of individuals, business corporations, funds, and foundations, who, through use of a limited guarantee, agree to satisfy losses up to a stipulated maximum amount resulting from defaults on bank loans to individual small businessmen. (3) The bank or banks are commercial banking institu- tions which agree to make commercial loans to the under- privileged business enterprises based on the fact that if the loan is not repaid in part or in total by the new business enterprise, repayment will be made through the guarantee supplied by the credit pool. 501(c)(3) Organization 30-19. The 501(c)(3) organization should be composed of experts in many business and professional fields to enable the organization to provide necessary business management and technical assistance to the new enterprises. To encourage prospective entrepreneurs to enter new business enterprises, the organization should provide man- agerial counseling, recommend sources of accounting and legal assistance, and arrange the financing needed to start the businesses through use of the credit pool guarantee. A committee of these experts interviews and screens prospective applicants to identify those who have the great- est prospects for success in. their chosen fields of business. H The institutions participating (1969) in the long-term financing are: Beneficial Mutual Savings Bank, Germantown Savings Bank, Philadelphia Savings Fund Society, Western Savings Fund Society of Philadelphia, Fidelity Mutual Life Insurance Company, Penn-Mutual Life Insurance Company, and Provident Mutual Life Insurance Company. 169 Most applicants will have some limited knowledge and ex- perience in their proposed fields of business, but will not have sufficient know-how, expertise and technical knowledge to establish a profitable business. If a proposed business is deemed worthwhile and the applicant meets its standards, the 501(c)(3) organization arranges for a bank or banks to make the necessary loan on the basis of the guarantee given by members of the credit pool. Any person or business financially assisted through the 501(c)(3) organization becomes obligated to submit to any training or counseling that the committee deems necessary to enhance the success of the proposed business venture. Credit Pool 30-20. The credit pool provides the credit mechanism that enables the new businesses to obtain necessary bank loans. The 501(c)(3) organization, through its members, creates the credit pool by recruiting individuals, business organiza- tions, funds, and foundations who are willing to participate in it. Of necessity, the credit pool will consist of economi- cally substantial persons and businesses. The identity of members of the credit pool is not dis- closed to anyone other than members of the committee of the 501(c)(3) organization and the bank or banks making the loan. Some type of life insurance is obtained to protect each member's share of the credit pool guarantee. Each member of the credit pool is committed for a specified amount for a specified time (which should be 10 or more years) in the form of a guarantee agreement between the 501(c)(3) organization and the bank. Such guarantee spells out the term of years, amount committed, and the bank's rights in the event of a default. 9 The commitment remains as collateral for the 501(c)(3) organization for that specified number of years and can be used when needed by the 501(c)(3) organization. Any other loans made by the bank to the prospective entrepreneur and /or his business prior or subsequent to the guarantee but not through the 501(c)(3) organization does not obligate the credit pool. Commercial Bank or Banks 30-21. The bank or banks made regular installment and term loans to the new entrepreneurs or their businesses as designated by the 501(c)(3) organization. Repayment of such loans is guaranteed by members of the credit pool. All normal and standard collection procedures are em- ployed by the bank to insure against premature use of the guarantee. Bank will probably require members of the credit pool to submit financial statements from time to time. Use of Guarantee Between 501(c)(3) Organization, Credit Pool, and Bank 30-22. Generally, only businesses deemed worthwhile but unable to obtain financing elsewhere are involved here. In each case, before a guarantee is authorized, the full board of the 501(c)(3) organization evaluates both the individual and the business and decides whether to proceed with the guarantee. The 501(c)(3) organization then goes to the bank, which has a special purpose form used for all such loans. 10 In effect, this form provides that each member of the credit pool will cosign for a proportionate share of the loan. As a practical matter, each time a loan is to be made, instead of each member of the credit pool giving a separate guarantee for the allocate share of the loan (it would be almost impossible to get all the credit pool members together at any one given time), a limited power of attorney is obtained from each member of the credit pool. 11 The limited power of attorney spells out in effect that upon written notice from the 501(c)(3) organization, that the attorney-in-fact, will execute for the bank a guarantee of payment in substantially the same form as annexed to the limited power of attorney. It should also include the following: (1) That there be a specified number of limited powers from other members of the credit pool so that the attorney-in-fact is acting for all of the other members of the credit pool at the same time. (2) That the term of the loan, including extensions, is not to exceed a specified number of years (usually 10). (3) That the principal amount of the loan, including renewals, shall not exceed a fixed dollar amount, specify- ing such amount. (4) That upon default of such loan, liability under such guarantee shall be several and not joint and shall not exceed the allocate share of the default limited to the maxi- mum amount provided in (3). (5) That in no event may it exceed the maximum amount guaranteed for all loans to be made, stating such specified amount. (6) That in event of a default, the attorney-in-fact is the proper party to accept the borrower's note and any note or interest the bank may have and to sign all necessary receipts or other instruments in connection therewith. He shall also be the person upon whom a summons or other legal process may be served by the bank in any proceedings which may be instituted by the bank for enforcement of the obligation under the guarantee of payment. (7) That the power can only be revoked by an instru- ment in writing properly executed, delivered to both the attorney-in-fact and the bank or banks involved. There should be a letter from the 501(c)(3) organiza- tion to the bank proposing assistance to the bank in notify- ing the members of the credit pool of any default through the attorney-in-fact. However, it should also state that the 501(c)(3) organization will not take any steps to enforce collection from the original borrower. Inasmuch as the 501(c)(3) organization will be assisting the new businesses, it will be aware of an impending default. LOAN GUARANTEE APPROACHES FOR AN LEDC 30-23. For a number of reasons, some of which are con- sidered below, a Local Economic Development Company may find it desirable to itself guarantee loans made to businesses which it sponsors rather than to rely on outside sources of guarantees. In considering whether such a pro- gram would be advantageous, the LEDC should consider the factors discussed in this section, which (1) describes the attitude of conventional commercial lending sources toward guarantees, and (2) proposes a form of guarantee with conditions and restrictions which might be acceptable to lenders and at the same time be satisfactory to the LEDC. Provision of a Guarantee by an LEDC 30-24. An LEDC may wish to assist a prospective bor- rower if the prospective lender requires the guarantee of a third party as a condition to the making of the loan. !) Sample terms of such a guarantee arc illustrated in the limited power of attorney, described in Section 30-22, and presented in Appendix 30-C. 10 A suggested special purpose form is presented in Appendix 30-B. 11 Sec Appendix 30-C. 170 To conserve its assets the LEDC should first see whether the guarantee can be obtained from the Small Business Administration or through a private organization. '- However, the guarantee of an LEDC or similar organiza- tion may be necessary for certain prospective borrowers. Under present law, SBA cannot guarantee loans made to borrowers engaged in certain types of business; the most relevant of these are: (1) borrowers that are consumer cooperatives; (2) borrowers that are engaged in the busi- ness of publishing newspapers, magazines, or books or which own a radio or television broadcasting station; or (3) borrowers that are banks or credit agencies or are other- wise engaged in the business of lending or investment. Private organizations may have similar or additional limita- tions on the types of borrowers they will guarantee loans for. Moreover, an LEDC guarantee could be very helpful to all prospective borrowers when, as has happened with some frequency in the past, SBA is short of funds or must impose limitations not found in the law on the availability of guar- antees. Private organizations may for similar or other rea- sons be temporarily unable to act; or the borrower's need for funds may be acute and cannot await the relatively long period between application and availability of funds com- mon with SBA (never much less than 2 months even under the best circumstances). However, in at least some cases the mere existence of an LEDC willing to provide guarantees may limit the avail- ability of a guarantee from a private organization. A private organization may feel that the number of recipients it can assist is necessarily limited and that its resources would be more usefully employed if directed to borrowers that are not in an area served by an LEDC willing to provide guarantees. In general, before approaching a bank, whether or not in conjunction with its own loan guarantee program, it should be possible for the LEDC to determine which banks in the community have been receptive to requests for financial assistance from minority businessmen by checking with the local office of the Small Business Administration. If the Urban Coalition, the Black Economic Union, the Interracial Council for Business Opportunity (ICBO), the National Business League, the Urban League, or similar organizations are operating in the community where financ- ing is desired, they should also be approached for such information. Terms of a Guarantee by an LEDC 30-25. Organizations such as SBA, the Interracial Council for Business Opportunity Fund, Inc. (ICBO), and the New York Urban Coalition, have facilitated loans by banks and other financial institutions to small businesses by furnishing guarantees, equity capital, subordinated loans, or other devices. They have generally done so on the premise that: ( 1 ) The assistance they provide to any particular borrower should be temporary. (2) Ultimately a lender will know the borrower well enough to make loans available without the comfort of these devices. (1) Risk to be Shared by the Lender. The assistance furnished by these organizations, at least when it involves a guarantee, has not been on ordinary commercial terms but has been designed to expose lenders to some risk from the outset so as to motivate them to become familiar with the affairs of their borrowers. In a purely commercial context, a bank might be unwill- ing to lend to a particular borrower unless the bank has an unconditional guarantee of the entire loan from an emi- nently solvent third party. In contrast to this, SBA has been able to facilitate loans to borrowers by furnishing guar- antees of only 90 percent, or in some cases a lesser per- centage, of the declining balance of the loan. Moreover, SBA guarantees are not the flatly unconditional guarantees ordinarily given in purely commercial contexts under which the guarantor normally undertakes to perform as if he were the borrower. With the most frequently used form of SBA guarantee, 60 days must elapse after default by the bor- rower before SBA is required to make good on its guar- antee, and it is a condition of payment by SBA that it be notified of the default within 30 days. (2) Percentage Guaranteed. It is of course possible that lenders will refuse to expose themselves to even the limited risks present with an SBA guarantee and insist on a fully commercial guarantee. However, SBA's guarantee has been widely accepted and the LEDC can show local banks evidence that guarantees even less favorable to lenders than the SBA guarantee have been accepted by prominent bank- ing institutions when coupled with an active management assistance program. (3) Collateral to Support Guarantee. Lenders often require a guarantor whose financial standing is not the highest to provide security to back up the guarantee. Such security is not required with SBA guarantees since the ultimate obligor is the United States. Some organizations, for example, ICBO, have thought it necessary to furnish security to lenders in order to enhance acceptability of its guarantee. ICBO security usually consists of an escrow deposit in the lending banks of 50 percent of the liability under the guarantee. Up to 1969, the ICBO guarantee itself has been for only 50 percent of the principal amount of the loan and interest thereon; this has meant ICBO could support a maximum of about $4 in loans for each $1 of funds avail- able. However, to the extent payments required to fulfill guarantees and operating expenses exceed earnings from guarantee fees and other sources, the maximum ratio could not be maintained. Variations are based on what seems to be the experience of lenders to small businesses, that the longer a loan re- mains outstanding over its life without a default, the more likely it is that no default will ever occur. (4) Limitation on LEDC Commitments. The LEDC acting as a guarantor may be willing to agree not to allow its liabilities to exceed a certain ratio of its assets as an induce- ment to the lender. Other agreements which an LEDC acting as a guarantor might be asked to provide by some lenders are ( 1 ) to con- duct only certain types of financial activities (thought to be necessary by some lenders to avoid exposure of the assets of the LEDC to risks other than those approved by the lender), and (2) not to put a lien on any of its assets, other than by making escrow deposits as part of the exten- sion of new guarantees. Any undesirable effects of giving these agreements can be lessened by establishing a separate legal organization en- tirely owned by the LEDC empowered only to give and service guarantees. Thus an agreement to limit the types of activities to be engaged in or to forbid the creation of liens would affect only the separate legal organization and would not interfere with other activities of the LEDC. A separate legal organization may also be administratively convenient. ICBO provides guarantees through a separate legal organization for this reason. 12 Other alternatives, the use of a local group of private guarantors and a bank pool arrangement, are covered in Sections 30-4 to 30-22. 171 SBA LOAN GUARANTEE PROGRAM AS COMMUNITY MODEL 30-26. The experience of SBA in establishing its loan guar- antee program is particularly relevant to an LEDC con- sidering the establishment of its own guarantee program. Since the guarantee provided by SBA under the Simplified Blanket Guarantee Plan has been quite widely accepted by lenders and since it involves probably the least onerous guarantee which an LEDC can presently expect most lenders to accept, this approach is discussed in detail here, with the suggestion that an LEDC pattern its own guar- antee program after this Plan. Until 1966, SBA guarantees were available only on an individual basis; that is, an application for a SBA guarantee was processed in essentially the same manner as an applica- tion for a direct loan from SBA, with all the attendant delays. Beginning in 1966, SBA introduced the Simplified Blanket Guarantee Plan. Under this Plan any lender wish- ing to participate enters into a master agreement with SBA; thereafter, whenever the lender proposes to make a qualifying loan, it submits a very short application to have the loan covered by the master agreement, together with comparatively few (as compared with prior procedure) accompanying documents. The important provisions of the Simplified Blanket Guar- antee Plan are discussed below and contrasted with analogous provisions in SBA's Individual Guarantee Pro- gram and in an ordinary commercial guarantee. LEDCs negotiating with local banks should seek similar protection. Closing of Loan Transaction 30-27. Both SBA guarantees attempt to provide some pro- tection for SBA by conditioning the effectiveness of the guarantee on the lender observing certain procedures in making the loan. Commercial guarantees do not usually attempt to provide this protection for the guarantor. There is less necessity to provide such protection in the case of an SBA guarantee since the lender is never backed by a 100 percent guarantee whereas in an ordinary commercial guarantee the guarantor usually guarantees the entire amount. Nevertheless, SBA does not choose to rely on the self-interest of lenders. Guarantees under SBA's Individual Guarantee Program are quite specific in providing the type of security agree- ment covering the borrower's property, insurance policy on the borrower's property covered by the security agree- ment, opinion of counsel, and evidence of no adverse change in condition, financial and otherwise, of the bor- rower, which the lender must receive. However, guarantees under SBA's Simplified Blanket Guarantee Plan are more flexible and basically only require the lender to take such actions which, "consistent with prudent closing practices, are required in order fully to protect or preserve the inter- ests of lender and SBA in the loan." Servicing of Loan 30-28. Both SBA guarantees also attempt to provide some protection for SBA by requiring the lender to observe cer- tain procedures in servicing the loan. Commercial guar- antees not only do not usually provide this protection, but they usually are quite explicit in allowing the lender, with- out the consent of the guarantor, to do exactly the things which SBA would forbid. For the reasons set forth under Section 30-27 above as to closings of loan transactions, it would seem that SBA could rely to a greater extent on the self-interest of the lender in servicing SBA guaranteed loans. Generally, the guarantee under SBA's Individual Guar- antee Program would release SBA from all liability if the lender services the loan in a negligent manner such that a substantial loss on the loan may result, while the guarantee under SBA's Simplified Blanket Guarantee requires the lender to follow "accepted standards of loan servicing em- ployed by prudent lenders generally." The most important specific service requirement of the SBA guarantees, requirements set forth in both guarantees, are that, without SBA's consent, the lender may not ac- celerate the maturity of the promissory note evidencing the loan (that is, the lender may not, without consent, declare the loan to be immediately due and payable even though the borrower has failed to pay an installment when due or has become bankrupt or has breached an important coven- ant) and may not sell the promissory note. Less importantly both provide, among other things, that the lender may not, without SBA's consent: (1) alter the terms of the promissory note or the security agreement on the borrower's property securing the loan; (2) release or substitute any of the borrower's property covered by the security agreement (in the case of the guarantee provided under SBA's Simplified Blanket Guarantee Plan, consent of SBA is necessary only if the proposed release or sub- stitution affects property "having a value, as reasonably determined by the lender, which is more than 10 percent of the outstanding loan balance"); (3) sue upon the promis- sory note; or (4) waive any claim against the borrower or any other person obligated in connection with the loan. Guarantee Fee 30-29. Under both SBA guarantees, SBA collects from the lender, on a quarterly basis, a guarantee fee of not more than '/4 of 1 percent of the guaranteed percentage of the unpaid principal actually outstanding during the quarter. SBA requires that this guarantee fee "not be added to any amount which a borrower is obligated to pay under a loan," but this is a requirement which probably can be avoided, at least in part, in practice. A lender could quite easily increase slightly the interest rate otherwise to be charged to the borrower to produce an amount sufficient to pay all or part of the guarantee fee. For this reason guar- antee fees for ordinary commercial guarantees are usually imposed directly on the lender. Payment Upon Default 30-30. Under both SBA guarantees there is considerable delay between occurrence of a default and payment by SBA pursuant to its guarantee. Commercial guarantees, on the other hand, normally aim for the shortest period possible; many of them do not even require the lender to give notice to the guarantor of the borrower's default. Depending on the kind of default under SBA's Indi- vidual Guarantee Program, three quite different results can ensue: (1) If the default were the commencement of any bankruptcy proceeding by or against a borrower (including as a bankruptcy proceeding any receivership, dissolution, or creditor's rights proceeding or an assignment by the bor- rower for the benefit of his creditors, but not including any proceeding under provisions of the Bankruptcy Act which are designed to keep the borrower in business while working out his problems), SBA would be required to pay immediately pursuant to its guarantee upon being notified of such commencement. (2) If the default were the nonpayment of principal or interest on the loan, the lender, in order to receive pay- ment of the guaranteed percentage of the loan, would be 172 required to (a) give written notice to SB A of the non- payment within 20 days from the date payment was due; (b) wait out the passage of 90 days from the date payment was due during which it remains unpaid; (c) give the writ- ten demand to SBA that it make payment pursuant to its guarantee; and (d) wait out the passage of a maximum of 30 days from receipt of such written demand by SBA dur- ing which period SBA is required to pay pursuant to its guarantee. (3) Finally, if the default were something other than commencement of bankruptcy proceedings or nonpayment (for example, the breach of a covenant requiring the bor- rower to pay its taxes when due), the lender would be unable to do anything unless he were able to persuade SBA to allow the lender to accelerate the maturity of the promissory note; if this were done and if the borrower later failed to pay, the lender would be entitled to receive pay- ment of the guaranteed percentage of the loan after going through all the steps outlined (2). It can be seen that for defaults other than commencement of bankruptcy proceed- ings, if anything can be done at all, it will be necessary to wait a minimum of 91 days after occurrence of the default. Many lenders found the time-consuming procedures re- quired under SBA's Individual Guarantee Program unsatis- factory, and for some this probably affected the level of their participation. The guarantee under SBA's Simplified Blanket Guarantee Plan was designed to alleviate some of the problems of these lenders. Under it the result of any default (at least if it is the nonpayment of principal or interest or any other event which the lender "determines to constitute an adverse change in the borrower's ability to repay the . . . loan"), and the length of time required to receive payment from SBA, is the same. To receive pay- ment of the guaranteed percentage of the loan, the lender would be required to (a) give written notice to SBA of the default within 30 days from the date of its occurrence; (b) wait out the passage of 60 days from the date of occurrence of the default during which the default remains outstanding; (c) give a written demand to SBA that it make payment pursuant to its guarantee; and (d) wait out the passage of a maximum of 20 days from receipt of such written demand by SBA during which period SBA is re- quired to pay pursuant to its guarantee. Thus SBA's Sim- plified Blanket Guarantee Plan shortened the minimum period which a lender must wait after default from 91 to 61 days and considerably expanded the kinds of defaults the occurrence of which would require SBA, without its consent, to pay under the guarantee. A form of blanket guarantee agreement and a form of application for particular loans to be included thereunder appear in Appendixes 30-D and 30-F; both forms are closely modeled on the SBA forms. 173 Section 31 FINANCING WITH COMPANY ASSETS SOURCES OF SHORT-TERM CREDIT 31—1. The basic funds invested in a new business are almost never sufficient to finance its going operations in full. The Local Economic Development Company is interested in help- ing the new business to use, or "leverage," its initial assets so that they will form a basis on which the needed additional funds can be obtained. To do this most effectively, one must first understand the traditional methods by which these funds are obtained. Numerous sources of money or credit can be tapped by new businesses. These sources and their attributes are discussed below. One common denominator they all have is that they are in business for a profit. It is, therefore, a fundamental and often difficult problem faced by the new business to con- vince the money sources that the new operation is an attrac- tive (that is, profitable) avenue for credit. To accomplish this, the various money sources and their particular needs, goals, and traditions should be understood. The major existing sources of funds were not created with poverty area programs in mind. Rather, their general orienta- tion is toward profitable, proven, businesses in an already established marketplace. Nevertheless, this is the atmosphere in which the new business is forced to operate. This Section aims primarily to foster understanding of that atmosphere. Without such understanding, the crucial task of entering the credit marketplace to satisfy the needs of the new business cannot be faced intelligently. To be of maximum help to the new business as a basis for credit, the concept of "assets" should be given a broad mean- ing. For credit purposes, particularly when the new business is considered, the assets of a business exceed what appears on the left side of a balance sheet. Imaginative and constructive financing arrangements can be based on more than plant and equipment. For the undercapitalized business with a short performance record, franchises, licenses, distributorship agreements, desirable locations, and the like can all serve as a basis for secured financing. For some businesses the sup- port of friends and of an LEDC (in the form of guaranties or property hypothecations) may be of significant value as a business asset. It is fundamental, however, that the type of asset that may prove of value must be related to the particular creditor whose financial assistance is being sought. There are many sources of credit based upon business assets. These vary by group and quite often show significant variations even within a group. Since the first significant decision a business seeking credit on the basis of its assets must make is where to look, the major private (non-governmental) sources of money and credit in the secured financing market are described below. Commercial Banks 3 1-2. Banks, as compared with some of the other sources of credit, generally require higher credit standards and higher conformity to their own procedures, forms, and practices than other institutions. They generally offer somewhat lower rates than other creditors. The conservatism of banks stems from their need to pro- tect their depositors' money. Looked at somewhat differently, however, this interest in depositors can be a stimulus to a bank's interest in a new business. Particularly to the smaller, local banks, increased local trade and prosperity means in- creased depositors as well as loan business. While not a substitute for credit strength or collateral, an influence to- ward stimulating neighborhood trade may influence a forward-looking bank to accept marginal risks. The only way of testing this interest is to talk with the bank loan officers. This is an area in which local trade groups, businessmen's societies, and LEDCs can be of particular value in pointing out to local banks the benefit to them from investments in new local trade. Finance Companies 31-3. A diverse group of companies, generally called "finance companies," extend credit secured by debtors' as- sets. These companies vary in size from organizations with assets in the billions of dollars and of national scope to relatively small local companies. These companies are not difficult to locate through local businessmen, lawyers, and bankers. Many are members of the American Industrial Bankers Association, 1629 K Street NW., Washington, D.C. 20006. Probably their most significant contribution is their ability to investigate the particular needs of a business and tailor a financing arrangement to the individual concern. Thus, finance companies may be better able than the more structured banking group to create varying payment sched- ules, fluctuating rates of amounts of credit, and other credit variables based on the needs of the debtor. Their services cover a broad spectrum including direct loans of money, the financing of installment purchases, the discount of ac- counts receivable, inventory financing, and forms of leas- ing. Certain assets of a new business, particularly its in- tangible assets, may be of greater interest and collateral value to a finance company than a bank. In return for their willingness to take greater risks and meet unusual credit needs, the finance companies generally charge rates somewhat above bank levels. Competition among finance companies is keen. A com- pany may be willing to risk credit with a relatively untested business if there is a reasonable expectation of future profit, growth, and, consequently, increased business to the finance company. First, however, the credit needs of a finance company must be understood in making a presen- tation. These are summarized in the following sections. If they cannot be met at an initial stage in the new business's development, a convincing forecast that they will be met in the foreseeable future will be attended to with interest. In the last analysis, the finance company must be satisfied that the new business will represent a sound business risk. 174 Seller Credit 31-4. A prime source of credit by which a new business may acquire equipment and inventory are the suppliers to it of those goods. Most regular dealers in the sale of goods have established some method by which payment may be made on a deferred basis and will describe this upon request. Often, particularly in the sale of relatively fixed assets, the seller will retain a security interest in the goods sold as collateral for the unpaid balance. Most sellers who extend this form of credit also receive financing themselves. There will, therefore, be a finance charge for that type of credit that will approximate the charge imposed by the credit institution that finances the seller. Sellers extending credit may be expected to make the same type of credit investigation of the buyer as would a bank or finance company considering a loan. Factors 31-5. Specializing in the financing of accounts receivable is a group of financing organizations called "factors." These tend to be smaller in size than the banks and the larger finance companies. For this reason, they are also able to vary the terms of their credit depending upon the needs of particular businesses. As discussed under Accounts Re- ceivable Financing, Section 31-26, there are various forms of factoring suitable for various types of business opera- tions. Factoring is often combined with the financing of the merchandise of a business and in many situations the fac- toring credit may also be supported by security in other business assets. Factoring is particularly useful in a business which has varying needs for credit which rise and fall with seasonal fluctuations. As factoring credit is usually repaid with the payment on the receivable, it is a form of financing that may be quickly liquidated and is, therefore, particularly suited to changing business needs. Factors tend to specialize in particular businesses and their advice is often useful in the field they tend to finance. SBICs, the SUA, and Other Government Agencies 31-6. The assistance that may be given new businesses by government organizations as well as by a Small Business [nvestment Company may also be secured by business assets. This subject is covered elsewhere in this book. 1 Participations and Multiple Financing 31-7. An important area to investigate in business financing is the possibility of a combination of credit sources. Each of the above types of financing can be used alone or in :ombination with one or more of the others. This may be particularly significant in the financing of new businesses where, for example, a bank may be willing to extend rela- tively low-cost credit but in insufficient amounts. A more adventurous financer might be willing to supplement this and take a collateral position or repayment schedule behind the bank but at a higher rate on its portion of the credit. Many combinations are available, sometimes with vary- ing sources of credit taking security in different assets. Often the credit sources will agree among themselves as to their relative standings but this is not always the case. It also often happens that a bank may have an affiliation with a finance company or factor and may itself assist in dividing the credit through two or more organizations. In considering these various sources of credit, the LEDC may be thought of as having two roles: (1) Persuasion. No source of credit will involve itself in a business situation unless it is persuaded that its needs, be they business profit or social welfare, will be met by the situation. Thus, those needs — which do vary among enter- prises — must be understood so that the business seeking credit can be advised as to where and with what methods and arrangements it is to proceed. (2) Support. If the new business fails in its credit pres- entation, additional supports may be required. To the ex- tent that the LEDC can supply them (whether they be additional equity funds, guaranties, additional collateral, governmental assistance, or whatever) it can be of invalu- able assistance in helping to solve credit problems. The remainder of this chapter is devoted to more spe- cific aspects of secured credit, with particular reference to the newly created enterprise. ELEMENTS COMMON TO ALL FORMS OF SECURED CREDIT 31-8. Elements that commonly affect all forms of secured credit include: (1) amount of credit and terms of repay- ment, (2) finance charge, (3) other charges, (4) usury, (5) disclosure statutes, (6) restrictive covenants, (7) guar- antees, endorsements, and co-makers, and (8) debt sub- ordination. Amount of Credit and Terms of Repayment ^3 1—9. The first question is always how much credit is avail- able and how it must be repaid. In the classic business situation this is determined by applying traditional business principles. Reference has been made to the appeal that may be made to "enlightened self-interest" in financing new businesses in poverty areas. To the extent that any financ- ing source can visualize its own growth through the growth of neighborhood business, this will be an element in the stimulation of financing. Nevertheless, in the final analysis, the credit grantor will resort to traditional business principles in making its final decision on the terms of credit. These principles apply to all forms of secured financing and are therefore relevant to each of the succeeding sections. A business seeking credit may be assured that the potential creditor will always investigate these elements. Secured financers are primarily concerned with the "Three C's: character, capacity, and collateral." In con- sidering character, the lender is concerned not only with the debtor's honesty and reputation, but also with the question of whether he is adequately motivated to make the personal sacrifices necessary for business success. Under "capacity" would be considered such factors as the debtor's abilities, training, and experience in the field, the future of the industry, and whether the projected cash flow can retire the proposed obligation. In determining capacity the financer will ordinarily require the debtor to deliver to him suitable financial statements and similar information. As regards the collateral, the financer must first deter- mine its present value. If the collateral is new, the purchase price will ordinarily be accepted as its present retail value. If the collateral is used, its value may be determined by appraisal, or by reference to a list of estimated values pre- pared by a trade or dealers' association or an auctioneer. The financer must also determine the probable economic life of the collateral if he is to be assured that its value will at all times exceed the balance of the indebtedness by a satisfactory ratio ("collateral ratio"). Lastly, the financer must decide how much he can realize on the collateral, not under ideal conditions but when an entire plant is 1 See Sections 10 and 26. 175 suddenly dumped on the market under forced sale condi- tions. When the collateral consists of intangibles such as ac- counts receivable, additional factors apply, such as the credit strength of the account debtors, collection experience, etc. The above factors determine the amount of credit and the term it will be extended for. Within these confines, there is some flexibility, and the debtor should attempt to work out with the financer a repayment schedule that best fits the debtor's requirements. For example, if the debtor is a new supermarket which is building its trade, the repayment schedule may provide for smaller payments during the start-up period and larger payments thereafter. If future expansion is contemplated, the payments can be low during the start-up period, then higher, then low again when the projected expansion costs are anticipated. If new equipment is being financed and the debtor employs an accelerated method of depreciation, the repayment schedule can provide for higher payments at the beginning of the term and progressively lower payments thereafter, calcu- lated to "gear in" with such depreciation and the cash flow created thereby. There are many possibilities. Finance Charge 31-10. The principal charge in any credit transaction is, of course, the finance charge. In loan transactions, the finance charge is the interest charge, and it is customarily expressed in one of three ways: a simple interest charge, an "add-on" charge, or a "discount" charge. The borrower must under- stand how these charges are computed if he is to under- stand what he is truly paying for the credit extended to him. Let us assume that a debtor borrows $1,200, repayable in 12 monthly installments of $100 each. The finance charge can be expressed as a straight interest charge, say 6 percent, in which case the debtor will each month pay an amount equal to $100 (as repayment of principal) plus an amount computed on the outstanding balance of the loan for such month at the rate of 6 percent per annum. Thus, the interest for the first month would be V2 percent (1/12 of 6 percent) of $1,200, or $6, the interest for the second month would be Vi percent of $1,100 or $5.50, and so on. In this example the total dollar amount of in- terest paid over the 12 months would be $39.00. In an "add-on" transaction, the finance charge is added to the principal and is paid off over the term of the loan. In our example, if a 6 percent add-on charge were used the debtor would sign a note for $1,272 ($1,200 principal plus the 6 percent add-on charge of $72) and would repay the loan in 12 monthly installments of $106 each. Note that the 6 percent add-on charge amounts to $72 whereas the 6 percent straight interest charge comes to $39. The straight interest charge is paid only on the actual balance outstanding at the end of each month, which diminishes as the loan is paid down in installments. The "add-on" charge, however, is based on the orginal amount of the loan, even though the borrower does not have the use of that amount over the full term. The 6 percent "add-on" charge actually yields a true interest of 10.9 percent in our example. In a 6 percent "discount" transaction the $72 charged would be deducted from the $1,200 figure and the bor- rower would receive only $1,128. He would pay back a total of $1,200 in 12 monthly installments of $100 each. This results in an even higher yield to the lender (11.6 percent) than the equivalent add-on charge, since in both cases the finance charge is $72 but in the discount trans- action the borrower received $1,128 whereas in the add-on transaction he received $1,200. In making certain loans, banks may require that the borrower maintain, as a "compensating balance," an ac- count with the bank in a certain minimum amount. A $50,000 loan might necessitate a compensating balance of $10,000. In such case the borrower is getting the effective use of only $40,000. Thus, if the simple interest charge is 8 percent, the borrower is paying such 8 percent for the use of $40,000, not $50,000, and the effective rate to the borrower is 10 percent. Other Charges 31-11. There are costs other than the finance charge that may have to be borne by the debtor. The debtor should determine what these charges will be so that he understands the total cost of his loan. Typical of such charges in a business loan secured by equipment are: (i) appraisal fees, (ii) costs of lien searches, (iii) costs of insurance on the collateral which the lender will require to protect his in- terest therein, (iv) out-of-pocket attorneys' fees incurred by the lender in the documentation of the transaction, and (v) filing fees. Usury 31-12. The finance charge in loan transactions, no matter how such charge is computed or stated, is subject to the provisions of interest and usury statutes. In a few States such statutes do not impose a "ceiling" on the interest charge, and in some States the ceiling is so high that the ordinary business loan will have ample clearance. In a number of States, however, the highest rate permitted by the general interest statute is not adequate to accommodate business loans under the realities of the contemporary money market. To accommodate such loans, the legislatures of many States have enacted exceptions to the general interest statutes, the most significant of which removes the usury ceiling from loans to corporations. A variation of this approach is to retain a ceiling on corporate loans, but to raise the ceiling to a higher figure. Several States have eliminated the ceiling on all business loans, regardless of whether the borrower is a corporation, partnership, or in- dividual. The interest and usury statutes of the various States are subject to change from time to time, and legal counsel should be consulted to determine the applicability of such statutes to a given transaction. It should be noted that in an installment sale, the finance charge imposed by the seller in most commercial (as con trasted with consumer) transactions is not subject to the usury laws. This is because the basic transaction is a sale and not a loan; the legal principle behind this is generally called the "time price doctrine." In a number of States however, this doctrine is not applicable because of special statutes (such as the Retail Installment Sales Acts described elsewhere herein) or decisions applying rate ceilings to sales as well as loans. Disclosure Statutes 31-13. A number of statutes, both on the State and Federal level, require special disclosures in the documents evidenc ing a credit transaction. While the duties imposed by these statutes are upon the creditor rather than the debtor, the prospective debtor should be aware of their existence and the function they serve in credit transactions. The various disclosure statutes may be briefly summar ized as follows: (1) An outgrowth of the public demand that finance charges in credit transactions be disclosed in one way only 176 so as to permit heightened consumer understanding, the Federal Truth in Lending Act of 1968 2 requires disclosure of the finance charges in terms of simple annual interest. However, it is applicable only to credit given "for personal, family, household, or agricultural purposes." "Agricultural purposes" is restricted by definition to cover the operations of a farmer or husbandman (and not, for example, a food processing plant). Thus, unless a business or com- mercial credit transaction falls within the limited agricul- tural group, it will not be affected by the Truth in Lending Act. (2) The Uniform Consumer Credit Code 3 requires the disclosure of certain credit information but applies only to the same categories as the Federal Truth in Lend- ing Act. (3) A number of States have statutes that require specified disclosures in transactions involving the install- ment sale of goods or services to businesses. (A consider- ably larger group of States require disclosure in installment sales transactions for personal, household, or family pur- poses.) These disclosure statutes do not cover loans of money; they relate only to sales on time. They usually require such items as the cash price, the down payment, insurance charges, and the dollar amount of the finance charge to be disclosed: they do not require a statement of the finance charge in terms of simple annual interest. (4) A small group of States requires creditors to give some form of disclosure of the finance charge to debtors in business and commercial loan transactions. Restrictive Covenants 31-14. There are certain minimal requirements 4 that are contained in virtually all financing agreements, which the community businessman should expect to encounter. In addition to these minimal provisions, the financer may desire to include various clauses which restrict the debtor from taking certain actions ("restrictive covenants"). A long-term insurance company loan agreement contains many pages of such covenants. 5 On the other hand, chattel mortgage loans made by finance companies and banks, often in sizeable amounts, may contain no restrictive cov- enants. Each case must be negotiated on its own facts. The debtor should carefully consider the consequences of agreeing to any material restriction. Among the more common restrictive covenants are those relating to: (1) borrowing of funds from others, (2) en- cumbrance, sale, or leasing of the debtor's assets, (3) maximum remuneration of officers and directors, (4) pay- ment of dividends, (5) purchase of fixed assets, (6) main- tenance of certain working capital and net worth figures, (7) making of loans or advances to affiliates or third parties or guaranteeing the obligations thereof, and (8) merger, consolidation, or alteration of the debtor's business. Guaranties, Endorsements, and Comakers 31-15. When the debtor lacks credit strength, the financer may nevertheless be willing to proceed with the financing if another party having the required credit strength is will- ing to add his signature to the debtor's. The additional signature can be in the form of ( 1 ) a comaker of the obligation, (2) endorsement of the debtor's note, or (3) execution of a separate form of guaranty. ,; This avenue of credit support may be of particular value to the new business. For a variety of reasons, those interested in the success of the new business may be persuaded to stand behind all, or even portions, of its credit. A supplier may be willing to guaranty credit to insure himself a buyer for his product; a landlord may wish to help underwrite a lessee; persons or business groups with particular interest in community growth may guaranty debt for this reason. The giving of guaranties can be a business too and there are prices for a guaranty that a new business may be able to afford. For example, a guarantor might be willing to guaranty current debt for some share in future earnings or an option to buy stock at what might prove eventually to be an attractive price. Debt Subordination 31-16. In some cases, particularly those involving closely held corporations, indebtedness may be owing by the debtor corporation to one or more of its officers, directors, or stockholders. To improve its position against such an in- sider, the financer may require that the insider enter into a subordination agreement which provides that in the event of the debtor's insolvency the insider shall not collect any- thing on his claim until the financer has been fully paid. Purchase Money Financing 31-17. As the name implies, "purchase money" financing is financing in which the proceeds are used to enable the debtor to acquire the property which is to be used as the collateral. This can be accomplished through two different routes. First, the financer can loan funds to the debtor for use in purchasing the equipment. In such case the lender will ordinarily require the borrower to authorize the lender in writing to disburse funds directly to the seller of the property. Although the lender under these facts enjoys a purchase money priority status under the Uniform Com- mercial Code, it should be remembered that the transac- tion is a loan. The interest and usury laws are fully appli- cable, corporate procedures and restrictions relating to loans apply, etc. The second route is by means of an installment sale. Here the seller of the equipment permits the debtor to buy the equipment "on time," a suitable down payment usually being made and the balance of the purchase price being paid off in installments. This form of financing is discussed in Section 31-29. REAL ESTATE FINANCING 31-18. Undoubtedly the prime source of financing that relates to the real estate owned by a business is the first mortgage financing that is normally utilized to finance the original acquisition of the property. Among the lowest cost financing available to a business, this form of credit is usually obtained from a bank, an insurance company, or similar institutional lender; it is a unique and specialized field and is covered in another section. 7 Second Mortgage Financing 31-19. The traditional first mortgage loan requires that it be repaid gradually but regularly, usually over the course of many years. Assuming that the loan originally had some reasonable relationship to the then value of the property, partial repayments can be expected to result in constantly increasing amounts of surplus property value in excess of the amount actually required to secure the loan in full. Simultaneously, if the real estate value increases, this sur- plus property value grows even greater. ^ Act of May 29, 1968, PL 9-321. :i Adopted only in Oklahoma and Utah. 4 See Section 31-23. '-> See Section 29. 11 See Section 30. " See Section 29. 177 This surplus value is called the owner's "equity" in the property. In a very real economic sense this equity is a business asset that can be used as a credit base. Basically, it can serve as collateral in two different ways: ( 1 ) Loans may be made directly on the security of this equity, or (2) A security interest in this equity may be given as additional collateral to a credit grantor who is relying primarily on other assets but finds them insufficient. A basic problem in financing this equity, or "second mortgage," financing, is that the interest of the first mort- gage holder must always precede the second mortgage financer. Whatever surplus value, or equity, the latter may have relied upon is always subject to the former being repaid the outstanding balance of his loan from the pro- ceeds of a foreclosure sale. Since this often occurs in a period of business stress, the second mortgage holder may be found to have less equity supporting his position than he had expected. Largely because of this contingent position, rates for second mortgage financing are usually substantially higher than those for first mortgages. Most banks, insurance companies, and other conservative sources of credit will not or cannot by law engage in second mortgage financing. The sources for this type of credit tend more to be the finance companies and other higher risk lenders. If second mortgage financing appears to be a business possibility, certain precautions are desirable at the time the first mortgage is given. First, an "open-end" feature in the first mortgage can create problems in second mortgage financing. An open-end mortgage is one that provides that it not only secures the specific dollar credit extended at the time of its creation but it also secures other advances that the lender (mortgagee) might thereafter make to the borrower (mortgagor). Obviously additional advances under a first mortgage of this type might dissipate any equity relied upon by the second mortgage lender. In addition, the first mortgage should not contain a pro- hibition against subsequent mortgages on the premises. When present in the first mortgage, the placing of a second mortgage on the property is an event of default permitting the first mortgagee to foreclose his interest. While an agree- ment may subsequently be obtained from a first mortgage holder permitting a second mortgage, the absence of such a provision in the first mortgage eliminates the problem. Leasehold Financing 31-20. In its early stages, it is unlikely that a business will have any substantial equity above a first mortgage that may be pledged for additional credit. Furthermore, it may be that the business leases rather than owns its property. In this event the lease itself should be studied and evaluated as a possible base for financing. The interest of a tenant under a lease, just as with the interest of a landowner, can be of value to persons other than the immediate tenant — and thus may be a valuable item of collateral. Many considerations relating to leasehold financing are really applications to this specialized area of the standard principles of mortgage financing. Of primary importance obviously is the value of the location. Here a new business may be in an advantageous position if special considerations that might have been given to it enabled it to obtain a lease of particular desirability. As with other types of real estate financing, the value of the leasehold to a potential creditor will vary with such factors as the neighborhood, the uses to which the premises may be put (under the terms of local zoning ordinances as well as the lease), the availability of alternative space for lease, the term of the lease, renewal options, amount of rent, etc. When financing is extended to a business secured by its various assets, a security interest in its leasehold can have another important function. It can enable the entire busi- ness plant to be liquidated as a package and thereby con- siderably enhance its value to a buyer in a foreclosure proceeding. The legal problems of this form of financing vary de- pending on individual State laws and the legal classification they give to leasehold interests. Of additional significance is whether the lease entitles the tenant to pledge or convey his interest to a secured lender. Since a landlord will cus- tomarily insist upon exercising selectivity over his tenants, the typical lease places restrictions on the power to trans- fer. While a landlord could not reasonably be required to accept any tenant to whom the leasehold estate might be conveyed upon a tenant's default to his lender, a care- fully drawn lease can provide for reasonable latitude here. A new, perhaps undercapitalized business, dependent for its success in substantial measure upon its particular loca- tion may find its lease a significant, albeit unexpected, source of financing. Despite its utility, however, lease financ- ing is generally considered a relatively esoteric form of credit base. It tends to be available, therefore, from the finance companies and other higher risk and higher rate creditors than from the more institutionalized groups. EQUIPMENT LOANS 31-21. The variety of equipment used as collateral for business loans is virtually without limit. So long as the lender can get a valid first lien and he is satisfied as to the value, economic life, and disposability of the equipment, it is of little importance to him whether the collateral is a sprinkler system, a cash register, a jet aircraft, a dentist's drill, store shelving, a concrete mixer, or laundry equip- ment. The lender is relying on the value and ultimate liquidity of the equipment, not on its function. It is important that the provisions of the lease and/ or mortgage be drawn in such a way as to ensure that such assets do not become subject to the landlord's lien or to the mortgagee's lien. Requirements for Closing of Typical Equipment Loan 31-22. In all equipment loans the borrower will be re- quired to execute a security agreement (see Section 31-23) and the lender will file a financing statement or take such other steps as may be necessary to perfect his security in- terest (see below). In addition, the lender will require that certain other steps be taken, and conditions be satis- fied, before he will close the loan. The actual forms naturally do vary in both style and content from lender to lender. A potential lender is rarely reluctant to deliver a copy of his "standard" form for per- usal well in advance of a credit decision. It will then be possible for the borrower to review the form, preferably with the assistance of counsel, to determine the provisions he finds he would like varied. There is nothing sacred about a printed document and most lenders will listen to reasonable requests for alterations. Typical of the conditions which the lender will insist upon compliance with are: (1) Evidence of Borrower's Ownership. To establish that the borrower actually owns the equipment being offered as security, the borrower will be asked to produce evidence of such ownership. The evidence will usually take the form of invoices or bills of sale. (2) Lien Searches. The lender will search in the Uniform Commercial Code filing office to determine if there are any 178 financing statements on file which contain a description of collateral broad enough to cover the equipment being offered to the lender as security. If a conflicting financing statement is found, the lender will require a suitable ter- mination, release, or subordination before he will advance funds. The lender will also search for tax liens, judgment liens, mechanic's liens, and similar encumbrances. (3) Examination of Loan Agreements and Indentures. If the borrower is a party to a loan agreement or inden- ture, counsel for the lender will wish to examine such document to determine whether it contains any restrictions on borrowings by the borrower or the granting of a security interest in the borrower's assets. (4) Landlord's and Mortgagee's Waivers. If the equip- ment may be deemed a fixture under applicable law, the lender will ordinarily require that any person holding a mortgage on the premises to which the equipment is at- tached, and the landlord of the premises if the borrower is a tenant, agree that the lender can repossess and remove the collateral free of all claims by such landlord or mort- gagee. (5) Corporate Action. If the borrower is a corporation, its board of directors will be required to adopt a resolution authorizing the borrowing and the granting of the security interest. If the security interest covers a large part of the borrower's assets, applicable State law may also necessitate the obtaining of a resolution or consent of the borrower's stockholders. (6) Insurance. The lender will ordinarily require the borrower to insure the collateral against such risks and in such amounts and with such insurers as are acceptable to the lender, with suitable endorsement of the policies to protect the lender's interest in the collateral. Form of Security Agreement for Equipment Loan 31-23. Certain minimal provisions are contained in any such security agreement, including those covering: (1) the borrower's obligation to repay, (2) creation of the security interest in the collateral, ( 3 ) rights and obligations of the parties upon default by the borrower, (4) insurance, main- tenance, and care of the collateral, (5) payment of taxes and assessments, (6) risk of loss, and (7) the debtor's rights against any assignee of the lender. There are additional provisions that the lender may seek to include in the security agreement, which the borrower should carefully consider. The lender may require the in- clusion of certain restrictive covenants (these are discussed in Section 31-14). The lender may seek to obtain a security interest not only in the equipment which was bargained for as collateral, but also in other assets of the borrower including future equipment and other assets. Under the Uniform Commer- cial Code, such a "basket lien" (which may be included in the "fine print" of the security agreement) is valid. From the standpoint of the borrower, a basket lien will interfere with the obtaining of future credit, both secured and unsecured, since the holder of such lien has first call on the assets covered thereby, and the borrower should therefore make every attempt to avoid the inclusion of such a basket lien provision. In addition to the security agreement, the borrower will ordinarily be asked to execute a promissory note. Perfection of the Lender's Security Interest 31-24. In all States except Louisiana (which has not adopted the Uniform Commercial Code), the lender will, in the typical equipment loan transaction, file a financing statement against the debtor. The financing statement calls for a description of the collateral which may be either by item (for example, "one IBM Model 360 Computer, Serial No. 355") or by general type (for example, "business equipment"). The borrower should insist that the financing statement list only the items actually being taken as collateral by the lender. If instead a broad description is used, and the bor- rower subsequently requests a different lender to loan funds against items of his business equipment other than those serving as collateral for the first loan, the future lender will probably refuse to advance funds unless he receives a suitable release or subordination of the broad form filing made by the first lender. In the case of certain kinds of collateral, the lender may, in addition to, or in lieu of, the filing of a financing state- ment, take other steps to perfect his security interest. Thus, if the equipment is a motor vehicle which takes a certifi- cate of title, the security interest will be noted on the certificate, and if the equipment is an aircraft or railroad rolling stock, filing will be required with a Federal agency. ACCOUNTS RECEIVABLE FINANCING 31-25. Upon the sale of its product or service, every busi- ness that does not sell on a cash-on-or-before-delivery basis is necessarily in the business of granting credit. A time lag exists between the sale and the payment during which the seller holds its customer's obligation to pay. This time may be short or long. To the business with capi- tal shortages, this payment lag can be a serious problem. The financers of accounts receivable fill this gap by supply- ing funds to businesses immediately upon assignment of the account receivable to the financer. The financer then ob- tains repayment from the funds paid subsequently by the borrower's customers. To the new and undercapitalized business, accounts re- ceivable can be a particularly valuable asset serving as a basis for financing. With perhaps a modest amount of capi- tal and little in the way of land, plant, or equipment, the goods or services actually produced and sold by the busi- ness themselves become the assets available for secured financing. As will be described, the financing arrangement can be agreed upon and fully structured before the sales are made. Then, the new business, its avenues to financing established, can proceed in the manner decided by the business and its new credit sources. This is not to say that the new business will necessarily have the same experience in the capital market as the established enterprise. Funds will always be more readily available to the latter. A knowledge of the function of accounts receivable as collateral can, however, indicate another course the financial planners of the new business should pursue. The accounts receivable suitable for financing are gen- erally unsecured, "open-account" receivables. (The fact that the accounts are unsecured should not be confused with the concept that the accounts themselves represent security for advances to the business by the financing agency.) The amount of funds that the financer will make available to the borrower is based on an agreed-upon percentage of the dollar value of receivables that the financer finds ac- ceptable. There are two basic methods of securing funds based on accounts receivable: "factoring" and "commercial financ- ing." Factoring 31-26. Factoring, or "old line factoring" as it is often called, basically means the outright purchase of accounts 179 receivable by the factor. The factor will generally first check the credit standing of the retail buyer and notify the seller (or "client" as he is called) whether or not he will buy the account. Once an approved account is sold to the factor, the credit risk — the risk that the account might not be paid — is upon the factor. The client has no continuing responsibility beyond his contractual assurances to the factor that a proper sale was in fact made. Upon his acquisition of an account, the factor will generally notify the retail buyer that his obligation has been assigned and is owing to the factor and that payment should be made directly to the factor. This arrangement is known as "noti- fication financing." Depending on the particular relationship between factor and client, the factor may often perform additional serv- ices. He may perform valuable bookkeeping services in- cluding the handling of invoices and the recording of col- lections. Perhaps most important of all, the factor is a professional in the credit business and usually expert in the business of his clients. He can thus usually do a better job in evaluating the credit of his client's customers than the client could do alone. The cost of factoring must be divided between the pay- ment the client makes for the services of the factor (credit checking, etc.) and the charge for the use of money. The former, called the "commission" in finance terminology, is based on the amount of the account purchased and runs between 1 and 2 percent thereof. The remainder of the factor's charge is for the advances actually made to the client and is a true finance charge based on the amount outstanding. The rate of this charge is generally set some- what above the prime bank rate. A possible disadvantage of having the factor collect money directly from the customer is that the factor, who does not have the same interest in retaining the good will of the customer, might use collection techniques that would sour future relationships with the customer. Commercial Financing 31-27. In so-called "commercial financing," the financer does not actually purchase the accounts receivable; rather he lends money on the security of those receivables. Since the client is obligated to repay the loan, the client in es- sence retains the credit risk on the assigned accounts. As contrasted with old-line factoring, the commercial financer normally does not precheck the credit of the retail pur- chasers. The amount of the advance from the financer will be a predetermined percentage of acceptable accounts, typically in the 60- to 90-percent range, subject to some absolute dollar maximum. The commercial financer does not normally notify retail buyers that accounts have been assigned. Payments from the buyers will normally be made to the seller who will establish some method of transfer- ring or accounting for them to the lender. As contrasted with factoring, where true business services are performed for a price by factor for client, the charge made by a commercial financer is entirely interest for the use of money. This charge is generally higher than the portion of the factor's total charge applicable to the use of funds. This is, however, subject to exceptions. An in- dustrial bank may engage in commercial financing at a rate lower than that charged by a small old-line factor operating in a relatively high-risk atmosphere. As a gener- alization, however, the charges a client pays for money are usually less in a factoring situation than in commer- cial financing. Whether a business is available for factoring or must resort to commercial financing depends mainly on the nature of its customers and the type of account receivable they generate. In general, the business for which an LEDC will be of service will not be factored. It is really only businesses, of some proven performance that qualify for factoring. Since the factor undertakes the credit risk, he considers it important to know that a legitimate and satis- factory sale was probably made. If an established manu- facturing business sells to department stores on a regular basis, factoring might be an available device. If sales are typically in small amounts to local neighborhood stores, commercial financing is probably the more practical way to realize on receivables. For a business entity, the factoring form of accounts re- ceivable financing can extend over many years and be- come a permanent element in its financial planning. This is less true of commercial financing, which normally termi- nates after shorter periods. For this reason, the latter is peculiarly suited to the needs of a new business. While it is a relatively high-cost form of financing, the actual amounts outstanding at any time can vary drastically as financed accounts are repaid by the business' customers. Receivables financing is therefore suited to the needs of businesses with uncertain, untested or perhaps rapidly changing needs for funds. A business in a highly cyclical industry might well require money during periods of high sale volume, but be in a very liquid position after payments are made. In both factoring and commercial financing, the amount of money a business may obtain from its factor is flexible. By paying for funds only as it needs them, even the high rates paid by the commercial finance client tend to be compensated for through the utility of the device. Accounts receivable financing is particularly susceptible to participations — a device whereby one financer divides a client with one or more financers. Thus, it may be pos- sible to obtain relatively low bank rates for a portion of an advance in combination with a finance company on the remainder, the net effect of which is to establish a rate to the client somewhere between the rates of the differing financers. This is another area where the services of an LEDC — in locating and intelligently relating the available sources of funds — can be of particular value to the new business enterprise. While the mechanics of accounts receivable financing may appear complex, the financing agencies have succeeded in routinizing this so the process of credit check, retail sale, account assignment, advance, and repayment operate sim- ply and efficiently. Once the basic agreements are executed and the program established, such matters as the amount of advance required at any time can be accomplished with little more than a phone call from client to factor. There are many types of accounts receivable financers. Not only are there organizations that specialize in this, but within the field there are firms that specialize in various specific industries. (The major factoring companies are members of a trade organization called the National Com- mercial Finance Conference, 29 Broadway, New York, N.Y. 10006. It can supply information concerning factors in a particular region.) In addition, many commercial banks and finance companies include accounts receivable financing as one of their financial services. The various advantages and disadvantages of these credit sources have been discussed. It should be added that, in some instances, the financer of accounts receivable requires that a certain percentage collected be held back as a reserve against which will be charged off bad (uncollectible) accounts receivable. The seller usually counts on getting this deposit or reserve at some time, and actually considers it an asset of his busi- 180 ness. Experience shows, however, that several charge-offs are made to such reserves, particularly when the financer is being changed. This is because it is usually only at the end of the relationship that bad accounts receivable are charged off, and other charges are made to the reserve. INTANGIBLES FINANCING 31-28. A business will normally have intangible assets that, while often not even reflected on its balance sheet, form the basis for the success of the venture fully as much as its plant and equipment. Such intangibles as a license; franchise; distributorship agreement from another business or a governmental agency; or a patent, copyright, or special relationship with valuable employees, suppliers, or cus- tomers are only some of the "assets" of a business that may fall into this significant category. To the new business which may have little more than these intangibles, many of them can be of value to other persons and can therefore serve as an important base for obtaining credit. As financing in this area of intangibles has increased considerably in recent years, the laws have generally been modernized to assist this type of financing. However, the intangible asset must be capable of trans- fer to have value to a third party. Insurance policies, stocks, bonds, and other negotiable securities that the business might own are clear examples of intangible assets capable of transfer; so are patents and copyrights. For the transfer of such intangible assets as government licenses to conduct specialized businesses (such as liquor stores or small loan offices), the government agency may have to approve the transferee. Nevertheless, liquor licenses have proven particularly valuable items of collateral, the secured lender usually feeling some assurance that he can locate a satisfactory taker. A combination of intangibles can occasionally be pack- aged to provide a particularly attractive inducement to a potential financer. A major attribute of a new business might be, for example, that a desirable producer has agreed to sell to it and a desirable consumer has agreed to purchase from it. Put back-to-back, these two intangible assets can be of special value to one who is or might be in a similar business. However, the purchase and sale agreements as well as their legal setting must be examined to ensure their transferability. INSTALLMENT PURCHASE OF EQUIPMENT 31-29. An important and traditional method of using the assets of a business as a base for obtaining credit is the original acquisition of those assets by means of a credit transaction with the seller himself. Many well-established sellers of industrial or commercial equipment can offer some arrangement whereby that equipment may be purchased on credit and paid for in installments over an extended time period. In this form of financing the seller will secure his posi- tion as an unpaid seller with a security interest in the goods sold. The buyer can have the use of the equipment; if he defaults in payment to the seller, the seller may then retake the equipment to apply against the unpaid balance. These elements applicable to credit given by a seller to a buyer are similar to those previously discussed as appli- cable to credit from lender to borrower. In the extension of seller credit, a cash down payment is normally required by seller from buyer at the time of the sale. This has the dual function of creating an imme- diate buyer equity in the equipment — thereby increasing his incentive to meet payments — and also bringing the unpaid balance of the debt closer to the probable collateral value of the equipment should it be foreclosed. Basic to an understanding of the secured credit sale is the fact that most sellers themselves finance the obligation they have created through their credit sale. Sellers in gen- eral require cash to conduct their operations and they will usually sell or pledge ("discount" in credit terms) the retail obligation for an agreed amount of cash to some financing agency — usually a bank or finance company — which will hold and collect the paper. As a result, once the sale has been made, any financial problems relating to payment that may arise will usually be between the retail buyer and the financing agency, not the original seller. Although the obligation is discounted subsequent to re- tail sale, the presence of the financing agency will gener- ally be felt as part of the sale negotiations. The agency will normally give the retailer a fairly clear indication of the transactions that may be discounted with it. A retailer may also discount his obligations with several different financers, thereby assuring himself continuing access to the credit market. The retailer will usually know in advance of the sale what charge his financers will require. These rates will differ in the same manner as rates for other forms of financ- ing, depending on such factors as the nature of the financer, the degree of risk he is willing to accept, and the nature of the security, among others. One retailer may discount some obligations with a bank that will accept a lower rate but demand high credit buyers; other obligations of higher risk may go to finance companies that will require com- mensurate return. The terms of the retail obligation are analogous to those of documents evidencing cash loans, previously discussed. One important addition to these is the so-called "waiver-of- defense" clause. Since it is anticipated that the retail obli- gation will be discounted to a financing agency, that agency will usually require that the retail buyer agree that any objections or complaints he may have with respect to the equipment he purchased be kept strictly as disputes be- tween original seller and buyer and not be used by the buyer as a reason for not paying the financer. The buyer could always make an independent claim against his seller that it had purchased defective goods, but, win or lose, payments to the financer would have to continue. How- ever little the purchasing business may care for its effect, it is most unlikely that a retailer would sell on time with- out such a provision in the agreement of sale, since the retailer would not then be able to discount the obligation. About a dozen States have special statutes, generally referred to as Retail Installment Sales Acts, that regulate in various ways sales on time to business enterprises. While these statutes differ in detail, they all regulate the form of the contract of sale and require that the essential at- tributes of the transaction (including such basic items as the cash price of the goods, the finance charge, the total dollar amount that the buyer will be required to pay on time, and the schedule of payments) be disclosed to the retail buyer. Typically they also prescribe certain provi- sions that must be — and others that may not be — in the retail contract. Most also regulate the amount of finance charge that may be levied on the retail buyer. These maxi- mum rates are usually rather liberal; business competition has tended to keep the rates in actual use below the legal ceilings. The discounting of secured time sales serves the purpose for the secured seller that financing accounts receivable does for the unsecured. While the techniques and even 181 the financers available may differ, both are, at bottom, the assignment of customers' obligations by the seller as a method of raising cash. Typically, however, the secured seller discounts on an individual transaction basis while unsecured accounts receivable are handled in the bulk man- ner previously discussed. Secured accounts can be sold to the financer (as in old-line factoring) or assigned as se- curity for loans from financer to retailer (as in commercial financing). The retailer who sells accounts may be asked to guaranty payment on some accounts assigned and not on others. Thus, if the business with which we are con- cerned is one which must sell on time, the portfolio of secured installment paper it creates is also readily avail- able as an asset that can serve as a base for secured financing. INVENTORY FINANCING 31-30. Another business asset often used as collateral is the debtor's inventory. The inventory may consist of "big ticket" items such as automobiles or tractors which are financed or "floor planned" on an item basis, or it may consist of a revolving mass of smaller items such as wear- ing apparel. Prior to the adoption of the Uniform Commercial Code, certain types of inventory financing were restricted in many States by the lack of a simple, effective means whereby the financer could get a valid security interest in the in- ventory. The Code, by providing this means, allows the debtor to effectively use his inventory as a source of funds. By taking the necessary steps under the Code, the financer can obtain a security interest in inventory whether it is on the shelves of the debtor's place of business, in a public- warehouse, in the possession of a common carrier, in a "field warehouse" set up on the debtor's premises for con- trol purposes, or elsewhere. The financing of a revolving mass of small ticket items is often coupled with accounts receivable financing, the accounts springing up to replace the inventory as it is sold. In some cases the accounts are the primary collateral, the inventory serving merely as back-up collateral. Because debtors requiring this type of inventory financing are often not the strongest credit risks, and because of the volatility of inventory collateral and the expenses incurred by the financer in establishing proper controls over, and records of such collateral, the finance charge in such inventory financing is relatively high. As in accounts receivable financing, however, the revolving nature of inventory fi- nancing of this type permits the debtor to keep outstanding (and therefore pay charges on) only such amounts as are actually used by him in his business. In some cases, particularly in connection with certain big ticket items, the financer is compelled, for business reasons, to offer inventory financing at a relatively low rate. For example, a finance company which desires to obtain the profitable retail installment paper being created by an automobile dealer may finance the dealer's inventory at a rate that in itself produces little or no profit. Similarly, a manufacturer may offer its distributors and dealers a low-cost inventory financing program as a tool to stimulate the sale of the goods of the manufacturer. LEASING 31-31. A "net" or "finance" lease is one in which the lessor's sole function is to acquire title to the equipment and lease it to the user. The lessor is merely a money source and often does not even see the equipment since it will normally be shipped directly by the seller to the lessee. The lessor has no continuing obligations with re- spect to the equipment; the lessee must maintain and serv- ice the equipment (or provide for such maintenance), bear all risk of loss, pay all taxes on the equipment, etc. Net or finance leases are often entered into by financial in- stitutions, since such institutions are in the business of advancing funds, not of servicing equipment. A "maintenance" or "operating" lease is one in which the lessor undertakes various duties with respect to the equipment, such as servicing it, training the personnel of the lessee in the use of the equipment, etc. Typically, such leases are offered by the manufacturer or seller of the equipment, although some leasing companies also offer such plans. Another basic distinction is between the "pay-out" and "cancellable" lease. The pay-out lease is one in which the lessee is firmly obligated to pay aggregate rentals in an amount equal to the price paid by the lessor for the equip- ment (plus a finance charge, ordinarily referred to as the "rental differential"). A cancellable lease is one which may be cancelled by the lessee before the purchase price has been recouped by the lessor. The cancellable lease pro- vides the lessee with one of the important advantages of leasing — avoiding the risk of obsolescence. However, the lessee should realize that such avoidance is not achieved without cost to him. Since the lessor assumes the risk of obsolescence, as well as the risk of obtaining another lessee after cancellation by the original lessee, the lessor will naturally take such risks into account in fixing the amount of the rentals. Lease vs. Conditional Sale Contract 31-32. As discussed below, the taxing, accounting, and legal consequences of a true lease are of fundamental import- ance. Not every document entitled "lease," however, can truly qualify as a lease. In many cases the transaction is really a conditional sale dressed up to look like a lease. Any "lease" which permits the "lessee" to purchase the equipment for one dollar or other nominal consideration will be deemed to be a conditional sale contract, not a true lease. Other cases are less clearcut and must be judged on the basis of their own facts. The disclosure and regulatory requirements discussed in Section 31-13 in connection with installment purchases do not apply to true leases. Nor is a lease subject to the filing requirements of the Uniform Commercial Code. This as- sumes that the lease is a true lease; if it is a conditional sale contract it will be treated as one for all purposes- Accounting Practice 31-33. Since leased equipment is not owned by the lessee, he cannot depreciate it as he would in a conditional sale transaction, but the rentals can be deducted as an expense in the lessee's profit and loss statement. The expensing of the rentals is probably the most important reason that leas- ing is chosen over alternate means of financing. Leased equipment does not appear on the lessee's balance sheet as an asset, nor is the obligation to pay rent included as a liability. Present accounting practice requires that leases of material importance be described in a footnote to the balance sheet. If the transaction is a conditional sale, on the other hand, the equipment would be listed as an asset and the balance owing under the contract would be included as a liability. The fact that the obligation to pay rent is not included as a liability is another major reason for the popu- larity of leasing. 182 Investment Tax Credit 31-34. The 7-percent investment tax credit (adopted in 1962, suspended in late 1966, reinstated in June 1967, and again suspended in 1969) provided a major tax incentive during its effective periods for certain leasing transactions. It is not discussed here. The True Cost of Leasing 31-35. The advantages of leasing do not come without cost to the lessee. For example, as mentioned above, a cancell- able lease can be truly desirable, but the lessee will pay for that advantage by increased rental costs. One factor that may be forgotten by a lessee when cal- culating the cost of leasing is the value of the equipment at the end of the lease term. If the equipment is returned to the lessor on expiration of the lease, the lessor has the bene- fit of this residual value. If the lessee has an option to pur- chase the equipment the lessor still gets the residual value, in the form of the option purchase price. This residual value must be added to the total cost of the lease if the lessee is to make a meaningful comparison between the true cost of leasing and the cost of alternate means of financing, such as purchasing the equipment by a conditional sale contract. In each case the lessee must balance the factors men- tioned above, such as the accounting and tax features, value of obtaining maintenance services from the lessor, risk of obsolescence, loss of residual value, etc., in reaching a final conclusion as to the advisability of leasing and the most advantageous form of lease. Sale and Leaseback 31-36. By means of a sale and leaseback, a lessee can free funds tied up in equipment already owned by him. This is accomplished by selling the equipment to another party who pays the purchase price in cash and leases the equipment back to the lessee. The lessee remains in possession of the equipment. If the leaseback is a pure lease, the comments set forth above with respect to leasing are fully applicable (but the parties should consider what impact the transaction may have on any investment tax credit being claimed by the lessee). If the leaseback is a conditional sale, the courts and tax authorities will view the entire transaction as a loan by the "lessee" from the "lessor." It will have to be reflected on the lessee's books as a loan, and will be subject to all of the legal requirements applicable to an equipment loan, such as the interest and usury laws, filing under the Uniform Com- mercial Code, etc. 183 Section 32 USE OF LEASE GUARANTEES NEED FOR LEASE GUARANTEES 1 32-1. Small businessmen often have difficulty in obtaining leases for prime industrial or commercial space. Allegations made in the 1960 report of the Senate Select Committee on Small Business, pertaining specifically to shopping centers, are germane to the problems faced by all small business- men, including retailers, wholesalers, and industrial and commercial tenants. The allegations were as follows: ( 1 ) The lending requirement of life insurance com- panies that a high proportion of the center's tenants have an AAA credit rating discriminates against the entry into shopping centers of independent businessmen in key retail fields. These were identified as the food, drug, variety, shoe, and women's apparel fields of retailing. Before a developer can obtain permanent financing for his center he must allegedly obtain a certain number of long-term leases having fixed minimum guaranteed rentals from major tenants with a top national credit rating. Since only national chains or large departmentalized local retailers are likely to have the one-million dollar net worth necessary to qualify for the top credit rating (AAA-1), in- dependent merchants are denied space in shopping centers. (2) The national credit rating requirement results in the all-too-frequent practice of charging a higher rent to independent retailers than to chain stores in the same retail field. This is allegedly a consequence of the strong bar- gaining position that the credit requirement gives to a na- tional chain organization in dealing with a shopping center developer. The developer must accept a low, often uneco- nomical rent from a prime credit retailer in order to obtain financing on the basis of its signed lease. To offset the low-rent deal with the chain, the developer, in order to make the investment worthwhile, must hike the rent paid by other tenants, particularly the independents. (3) The credit rating requirement forces the inde- pendent businessman, particularly in shoe retailing, to have a manufacturer or supplier cosign his lease for space in a center. This results in a certain loss of independence by the retailer in that he must enter into a gentlemen's agreement to buy his main merchandise requirements from the co- signer. He often must furnish the cosigner a monthly finan- cial statement of his operating condition. (4) The credit rating requirement was alleged to con- tribute toward the growing concentration of retail sales in many lines of merchandising. The life insurance com- panies were accused of arbitrarily excluding independent retailers from suitable locations in shopping centers at a time when the greatest number of new retail store openings in the years ahead appear to be in suburban shopping cen- ters. Hence, the lending policies contribute to increased con- centration of retail sales among a handful of large chain organizations which qualify for shopping center space. The Senate Small Business Committee later recommended that benefits of a lease guarantee program be made im- mediately available to the small business concerns which were in the most urgent need of improved facilities. Beneficiaries of Lease Guarantees 32-2. Lease guarantees provide major benefits for (1) tenants, (2) landlords, and (3) mortgage investors. (1) Tenants. Lease guarantees elevate the credit status of competent small businessmen, thereby enabling them to compete with larger businesses for the more desirable loca- tions and improvements. The additional security provided by lease guarantee insurance should also allow the tenant to lease his premises on more favorable terms, which may include lower rentals. (2) Landlords. Lease guarantee insurance should enable landlords to obtain more favorable mortgage financing from institutional mortgage investors. Since the guarantee pro- vides these investors with additional security, landlords enjoy more latitude in choosing tenants for their rentable space. A competent small business tenant fortified with a lease guarantee may be more acceptable to a mortgage lender than a larger tenant without such a guarantee. (3) Mortgage Investors. The coverage provided by a lease guarantee policy should enable financial institutions to make more favorable mortgage commitments to their customers while increasing their loan security at the same time. The program should make it possible for lenders to guarantee the receipt of rental income in an amount at least equal to the required mortgage payments. SBA LEASE GUARANTEE PROGRAM 32-3. The Congressional authorization and mandate for a lease guarantee program is Title IV of the Small Business Investment Act of 1958.- Provision for the SBA lease guar- antee program was added to the Housing and Urban De- velopment Act of 1965. The initial capital fund for the pro- gram was established at $5 million; eligibility was limited to small firms displaced by urban renewal and qualifying under the Economic Opportunity Act of 1964. In providing for the tease guarantee program, Congress set out the following restrictions and limitations on SBA's authority to issue guarantees: (1) SBA shall, to the greatest extent practicable, ex- ercise the powers in cooperation with qualified surety or other companies on a participation basis. (2) SBA shall guarantee a lease only when no guar- antee meeting the requirements of the small business appli- cant is otherwise available on reasonable terms. (3) To obtain an SBA lease guarantee a reasonable expectation must exist that the small business concern on 1 For information used at various points in this discussion, the author has relied upon John R. Foster's Federal Lease Guarantees and the U. of South Carolina, pub. No. 7, June 1968, and Lease Guarantee, 2nd edition. Small Business Administration. -• 15 U.S.C. 692-694, effective August 10, 1965. 184 >ehalf of which the lease guarantee is issued will fulfill the :ovenants and conditions of the lease. On October 11, 1967, Congress amended the eligibility equirements for lease guarantee insurance to include all mall business concerns. > articipation by Private Insurance Companies 12-4. One purpose of the lease guarantee legislation was o encourage private insurance companies to develop their >wn lease guarantee insurance programs without direct in- 'olvement by the Federal Government. The enabling legis- ation provided that SBA ". . . shall, to the greatest extent practicable, exercise the power ... in cooperation with lualified surety or other companies on a participation jasis." In complying with this provision, SBA is continu- dly seeking participation by as many private insurance :ompanies as possible. To encourage such participation, 5BA reinsures a large portion of the risk underwritten by Jiese companies. Government reinsurance is established as the result of a Participation Agreement between the participating private nsurance companies and SBA.' Under terms of the agree- ments, the private companies are responsible for paying 100 percent of claims and losses evolving from a guar- anteed lease up to an amount equal to 6 or 12 months of guaranteed rent. Subsequent losses are shared 80 percent by SBA and 20 percent by the participating company. Where private carriers are involved, the companies them- selves are responsible for the entire administration of their programs, from initial processing of applications to pay- ment of claims. 4 If participation with a private company is not available in a given case, SBA may itself guarantee the full amount of the rent payable under the lease. However, a tenant- applicant for a direct guarantee from SBA must certify that a guarantee meeting its requirements is not available on reasonable terms from qualified private insurance com- panies. Furthermore, in the application the tenant-applicant must recite any attempts to obtain a guarantee from private sources. 5 These safeguards are employed to prevent Federal competition with private business. ELIGIBILITY OF TENANTS 32-5. Any business that qualifies as small under Section 121.3-10 or Section 121.3-11 of Title 13 of the Code of Federal Regulations is eligible to apply for a lease guaran- tee from SBA or from a private insurance company par- ticipating with SBA. The practical effect of the SBA regulatory definition of a small business is to make any concern eligible for lease guarantee if it is eligible for financial assistance from SBA, from a small business investment company, or from a State or local development company. In addition, some private insurance carriers consider applications for lease guarantee insurance from businesses too large to qualify as small business concerns, even though the carriers are not able to reinsure these larger risks with SBA. For the purpose of receiving financial assistance from small business investment companies or development com- panies, Section 121.3-11 provides that a small business con- cern is one which, together with its affiliates: (1) Is independently owned and operated; (2) is not dominant in its field of operations; (3) does not have assets exceeding $5 million; (4) does not have net worth in excess of $2V2 million; and (5) does not have an average net income, after Fed- eral taxes, for the preceding 2 years in excess of $250,000 (average net income to be computed without benefit of any carry-over loss). If the applicant fails to qualify with (3), (4), or (5) above, it may be possible for the applicant to qualify under Section 121.3—10. This section provides the standards of eligibility for financial assistance directly from SBA. No change has occurred in Section 121.3-11 since implementa- tion of the Small Business Investment Act of 1958. How- ever, the standards under Section 121.3—10 are quite lengthy and undergo frequent change. Consequently, any generalization regarding size standards for financial assistance from SBA is per se unstable. Dif- ferent standards exist for industries classified as wholesale, retail, service, manufacturing, or transportation, and recent changes increased the annual sales size standards to $15 million for some wholesalers and to $5 million for some retailers. For manufacturers, the number of employees is the determining factor. The landlord's size or primary business has no bearing on the tenant's eligibility and it is of no consequence that the incidental or even primary benefits of the insurance will accrue to the landlord. Landlord-Tenant Relationship 32-6. For a lease to exist, there must be a real landlord- tenant relationship. To ascertain that the lease is a two- party transaction, SBA's usual rules for determining affilia- tion are applied to the facts as they exist when the applica- tion or inquiry is received. Every business is considered as having one or more parties who directly or indirectly con- trol or have power to control it. Control may be affirma- tive or negative and it is immaterial whether it is exercised so long as the power to control exists (Section 121.3— 14(c), Chapter I, Title 13, CFR). A landlord would have power to control a tenant if he owned 50 percent of the voting stock of the tenant or if he owned a percentage considered large in comparison to any other outstanding block of voting stock of the tenant. Also, the by-laws of a corporation may permit a stock- holder with less than 50 percent of the voting stock to block any actions proposed by the other stockholders. Section 121.3-14 governs not only SBA's determination of whether a landlord-tenant relationship can exist between two parties, but also whether a stranger to the lease trans- action is affiliated with the proposed small business tenant. If such affiliation exists, the volume or size of the third con- cern is added to the size of the proposed tenant in order to determine whether the tenant is a small business by SBA's size standards and eligible for a lease guarantee. If either the landlord or a big business controls or has the power to control the proposed tenant, an application cannot be considered because in the first instance a true lease does not exist and in the second instance the tenant would be ineligible by reason of size. Qualifications for Determining Specific Tenant Eligibility-Risk Rating System 32-7. A lease guarantee will not transform a bad tenant into a good one, or convert a regional shopping center doomed to failure into a financial success. A risk rating system developed by SBA enables SBA and participating insurance 3 For a current list of private insurance companies that have entered into participation agreements with SBA, contact Director of Lease Guarantees, Small Business Administration, Washington, D.C. 20416. 4 LEDCs may seek to encourage the issuance of private company guarantees for particular tenants by agreeing to the assumption of insurance company's risk for 1 out of 3 dollars of losses which might be incurred. 5 See application form in Appendix 32-A. 185 carriers to determine whether there is a reasonable ex- pectation that a small business will perform the covenants and conditions of its lease. The system is designed to grade the entire lease transaction to determine if it is an acceptable risk. The major sources of risk are grouped and evaluated as follows: (1) Ability and experience of the tenant's manage- ment: Management attributes are very difficult to evaluate quantitatively. Quality of experience in a similar business; personal attributes; merchandising, marketing, and admin- istrative abilities; and pricing practices are some of the features rated by SBA and /or the insurance carrier. (2) Financial position or structure of the organiza- tion represented by the lessee: Two basic considerations in rating the tenant's financial strength are past profitability and financial position (solvency). Profitability is judged by the tenant's operating history and projection of future busi- ness. Degree of solvency is determined by examining four main aspects of the tenant's balance sheet: working capital, capitalization, cash position, and debt position. In evaluating financial status, the financial specialists of both SBA and participating private insurance companies use ratios, trend analyses, and other analytical tools available to them. Out- side credit ratings, sources of funds, and external com- parisons with other businesses of the same type and size are also reviewed. (3) Viability of the location of premises being rented: Retail, wholesale, manufacturing, and service businesses each present different factors for consideration when evalu- ating the location of a business. Among the factors reviewed in analyzing trade potential are the building improvements; level and trend of incomes, rents, and occupancies in the area; adequacy of access facilities; competitive strength of the site; and alternative uses for which the premises are suitable. (4) Appropriateness of the terms of the proposed lease: The appropriateness of the business to its location, the availability of funds during the period of establishment, conformity of the tenant io the typical businesses in the area, and the rent for the premises compared with the level and trend in the trade area are some of the other factors considered by SBA and the insurance carriers in evaluating the lease for insurance purposes. TERMS OF PROGRAM 32-8. The terms under which a loan guarantee may be granted have been developed along the following lines. (1) Amount of Insurance. SBA has not set a limit on the amount of lease guarantee insurance it will provide in a particular case. However, one of the participating private insurance companies has insured fixed periodic rental in- stallments exceeding $l'/i million. (2) Policy Period. The maximum term of a lease guarantee policy in which SBA can participate is the term of the lease or 20 years, whichever is shorter. The minimum SBA term is 5 years. However, at present the maximum term of a lease guarantee offered by one of the major partici- pating private insurance carriers is 15 years. (3) Commitment Premium. There is no commitment premium if an application for lease guarantee is submitted directly to SBA. However, as indicated earlier, an applica- tion cannot be submitted directly to SBA unless the appli- cant has made efforts to secure the insurance from a par- ticipating private insurance company. SBA has authorized private insurance companies to impost a commitment pre- mium upon an applicant for a lease guarantee. At present the commitment premium charged by participating insur- ance companies is $100, payable at the time of acceptance of the application for processing. (4) Policy Premium. The policy premium due for lease guarantee insurance is a single premium for the entire policy period. There are no renewal premiums due. The policy cannot be cancelled by either the landlord or tenant, and no part of the premium paid is refundable. The dollar amount of the premium is determined by multiplying the total aggregate guaranteed rental during the policy period by an appropriate percentage. The percentages indicated below are those established as maximum by SBA. At least one of the participating private companies employs smaller percentages for shorter term policies. Premium as a percentage of total guaranteed rental Policy period'"' (in years): (percent) 5 6.5 6 5.9 7 5.3 8 4.8 9 4.4 10 4.0 11 3.7 12 3.4 13 3.1 14 2.9 15 2.8 16 2.6 17 2.4 18 2.3 19 2.2 20 2.1 (5) Three-Month Escrow Requirement or Deductible Pro- vision. To minimize the financial risk assumed under a guaranteed lease, SBA requires that an escrow account equal to 3 monthly installments be established with the insurer to assure payment of rentals for which the tenant is in default. The regulations provide that the lessee shall ". . . Pay an amount not to exceed one-fourth of the aver- age minimum guaranteed annual rental required under the lease, which amount shall be held by the Administrator or, in the case of participation, by the participant in an escrow interest-bearing account and shall be available (1) for forfeiture to the guarantor for application on rental charges accruing in any month in which the lessee is in default; or (2) if no default occurs during the term of the lease, for application (with simple interest accrued at the rate of 4 percent per annum) toward payments of final rental charges under the lease. . . ." During the past year, many existing and potential appli- cants for lease guarantee insurance indicated that this escrow requirement sometimes imposed an additional capi- tal burden on the tenant which added to his difficulties in relocating an existing business or starting a new one. Con- sequently, SBA amended the lease guarantee regulation on March 18, 1969. The amendment provided that in lieu of a 3-month escrow requirement by the lessee, "...The lessor shall agree that one-fourth of the average minimum guaranteed annual rental required under the lease shall be borne by the lessor as co-insurance." In other words, a 3-month deductible provision has been incorporated into the lease guarantee program as an alternative. (6) Increased Lease Guarantee Coverage to the Landlord Due to Increased Real Property Taxes. In an effort to make the lease guarantee policy more attractive to landlords, the 11 This period is not necessarily the same as the lease term since an application for guarantee may be submitted on only a portion of the lease term. 186 policy provides that the amount of the lease guarantee policy may be increased as real estate taxes on the demised premises are increased. The policy provides as follows: "If the lease of the premises provides for, and the lessee incurs, after the inception of this policy, a rental in- crease by reason of additional real property taxes levied or assessed against the land and buildings of which the demised premises form a part, then the lessor may increase the guaranteed aggregate rental provided for by this policy in an amount equal to the sum of the rental installment increases during the remainder of the policy period or for so long as such increases remain in effect. This increased coverage may be obtained for the benefit of the lessor upon the submission to the Company of a single premium on said amount computed at the current prevailing premium rate, along with written evidence of the tax increase. Upon receipt of these submissions, the Company shall evidence the increase in the aggregate amount of guaranteed rental by endorsing the policy accordingly." (7) Assignment of Lease Guarantee Policy by Landlord. Another significant feature of the lease guarantee policy is that it does not hinder the negotiability of the property itself. In the event of sale of the demised premises by the insured landlord, coverage provided by the policy accrues to the new owner, provided that he abides by the conditions of said policy. Procedure for Coverage 32-9. The SBA application for insurance and the applica- tion forms used by participating private insurance com- panies are almost identical. 7 The application is divided into two distinct parts. Part I is completed by the tenant. It requires the submis- sion of information on the type and ownership of the busi- ness, its capital structure, and the management qualifications of its operators. It is accompanied by the tenant's financial statements and by a resume of the history and background of the business, including information on its products, area of distribution, competitive ranking, and the responsibilities of its owners and operators. Part II is completed by the landlord. It requires informa- tion about the leased premises and their location. A copy of the lease, an appraisal of the fair rental value of the premises, a description of the furnishings and equipment to be installed on the premises by the landlord, and a cur- rent commercial credit report on the prospective tenant must accompany Part II. A supply of applications forms is avail- able upon request from SBA or any of the participating private insurance companies. If an application qualifies for a lease guarantee policy a commitment to insure is issued by SBA or by the private insurance company that received the application. A policy of lease guarantee insurance is issued to both the landlord and tenant when an executed copy of the commitment has been returned along with the insurance premium, when the tenant has taken occupancy of the premises, and when any special conditions in the commit- ment have been complied with. BIBLIOGRAPHY 32-10. "Description of Collateral in a Financing Statement — Should It Be Required?" 4 U.L. Rev. 205. Fall 1969. "Implied Warranties of Quality Protection in Chattel Leases," 1969 [/. /;/. L. Forum 115. "Insurance Investment Restrictions," 190 N.Y. Laws 1969. "Mortgage Banking Process and Single Family Residence Loans," 7 Houston L.R. 70. September 1969. "The Investment Credit: Act Five Repealed," 48 Taxes 144. March 1970. "White Help for Black Business," Harvard Business Review, May- June 1970. 1 The lease guarantee application by lessor-landlord appears in Appendix 32-B. 187 APPENDIXES 189 Appendix 2— A SAMPLE LOAN AGREEMENT BETWEEN AN LEDC AND A SPONSORED BUSINESS LOAN AGREEMENT 1 AGREEMENT dated this [ ] day of [ ] be- tween [John Doe], who resides at [ ], [the XYZ Corpo- ration], a [ ] business corporation whose principal office is at [ ], (the "Corporation"), and [the Local Economic Development Company], a [ ] member- ship corporation ("LEDC"). LEDC, consistent with the purposes for which it was formed, is willing to extend credit in the amount of [$20,000] to the Corporation, provided that [John Doe] and the Corporation will agree to certain covenants. [John Doe] is the sole holder at this time of capital stock of the Corporation and is therefore the only shareholder of the Corporation entitled to vote for the election of Directors thereof. In consideration of the agreement of LEDC to extend such credit, the parties agree as follows: 1. [John Doe] agrees that so long as he shall remain a holder of any shares of the [Class A Voting Stock] of the Corporation, he will vote such shares in favor of the elec- tion of a nominee of LEDC as a Director of the Corpora- tion; provided, however, that such obligation shall termi- nate from and after such date as LEDC ceases to be either a creditor of the Corporation or a guarantor of the pay- ment of any other indebtedness of the Corporation. It is the intent of this paragraph, and [John Doe] agrees to abide by such intent, that during the period of time re- ferred to above a nominee of LEDC shall always be repre- sented as a Director of the Corporation. At such time as LEDC shall cease to be either a creditor of the Corporation or a guarantor of payment of any other indebtedness of the Corporation, it shall cause its nominee Director to submit to the Corporation his written resignation as such if [John Doe] so requires. 2. LEDC, having this date been issued one share each of the [Class A Voting Stock] and [Class B Non-Voting Stock] of the Corporation, agrees that it will not transfer, assign, sell, pledge, hypothecate, or otherwise dispose of such stock (the "LEDC Stock"), or certificates representing the same, unless such shares shall have been first offered to the Corporation at a price per share of $1.00. Such offer shall be made in writing and remain standing for a period of 90 days. 3. [John Doe] agrees that he will not transfer, assign, sell, pledge, hypothecate, or otherwise dispose of any [Class A Voting Stock] owned by him or any other shares of vot- ing stock of the Corporation acquired by him (the ["John Doe A Stock"]), or the certificates representing the same, except as follows: (a) [John Doe] or his legal representatives may offer and sell all or part of the [John Doe A Stock] to such per- sons as may be approved in writing by LEDC (which ap- proval shall not be unreasonably withheld or delayed), at a price per share, payable in full in cash at the time of trans- fer, mutually acceptable to the sellers and the buyers; pro- vided, however, that the approval of LEDC shall not be a prerequisite to the transfer by [John Doe] of [John Doe A Stock] from time to time involving, in the aggregate, less than that number of such shares which would result in [John Doe] no longer holding at least 51 percent of the A Stock. (b) In the event that (i) [John Doe] indicates' to LEDC his intention of disposing of all or part of the [John Doe A Stock] under circumstances giving to LEDC a right of approval of any such disposition; or (ii) [John Doe] leaves the employ of the Corporation; or (iii) [John Doe] dies; LEDC may, within 30 days after receipt of notice of any such event, give [John Doe] written notice of its inten- tion to purchase all of the [John Doe A Stock], and if all of such Stock is not transferred to approved parties pursuant to paragraph 3(a) hereof within 30 days after LEDC gives such notice, then such Stock (or the part thereof still retained by [John Doe]) shall be offered to LEDC at a price per share to be computed on the basis of the value hereinafter provided. The offer to LEDC shall cover all of the [John Doe A Stock] not transferred pursuant to para- graph 3(a) hereof as at the time the offer is accepted, and such offer shall be irrevocable for 30 days unless [John Doe] continues to be employed by the Corporation and notifies LEDC that he no longer desires to dispose of such [A Stock]; (c) If LEDC fails to purchase all or part of the [John Doe A Stock] under the conditions and within the time periods set forth in paragraph 3(b) hereof, then the Corporation (i) shall purchase such shares in the case of [John Doe's] death, or (ii) may purchase such shares if [John Doe] is living, provided in either case that it has available legally sufficient surplus so to do. The Corpora- tion shall have 30 days from the date on which LEDC's rights under paragraph 3(b) expire within which to pur- chase such shares at a price to be computed on the basis of the value hereinafter provided in paragraph 5, as revised from time to time as therein provided. The Corporation's right or obligation hereunder shall extend to all of the [John Doe A Stock] not transferred pursuant to paragraph 3(a) hereof as at the time of the Corporation's purchase; (d) In the event that LEDC and the Corporation fail to purchase [John Doe A Stock] within the time limits provided in paragraph 3(b) and 3(c) hereof, then, in addi- tion to the remedies set forth in paragraph 8 hereof, [John Doe] or his representatives shall be free to sell or dispose of the [John Doe A Stock] and such shares shall be free, transferrable, and no longer subject to the provisions and limitations of this Agreement. The provisions of paragraphs 3 and 4 hereof shall not bar a transfer, assignment, bequest, or sale of shares by [John Doe] to his spouse or adult (21 or over) child or children, or the inheritance of such shares by any such persons other than by bequest, which persons shall take with them the right to retain such shares subject, however, to all (he limitations of this Agreement, as if he or she were individually, and as a group (for purposes of the 51 percent test referred to in paragraph 3(a) hereof), a party hereto. So long as 50 percent or more of the [A Stock] is held by a person or persons other than [John Doe], al such persons other than [John Doe] shall, during such • Based on a loan agreement used by the Rochester Business Op- portunities Corporation. 190 period, vote such [A Stock], at any and all meetings of shareholders of the Corporation only for such directors of the Corporation as may be nominated by LEDC. 4. [John Doe] agrees that upon his death, or upon the death of any person who holds [John Doe A Stock] sub- ject to the terms of this Agreement, the executors, adminis- trators, or legal representatives of the deceased shall sell to approved parties pursuant to paragraph 3(a), or to LEDC or to the Corporation, all the [John Doe A Stock] owned by said person, all in accordance with the applicable provisions of paragraph 3 hereof. The price per share payable in any such event shall be computed on the basis of the value hereinafter provided in paragraph 5 as revised from time to time as therein provided. 5. The parties hereto agree that, for the purposes of paragraphs 3 and 4 hereof, each share of the [Class A Voting Stock] of the Corporation shall have a value per share to be computed in accordance with the following formula: The greatest of the following: (i) [$5.00] per share; or (ii) The assets and liabilities of the Corporation as of the end of the calendar month immediately preceding the event giving rise to a right or obligation to purchase [Class A Voting Stock] shall be determined. The cash sur- render value of life insurance policies held by the Corpora- tion shall be included, but goodwill shall be excluded. The liabilities of the Corporation as at such date shall be sub- tracted from the assets. From the net assets shall be de- ducted the par value of any preferred stock plus accrued divi- dends thereon, if any, and the remainder shall be divided by the number of common shares of every class issued and out- standing to arrive at a value per common share; or (iii) The net operating profit after taxes but before dividends per outstanding share of common stock of all classes of the Corporation (excluding nonrecurring gains or losses) for the fiscal year of the Corporation immedi- ately preceding the event giving rise to a right or obliga- tion to purchase [Class A Voting Stock] shall be deter- mined. The resultant sum shall be multiplied by 4 to de- termine the value per share. (iv) In the event that the common stock of the Corporation is publicly traded, the value per share shall be its current market price, that is to say: the Closing price of a share of such stock on the relevant date, de- termined on the basis of the last reported sale price regular way of such stock on the New York Stock Exchange (or on such other exchange upon which such stock is listed) or, if there is no such reported sale on the day in question, on the basis of the average of the Closing bid and asked quotations on such exchange, or, if such stock is not listed on any exchange, on the basis of the average of the bid and asked quotations on the over-the-counter market. Such determinations shall be made by the independent certified public accountants of the Corporation at the direc- tion and expense of the Corporation, and such determina- tions shall be final. In the event that there shall be no independent certified public accountants retained by the Corporation at the time, such determinations shall be made by the Board of Directors of the Corporation with the advice of a firm of independent certified public accountants of recognized standing, and such determinations shall be final. They shall in each case be made in accordance with generally accepted accounting principles applied on a basis consistent with prior periods. 6. Each certificate representing LEDC Stock, and each certificate representing [John Doe A Stock], shall bear the following legend, which shall be noted thereon conspicu- ously: "Transfer or pledge of the shares represented by this certificate is restricted under an Agreement dated [ ], 19[ ], among [John Doe], [XYZ Corporation], and [LEDC]. A copy of such Agreement which affects also other rights of the holder of these shares is on file at the principal office of the Corporation." 7. The provisions of paragraphs 3 and 4 shall termi- nate and become null and void on the date on which LEDC ceases to be either a creditor of the Corporation or a guarantor of payment of any other indebtedness of the Corporation. 8. Should at any time any dispute arise between any one or more of the parties hereto with respect to his or their rights, obligations or duties, or the requirements, under or by virtue of the provisions of this Agreement, except as to the valuation of shares, said dispute shall be referred to, and consent and approval of each of the parties hereto is expressly given to refer said dispute for determina- tion to, the American Arbitration Association, whose de- termination and/or decision pursuant to its rules shall be final and binding on the parties hereto, and there shall be no appeal from said decision. 9. The corporation is authorized to enter into this Agreement by virtue of a resolution adopted at a meeting of the Board of Directors held on [ ], 19[ ]. 10. The terms ["Class A Voting Stock" and "Class B Non-Voting Stock"] of the Corporation, as used herein, shall be deemed to refer to all such shares of the Cor- poration as they exist at the time of execution of this Agreement, any shares hereafter issued in exchange there- for by way of reclassification of shares, merger, consolida- tion, reorganization, recapitalization, or otherwise, and any additional shares of capital stock of the Corporation issued to or acquired by the respective parties by reason of stock splits, stock dividends, other share distributions, or increase in the outstanding shares, or purchase or other- wise. 11. All notices and offers required to be made under the terms of this Agreement shall be in writing and shall be forwarded to the appropriate party (including the per- sonal representative or representatives of any offering party) by registered mail; they shall be addressed to [John Doe] at his residence, to the Corporation at its principal office, to LEDC at [ ], and to the personal representative or representatives of any offering party at their respective residences. The mailing of any notice of offer or the ac- ceptance or rejection of same shall be deemed the effective date of such notice of offer or acceptance or rejection. 12. This Agreement shall be binding upon and shall inure to the benefit of the parties hereto and their legal successors, the latter being deemed to include without limitation all executors, administrators, receivers, commit- tees, other personal representatives; transferees of interest pursuant hereto; and other legal successors or assigns. 13. This Agreement may be terminated by unanimous written consent among the parties hereto. IN WITNESS WHEREOF, [John Doe] has signed this Agreement and the other parties hereto have caused this Agreement to be executed by their duly authorized officers, all as of the day and year first above written. [XYZ Corporation] By: [ ] [John Doe] Its [ ] [Local Economic Development Company] By: [ ] Its [ ] 191 Appendix 4— A VOLUNTEER CONSULTANT REGISTRATION FORM The information on this form will be used to match volunteer consultants with minority group entrepreneurs in need of management assistance. Please be as specific and complete as possible. Name: [ ]. Business address and telephone: [ ]. Home address and telephone: [ ]. Occupation and job title: [ ]. Age: [ ]. Previous training, work experience, or voluntary activity which might be valuable in providing management assist- ance: [ ]. Areas of special skill or interest: (Please list particular areas of expertise, e.g., accounting, production, marketing etc., and/or specific fields of business knowledge, e.g., retail clothing, plastics manufacture, offset printing, etc.) [ ]• Can you meet with clients during business hours? Yes No Can you meet with clients after business hours and/or on weekends? Yes No Comments: [ ]. Appendix 4— B GENERAL INFORMATION AND INSTRUCTIONS FOR THE VOLUNTEER CONSULTANT The following information and instructions have been compiled to assist you in your work as a volunteer con- sultant for minority entrepreneurs. Some of the material may appear obvious or unnecessary to most readers, but has been included on the basis of experience. No effort has been made to include everything the volunteer con- sultant should know, as the wide variety of situations en- countered in the field make this obviously impractical. As a general rule, best results will be obtained if the volunteer thinks of himself as a professional management consultant whose livelihood depends upon the goodwill of the client and the continued prosperity of his business. The full-time staff will attempt to keep you abreast of other work in progress, especially those aspects of each project which might be helpful to other volunteers. Re- current problems, as well as widely applicable solutions, will be announced to the volunteer staff on a periodic basis. Please feel free to make any suggestions which you feel would be helpful. Miiiorily Business Development — The Background [Here the individual advisory program should insert a description of the economic development needs and activi- ties in the particular community.] The Role of the Volunteer Consultant The preceding paragraphs should indicate a number of things to the prospective volunteer consultant: (1) That he is going to have to work at the limits of his capacity and available time to make the slightest progress toward the goal of proportionate representation of minority groups within the American economy. (2) That he may be looked upon with skepticism, suspicion, or even hostility by his prospective client. This situation is particularly likely to prevail in those instances (not infrequent) when a client has already been given the run-around or unrealistic expectations by other organiza- tions, private and public, which have ostensibly been cre- ated to help solve his problems. (3) That the volunteer should never make promises to his client which he cannot keep. The resources available for minority business development, including those of this organization, are much too limited to permit anything but a skeptical attitude toward the ultimate success of any given deal. The volunteer should be particularly careful not to assume that the business practices with which he is familiar will be available to his client. The volunteer's enthusiasm for the merits of a project on which he has worked is un- likely to be shared by the loan officer at a bank or the Small Business Administration. (4) That the volunteer must be absolutely reliable in meeting his personal commitments to the client. Appoint- ments must be kept, telephone calls returned, research completed, and forms filled out as promised by the volun- teer. If the volunteer cannot perform a needed service within the time required, he should say so at the outset, or seek assistance from another source. If, at any point, it is decided that a given deal merits no further effort on the part of the volunteer or this organization, it should be terminated quickly rather than allowed to die of in- attention. Nothing is more damaging to the overall pro- gram than the development of a reputation for unreliability or lack of follow-through. Additional Volunteer Procedures In addition to the items outlined above, there are further points which the volunteer consultant should bear in mind: (1) It is generally best to meet the prospective client, especially on the first contact, at his place of business, if already established. On-site inspection of the business (or the proposed location) is usually essential to a realistic appraisal of the client's situation. If the client is not yet in business, meet him at a location of his suggestion rather than at your office. In no instance should the client feel 192 hat he must "go downtown to meet the man" in order o receive assistance. (2) Do get as much information about your client is you can. The success or failure of most small businesses s primarily a function of managerial ability. Since the :lient's formal managerial skills are likely to be limited, ry to get some reading of such personal characteristics is willingness to work hard, capacity for realistic appraisal >f problems and solutions, ability to deal with people, etc. Jince many small businessmen have more experience in >roduction or retail sales than in overall management, ry to find out how much the client knows about such idministrative procedures as financial control, cost analysis, nventory control, etc. The objective is to equip the client vith those skills which are essential to his business, or o help him understand his need for such knowledge. The 'olunteer should avoid the two extremes of trying to edu- ;ate a client who is totally without basic business sense ind, on the other hand, of trying to impose upon a small :ntrepreneur the sophisticated procedures familiar to a professor of business admministration. (3) The volunteer consultant should not do all the ■vork involved in preparing a client's loan application, even f the volunteer feels that doing it himself will produce greater speed, accuracy, or personal satisfaction. The client should be given an opportunity to demonstrate his skill, determination, resourcefulness, and reliability. Further, if the volunteer undertakes to do all the preliminary work, the client may conceivably find himself going into business with little understanding of the financial, production, or sales requirements which are critical to his success. On the other hand, the volunteer should carefully double- check important figures, documents, and oral statements presented by the client. In an effort to convince the volun- teer or himself of the viability of his project, the client may (intentionally or unintentionally) overestimate sales, underestimate costs, oversimplify production problems, or otherwise obscure the risks involved. Insofar as possible, the volunteer should seek to assess accurately all the factors which will contribute to the client's success or failure and to make sure the client fully understands the implications of each factor. (4) It is often helpful and sometimes essential, when attempting to put together a deal, to seek the advice and counsel of someone with extensive experience in the busi- ness under consideration. Individual executives are generally good, but hard to find. The full-time staff will try to help you find a suitable individual. Appendix 4— C CHECKLIST FOR PRELIMINARY INTERVIEW: INFORMATION REQUIRED Date obtained Promised by 1) 2) Personal resume Personal financial statement 3) 4) Business financial statements and/or projections: a. Balance sheet b. Profit and loss statement c. Projections Business tax returns 5) Descriptions of (proposed) company and purpose of loan nstructions Remind the applicant that the information requested will )e required by the loan officers of banks and/or the SBA. Be careful to find out whether any of the information provided by the applicant is of a particularly confidential nature. Are there any restrictions on corroborating informa- tion with his employer, creditors, suppliers, customers, etc.? Item 3a and 3b should be no older than 60 days and should include the past 2 fiscal years. Projections should extend for 2 years. Discuss the general outlines of the applicant's proposal before going through the collection of complete data. Make sure the applicant understands, as specifically as possible, the obligations assumed in accepting a loan or other finan- cial assistance. Do not waste your time or the applicant's if, for some reason, his proposal appears clearly unsuitable for available types of assistance. Much of this data may be obtained or requested by telephone prior to the volunteer consultant's first meeting with the client. \ppendix 4— D DECRIPTION OF COMPANY AND PURPOSE OF LOAN to: -rom: It: (1) (2) (3) Investment Review Committee [Name of volunteer consultant] [Name of company and /or entrepreneur] Ownership and management: [ ]. Product or service: [ ]. Sales, costs, and profits: [ ]. (4) Employees, job descriptions, and wage scales: [ ]• (5) Physical size and location of plant: [ ]. (6) Proposed job creation: [ ]. (7) Capital requirements: [ ]. (8) General comments and plan of action: [ ]. 193 Instructions This form is intended primarily as a guide; please follow the suggested format when using a separate sheet of paper. Please do not fail to fill out this form in cases when a pro- posed venture is declined by the volunteer after the first meeting, as it will then be used as a termination report. In the event that you do not have the time or facilities to fill out this report yourself, your comments may be dictated by telephone to the office staff. Please file a report on each (proposed) business as soon as possible. This will enable the office staff to keep track of all assignments and to offer any information or assistance which might be relevant to a particular case. Exhaustive detail is not necessary. Give only as much information as will, in your opinion, adequately describe the key elements of the applicant's proposal to someone who is not familiar with it on a first-hand basis. Try to be fairly specific on Items (6) and (7). How many jobs will be created, by category? What are the proposed wage rates, including incremental increases? What is the training period, if any? What, specifically, will the required capital be used for, i.e., machinery and equipment, supplies and materials, salaries and wages, working capital, con- solidation of existing debt, etc.? As accurately as possible, break down total capital requirements into general line items. Give general description of type of financial assistance required, including desired terms. Be sure to indicate how much equity capital will be supplied by the applicant himself. Item (8) is for your overall analysis of the feasibility of the applicant's proposal and any other comments which you may wish to make. Please be sure to indicate what further steps are required, by yourself as well as by the applicant, to bring the applicant's proposal to the final stages. Give target dates, if possible. NOTE: Be sure to indicate whether applicant has at- tempted to secure financial assistance on this particular pro- posal from some other source or through some other agency. If he has previously been refused financial assistance, obtain details, name of bank, company, or public agency, and name of person dealt with. Get name and address of any other organization with which this proposal is concurrently pending. Appendix 5— A CERTIFICATE OF INCORPORATION OF [LOCAL ECONOMIC DEVELOPMENT COMPANY] Pursuant to the Membership 'Corporations Law of the State of New York WE, THE UNDERSIGNED, for the purpose of forming a membership corporation pursuant to the Membership Corporations Law of the State of New York, hereby certify: ( 1 ) The name of the proposed Corporation is [name of Local Economic Development Company]. (2) The purposes for which it is formed are: (a) To lessen neighborhood tensions, eliminate prejudice and discrimination, and combat community deterioration by expanding the opportunities available to members of underprivileged groups to own, manage, and operate business enterprises; to further the development of locally-owned or operated business enterprises in economi- cally underprivileged or depressed areas; to voluntarily assist members of underprivileged groups in developing the entre- preneurial and management skills needed for successful operation of business enterprises; and to voluntarily assist members of underprivileged groups in obtaining adequate financial support for the successful operation of business enterprises. (b) To voluntarily aid, support, and assist by gifts, contributions, or otherwise, other corporations, community chests, funds, and foundations organized and operated ex- clusively for charitable, religious, scientific, literary, or edu- cational purposes or for the prevention of cruelty to children or animal, no part of the activities of which is carrying on propaganda or otherwise attempting to influence legislation. (c) Either directly or indirectly, and either alone or in conjunction or cooperation with others, whether such others be persons or organizations of any kind or nature, such as corporations, firms, associations, trusts, institutions, foundations, or Governmental bureaus, departments, or agencies, to do any and all lawful activities which may be necessary, useful, or desirable for the furtherance, accom- plishment, fostering, or attainment of the foregoing purposes, including among other things: (i) To provide advice, support, credit, funds, capital, gifts, and all other lawful forms of assistance, finan- cial and otherwise, to or for use in business enterprises owned or operated, or to be owned or operated, by members of underprivileged groups; (ii) To voluntarily furnish management, admin- istrative, and other advice, support, training, and assistance to members of underprivileged groups in order to enable them to develop necessary skills successfully to operate business ventures; (iii) To encourage and voluntarily assist members of underprivileged groups to organize, create, acquire, ob- tain financing foi, own, manage, and operate business enter- prises; (iv) To obtain information and conduct research, studies, and analyses, and prepare and publish reports as to any and all matters that may be of use in furthering the expansion of business enterprises owned or operated by members of underprivileged groups, including information, research, studies, analyses, and reports as to markets, prod- ucts, services, skills, sources of financing, and any and all other matters; (v) To conduct educational and other efforts to eliminate any prejudice and discrimination in the business and financial community and to foster the establishment of sound and constructive relationships between the business and financial community and members of underprivileged groups seeking opportunities in business; and (vi) To voluntarily aid, support, and assist by gifts, contributions, loans, investments, and other lawful forms of assistance other persons or organizations seeking to expand the opportunities for business ownership by mem- 194 bers of underprivileged groups or furnishing assistance to members of underprivileged groups in organizing, creating, acquiring, obtaining financing for, owning, managing, and operating business enterprises. (d) In furtherance, but not in limitation, of the foregoing purposes, the Corporation shall have power and authority: (i) To receive and administer funds and contribu- tions received by gift, deed, bequest, or devise, and other- wise to acquire money, securities, property, rights, and services of every kind and description, and to hold, invest, expend, contribute, use, sell, or otherwise dispose of any money, securities, property, rights, or services so acquired for the purposes above mentioned; (ii) To borrow money and to make, accept, en- dorse, execute, and issue bonds, debentures, promissory notes, and other corporate obligations for money borrowed, or in payment for property acquired, or for any of the pur- poses of the Corporation, and to secure payment of any such obligation by mortgage, pledge, deed, indenture, agree- ment, or other instrument of trust, or by other lien upon, assignment of, or agreement in regard to all or any part of the property, rights, or privileges of the Corporation; (iii) To invest and reinvest its funds in such mort- gages, bonds, notes, debentures, shares of preferred and common stock, and any other securities of any kind whatso- ever, and property, real, personal, or mixed, tangible or intangible, all as the Corporation's board of directors shall deem advisable and as may be permitted by law; (iv) To do all such other acts as are necessary or convenient to accomplish the objects and purposes herein set forth to the same extent and as fully as any natural person could or might do and as are not forbidden by law or by this Certificate of Incorporation or by the By-Laws of the Corporation; and (v) To have all powers that may be conferred upon charitable corporations formed under the Membership Corporations Law of the State of New York. All of the foregoing purposes and powers and all other purposes and powers in which the Corporation is permitted to engage by this Certificate of Incorporation shall be exclu- sively for such public charitable and educational purposes as are within the meaning of Section 501(c)(3) of the Internal Revenue Code of 1954 as it is currently and shall hereafter be in force and effect. Nothing herein contained shall authorize the doing of any act which would require the approval of any Department of the State of New York; or the doing of any acts mentioned in Section 11 of the Membership Corporations Law of the State of New York or Section 35 of the Social Welfare Law of the State of New York. (3) No part of any net earnings of the Corporation shall inure to the benefit of any member or individual, and no substantial part of the activities of the Corporation shall consist of carrying on propaganda or otherwise attempting to influence legislation. Upon any dissolution of the Cor- poration no member shall be entitled to any distribution or division of its remaining property or its proceeds, and the balance of all money and other property received by the Corporation from any source, including its operations, after the payment of all debts and obligations of the Corporation of whatsoever kind and nature, shall be used or distributed, subject to the order of the Supreme Court of the State of New York as provided by law, exclusively for purposes within those set forth in Article 2 of this Certificate and within the intendment of Section 501(c)(3) of the Internal Revenue Code of 1954 as the same may be amended from time to time. (4) The territory in which the operations of the Cor- poration are principally to be conducted is the Continental United States, but such operations may also be conducted throughout the world. (5) The principal office of the Corporation is to be located in the [City, County, and State of New York]. (6) The number of directors of the Corporation shall be not less than three nor more than fifteen. (7) The names and residences of the directors of the Corporation until its first Annual Meeting are: Name Residence [ ] [ 1 (8) All of the subscribers of this Certificate are of full age; at least two-thirds of them are citizens of the United States, and at least one of them is a resident of the State of New York. Of the persons named as directors, at least one is a citizen of the United States and a resident of the State of New York. IN WITNESS WHEREOF, we have made, subscribed, and acknowledged this Certificate as of the [ ] day of [ ], 19[ ]. [signatures] 195 Appendix 5-B FORM 1023 (Rev. April 1965) U.S. TREASURY DEPARTMENT— INTERNAL REVENUE SERVICE EXEMPTION APPLICATION (To b* mode only by a principal ollictr of the organization claiming exemption) To be filed In duplicate with the District Oiiectn for your District For use of organizations applying for exemption under section 501(a) and described in section 501(c)(3) of the Internal Revenue Code, which are organized and operated (or will operate) exclusively for one or more of the following purposes (check purpose(s)): D Religious (jfl Charitable □ Scientific □ Testing for Public Safety LJ Educational LJ For the prevention of cruelty to children or animals Q Literary Every organization that claims to be exempt must furnish the information and data specified in duplicate. If any organization fails to submit the information and data required, this application will not be considered on its merits and the organization will be notified accordingly. This application shall be open to public inspection in accordance with section 6104(a)(1) of the Internal Revenue Code. See separate instructions for Form 1023 to properly answer the questions below. la. Full name of organization [Community Development] b. Employer identification number application herewith 2. Complete address (number, street, city or town, State and Postal ZIP code) Street, New York, New York 3a. Is the organization incorporated? S Yes □ No 4a. If not incorporated, what is form of organization? b. If "Yes," in which State and under which law (General corporation, not for profit, membership, educational eleemosynary, etc.)? Cite statutory provisions. New York State Membership Corporations Law b. Date incorporated or organized c. Month and day on which the annual accounting period ends January 24, 19f$9 December 31 5a. Has organization tiled Federal income tax return (s)? □ Yes S) No b. If "Yes," form number of return filed and Internal Revenue District where filed. c. Year(s) filed 6. After July 1, 1950, did the creator of your organization (if a trust), or a contributor to your organization, or a brother or sister (whole or half blood), spouse, ancestor, or lineal descendant of such creator or contributor, or a corporation controlled directly or indirectly by such creator or contributor, enter into any of the transactions (or activities) enumerated below? NOTE: If you have any knowledge or con- template that you will be a parry to any of the transactions (or activities) enumerated in 6a through 6f, check "planned" in the applicable block(s) and see instructions. Yes No Planned d. Purchase any securities or other prop- erty from you? Yes No Planned a. Borrow any part of your income or corpus? X X b. Receive any compensation from you? X e. Sell any securities or other property to you? X c. Have any part of your services made available to him? X f. Receive any of your income or corpus in any other transaction? X 7. Have you issued or do you plan to issue membership, stock, or other certificates evidencing voting power in the organization? Yes X X X We X 8a. Are you the outgrowth or continuation of any form of predecessor(s)? X b. Do you have capital stock issued and outstanding? X c. Have you made or do you plan to make any distribution of your property to shareholders or members? X d. Did you receive or do you expect to receive 10 percent or more of your assets from any organization, group of affiliated or- ganizations (affiliated through stockholding, common ownership, or otherwise), any individual, or members of a family group (brother or sister whether whole or half blood, spouse, ancestor, c- lineal descendant)? e. Does any part or will any part of your receipts represent payment for services of any character rendered or to be rendered by you? X f. Are you now, have you ever been, or do you plan to be engaged in carrying on propaganda, or otherwise advocating or opposing pending or proposed legislation? X g. Do you participate or plan to participate in or intervene in (including the publishing or distributing of statements) any political campaign on behalf of or in opposition to any candidate for public office? X h. Have you made or do you plan to make any payments to members or shareholders for services rendered or to be rendered? 1. Does any part or do you plan to have any part of your net income inure to the benefit of any private shareholder or individual? X J. Are you now or are you planning to bo affiliated in any manner with any organization(s)? X k. Do you hold or plan to hold 10 percent or more of any class of stock or 10 percent or more of the total combined voting power of stock in any corporation? 196 Pate 2 9. Has any State or any court (including a Court of Frobate, Surrogate's Court, etc.) ever declared whether you were or were not organized and operated for charttable, etc., purposes? H Yes Q No. II "Yes," attach copies in duplicate of pertinent administrative or |udi- cial decisions. See Certificate of Incorporation. 10a below 10. You must attach copies in duplicate of the following: a. If incorporated, a copy of your articles of incorporation, or if not incorporated, a copy of your constitution, articles of association, decla- ration of trust, or other document whereby you were created setting forth your aims and purposes, a copy of all amendments thereto. and any changes presently proposed. b. A copy of your bylaws or other similar code of regulations, all amendments thereto, and any changes presently proposed . c. A complete statement of assets and liabilities as of the end of each annual accounting period (or as of the date of the filing of this application, if you were in existence for less than a year). d. A statement of receipts and expenditures for each annual accounting period of operation (or for the period for which you were in exist- ence, if less than a year). See Article 3 of Certificate of Incorporation, 10a above e. A statement which clearly indicates what State statutes or court decisions govern the distribution of assets upon dissolution. (This state- ment may be omitted if your charter, certificate, or other instrument of organization makes provision for such distribution.) f. A brief statement of the specific purposes for which you were formed. (Do not quote from or make reference to your articles of incorpo- ration, constitution, articles of association, declaration of trust, or other document whereby you were created for this question.) g. A statement explaining in detail each fund-raising activity and each business enterprise you have engaged in or plan to engage in, accompanied by copies of all agreements, if any, with other parties for the conduct of each fund-raising activity or business enterprise. h. A statement which describes in detail the nature of each of your activities which you have checked on page 1, activities which you spon- sor, and proposed activities . none 1. A statement which explains fully any specific activities that you have engaged in or sponsored and which have been discontinued. Give dotes of commencement and termination and the reasons for discontinuance. ^__^_ j. A statement which describes the purposes, other than in payment for services rendered or supplies furnished, for which your funds are expended or will be expended. k. A schedule indicating the name and position of each officer, director, trustee, etc., of the organization and the relationship, if any, by blood, marriage, adoption, or employment, of each such person to the creator of the organization (if a trust), to any person who has made a substantial contribution to the organization, or to a corporation controlled (by ownership of 50 percent or more of voting stock or 50 percent or more of value of all stock), directly or indirectly, by such creator or contributor. The schedule shall also indicate the time devoted to position and compensation (including salary and expense account allowance), if any, of each officer, director, trustee, etc., of the organization. I. A copy of each lease, if any, in which you are the lessee or lessor of property (real, personal, gas, oil, or mineral) or in which you own an interest under such lease, together with copies of all agreements with other parties for development of the property. SIGNATURE AND VERIFICATION Jnder penalties of perjury, I declare that I have examined this application, including accompanying statements, and to the best of my knowledge ind belief it is true, correct, and complete. President Signature ot olticer US. GOVERNMENT PRIMING OFFICE : IKi—O- 764-147 FORM 1023 (REV. *-«3) 197 ATTACHMENTS TO EXEMPTION APPLICATION (FORM 1023) [February 28, 1969] [LOCAL ECONOMIC DEVELOPMENT COMPANY] [Street Address] [New York, New York] ITEM 8d: All of the assets of [Local Economic Development Com- pany] (hereinafter called ["LEDC"]) were contributed to it by [Mr. lohn lones]. Such assets consisted of cash in the amount of [$25,000], contributed on [lanuary 31, 1969], and [800] shares of [common stock] of [name of corporation] contributed on [February 6, 1969]. Such shares had an aggregate value on the date of transfer to [LEDC] of approximately [$79,550], determined on the basis of the market value of such securities (the mean between the high and low selling prices thereof) on the date of such transfer. Additional contributions to [LEDC] may be made in the future by [Mr. John Jones] and it is expected that [Mr. John Jones] will be the principal source of the funds of [LEDC]. However, contributions may also be made by other persons, including individuals, corporations, foundations, and other entities. ITEM 8h: [Name], one of the members (and a director) of [ ], a partner of [ ], counsel to [LEDC], may receive fees from [LEDC] for legal services rendered. ITEM 8k: See attachment to item lOh for circumstances under which [Mr. John Jones] may hold 10 percent or more of the stock or voting power of the corporation. ITEM 10c: Statement of Assets and Liabilities [February 17, 1969] Assets Cash [$23,426.55] Securities: [800 shares ABC Manufacturing Company, Inc.] [$79,550.00] Total Assets [$102,976.55] Liabilities Payroll taxes [$ 434.80] Principal Balance (see attachment to item lOd) [$102,541.75] [$102,976.55] ITEM Wd: Statement of Receipts and Disbursements [February 17, 1969] Receipts Contributions (see item 8d for description) [$104,550.00] Disbursements Salaries [$1,687.50] Consulting fee to outside consultant [200.00] Stationery and supplies [120.75] [2,008.25] Balance [$102,541.75] ITEM Wf: [LEDC] was formed for the purpose of lessening neigh- borhood tensions, and combating community deterioration by expanding the opportunities of low-income groups to own and operate businesses and by increasing the number of locally owned or operated business enterprises in economi- cally underprivileged or depressed areas. At present the opportunities of low-income persons for business ownership are limited, due to the difficulties faced by members of low- income groups in obtaining capital and other forms of financing, lack of training in management methods and other necessary skills, and other factors. [LEDC] proposes to assist members of such groups in obtaining necessary financing and skills to successfully operate business enter- prises as more fully set forth in the attachment to item lOh. ITEM Wg: [LEDC] has not engaged in any fund-raising activities and it does not propose to solicit funds from members of the public. Although it has no present plans to do so, it might in the future seek or accept contributions from other corporations, individuals, foundations, or entities interested in the charitable purposes to be pursued by [LEDC]. [LEDC] has not engaged in and does not propose to engage in any business enterprise. However, it does plan to furnish financial assistance to members of low-income groups to enable them to acquire, expand, operate, or establish business enterprises and in some instances this assistance may take the form of equity investments in the business entity involved. Such investments, if made, will be for the purpose of carrying out the charitable goals of [LEDC] by furnishing financial assistance to members of low-income groups of the kind needed by them and not for the purpose of engaging in any business enterprise or activity. See attachment to item lOh for a more complete description of the proposed activities of [LEDC]. ITEM lOh: As set forth in the attachment to item lOf, [LEDC] pro- poses to furnish assistance to members of low-income groups to enable them to acquire, expand, operate, or establish business enterprises. Such assistance will be principally in the following areas: (1) Financial Assistance. Because of the difficulties faced by members of low-income groups in obtaining fi- nancing for business purposes, [LEDC] proposes to provide such financing to qualified individuals within such groups. Such financing in most instances will be in one or more of the following forms: (a) Loans. In appropriate cases, [LEDC] will make loans to the individual or individuals being assisted or to the business in which they are engaged or propose to estab- lish, whether such businesses be sole proprietorships, partner- ships, corporations, or other business forms. Such loans normally will be unsecured and they may be subordinated to loans from banks or other sources. Loans made by [LEDC] may be on a short-term or long-term basis, depend- ing on the needs of the business and other factors. Although no formula has been fixed for determining the interest to be charged for such loans, loans made by [LEDC] will in all instances bear interest at rates consider- ably less than the nature of the risks involved would other- wise require. (b) Guarantees. To conserve its funds so that the maximum number of individuals can receive assistance, [LEDC] will, in instances where conventional financing can be obtained on the credit of [LEDC] resources and if other- wise appropriate, guarantee loans made by banks or others to the individual or business being assisted. (c) Equity Investments. In some instances, the finan- cing required by the individual to be assisted will be in the nature of long-term capital, rather than debt, for example, where the business will not be able to meet requirements for debt service, where capital is required by other creditors or sources of financing, or other instances. Accordingly, [LEDC] may in appropriate cases acquire an equity interest in the business in the form of stock or other equity partici- pation. Since the businesses assisted will in many instances 198 be managed by persons with limited or no financial re- sources, and with limited or no experience in management, such equity interest may constitute a controlling interest in the business involved. Since [LEDC's] purpose, however, is to assist members of low-income groups to own and oper- ate their own businesses, rather than to engage in or own any business enterprise itself, ownership of any controlling or other equity interests by [LEDC] will be temporary only, and to that end provision will be made whereby the individ- ual or 'individuals being assisted can acquire [LEDC's] interest in the business. (d) Other. In addition to furnishing financial assist- ance directly, [LEDC] plans to furnish advice and other assistance to qualified individuals in receiving necessary financing from other sources, without charge to such in- dividuals for [LEDC] assistance in this connection. Such sources may include government agencies and nonprofit private institutions as well as banks and other conventional sources of financing. (2) Management Assistance. Since [LEDC] will be extending financial support to individuals with limited busi- ness management experience, it recognizes that management counselling and technical assistance of various kinds may be required. Although [LEDC] does not at the present time plan to maintain a management counselling staff or offer formalized management instruction, it will provide a certain amount of informal guidance to those being assisted by it. In instances where more formal or specialized instruction is needed, [LEDC] presently proposes to assist those whom it is helping to obtain such instruction from government and private agencies or institutions. (3) Eligibility Requirements. [LEDC] does not pro- pose to establish rigid rules or policies as to the individuals to be assisted or the nature of the businesses to be estab- lished or financed. However, in choosing among those mem- bers of low-income groups who apply for assistance, con- sideration will be given to the following factors among others: the extent to which the business for which financing is sought offers job opportunities or other benefits to mem- bers of low-income groups; whether the project is located in an economically disadvantaged or depressed area; the amount of financing required for the success of the project; prospects for success: and availability of financing from conventional sources. Such factors constitute general criteria and may be departed from in appropriate cases, for ex- ample, although it generally would be desired that businesses to be assisted be located within an economically depressed or low-income area, financial assistance may be furnished to otherwise qualified individuals seeking to establish busi- nesses elsewhere. In evaluating a candidate's prospects for success, [LEDC] recognizes that conventional banking criteria cannot be applied since [LEDC] will not be seeking to assist those for whom financing is already available on reasonable terms from existing financial sources. Rather, [LEDC] will be prepared to accept greater risks and will consider the gen- eral feasibility of the project and the character and abilities of the individuals involved. Within the context of its general purposes, and the overall criteria to be applied by it, the assistance to be furnished by [LEDC] will be made available to all qualified applicants on a nondiscriminatory basis. Although it may expand the geographic scope of its activi- ties, [LEDC] initially proposes to concentrate its activities in [the metropolitan New York City area]. ITEM JOj: Reference is made to the attachments to items 8d and lOg for a description of the source of funds of [LEDC]. Expenditures of such funds will be made in connection with the activities described in the attachment to item lOh. ITEM 10k: Officers [lohn Smith] President I ] Vice President [ ] Treasurer and Secretary [ ] Controller and Assistant Secretary Directors [lohn Smith] None of the officers or directors named above has any relationship by blood, marriage, adoption, or employment to any substantial contributor to [LEDC] or to any corpora- tion controlled by him, except that [Mr. John Smith] is financial advisor to [Mr. John Jones] (and to various com- panies in which [Mr. Jones] has a substantial interest), the sole contributor to [LEDC], and Messrs. [ ] are em- ployed by [Mr. Jones]. None of such officers or directors receives or will receive compensation from [LEDC], except that [Mr. ] will receive compensation at the rate of [$18,000] per year. [Mr. ] is a partner of [ ], counsel to [LEDC]. [ ] may receive fees from [LEDC] for services rendered. Except for [Mr. ], who will devote full time to the affairs of [LEDC], none of such officers or directors will devote all or substantially all of their time to [LEDC]. 199 Address any reply to: Appendix 5-C ®@[o)§Fto@[n]G ®ff GOO® ^©gJgQflD 3 ^ ®0©ft[?B©S ®0(?®©G®[? Internal Revenue Service Date: February 29, 1970 In reply refer to: AU:F:607:GB > Local Economic Development Corporation Street New York, N.Y. Purpose: Charitable Address Inquiries to Director of Internal Revenue: Manhattan Accounting Period Ending: December 31 On the basis of the information submitted and the understanding that your operations will continue as evidenced to date or will conform to those proposed in your application, we have concluded that you are exempt from Federal income tax as an organization described in section 501(c)(3) of the Internal Revenue Code. Any changes in operation from those described, or in your character or purposes, must be reported immediately to the District Director shown above for consideration of their effect upon your exempt status. You must also report any change in your name or address. In this letter we are not determining whether you are a private foundation as defined in the new section 509(a) of the Code. Your attention is invited to the new section 508(b) of the Code, which sets forth requirements for establishing that an organization exempt under section 501(c)(3) is not a private foundation. When procedures are developed to implement these new requirements, we will advise you how to proceed to notify the Internal Revenue Service if you do not believe yourself to be a private foundation. For years, beginning prior to January 1, 1970, you are (not) re- quired to file the annual information return, Form 990-A. For sub- sequent years, please refer to the instructions accompanying the Form 990-A for that particular year to determine whether you are required to file. If filing is required, you must file the Form 990-4 by the 15th day of the fifth month after the end of your annual accounting period. You are not required to file Federal income tax returns unless you are subject to the tax on unrelated business income under section 511 of the Code. If you are subject to this tax, you must file an income tax return Form 990-T. In this letter we are not determining FORM L-178 (REV. 2-701 200 whether any of your present or proposed activities are unrelated trade or business as defined by section 513 of the Code. Contributions made to you are deductible by donors as provided in section 170 of the Code, as amended by the Tax Reform Act of 1969. Bequests, legacies, devises, transfers or gifts to or for your use are deductible for Federal estate and gift tax purposes under the provisions of sections 2055, 2106 and 2522 of the Code. You are not liable for Federal Unemployment taxes. You are liable for Social Security Taxes only if you have filed Waiver of Exemption Certificate, SS-15, as provided in the Federal Insurance Contributions Act. This is a determination letter. Sincerely yours, /Signed by IRS District Director/ District Director 201 Appendix 7— A CERTIFICATE OF INCORPORATION UNDER THE MODEL NON-PROFIT CORPORATION ACT ARTICLES OF INCORPORATION OF[ ] The undersigned, acting as incorporator(s) of a corpora- tion under the [ ] Non-Profit Corporation Act, adopt(s) the following Articles of Incorporation for such corporation: FIRST: The name of the corporation is [ ]. SECOND: The period of its duration is [ ]. THIRD: The purpose or purposes for which the corpora- tion is organized are [ ]. FOURTH: The address of the initial registered office of the corporation is [ ]. FIFTH: The number of directors constituting the initial Board of Directors of the corporation is [ ], and the names and addresses of the persons who are to serve as the initial directors are: [ ]. SIXTH: The name and address of each incorporator is: Dates: [ ]. Incorporators: [ ]. [signatures of incorporators] Appendix 7— B CERTIFICATE OF INCORPORATION UNDER PRESENT N.Y. MEMBERSHIP CORPORATION LAW CERTIFICATE OF INCORPORATION OF [ ] (Pursuant to the Membership Corporations Law) We, the undersigned, desiring to form a charitable and educational corporation under and by virtue of the pro- visions of the Membership Corporations Law of the State of New York, do hereby make, subscribe, and acknowledge this certificate as follows: FIRST: The name of this corporation is [ ]. SECOND: The purposes for which the corporation is to be formed are: To solicit, receive, and maintain a fund or funds and to apply the whole or any part of the income and principal thereof ( 1 ) to aid poor groups to train for and enter upon business careers and to develop, operate, and own their private business enterprises, and (2) to assure that the op- portunities and benefits of business ownership and manage- ment shall be made available to members of such minority groups through educational and related efforts to eliminate prejudice and discrimination in the business community and to foster the establishment of customary business relation- ships between existing sources of commercial credit in the financial community and those members of poor groups seeking such opportunities. Such purposes shall be exclusively for such public chari- table and educational purposes as are within the meaning of Section 501(c)(3) of the Internal Revenue Code of 1954. The funds of the corporation will be devoted to these purposes, in part, through the development and implementa- tion of a loan guaranty program whereunder the corpora- tion may guarantee a part or all of any lean made by a financial institution to a member of a poor group whose qualifications and business purposes conform to the stated purposes of the corporation. As a means of accomplishing the purposes for which it is formed, the corporation shall have the power: a. to receive gifts, devises, and bequests of money or of property of whatsoever kind and wheresover situated; b. to acquire by purchase, lease, devise, gift, or other- wise, and to hold, own, occupy, use, manage, improve, develop, maintain, lease, sell, mortgage, transfer, or other- wise deal with real and personal property of whatsoever kind and wheresoever situated and with any estate or interest therein, legal or equitable; c. to borrow money and to make, accept, endorse, execute, and issue promissory notes and other evidences of indebtedness and obligations in payment for property ac- quired or money borrowed, and to secure the payment » thereof and interest thereon by mortgage upon, or pledge, ■ conveyance, or assignment of any part of, the property of I the corporation; d. to guarantee the obligations of others and to secure such guaranties by mortgage upon, or pledge, conveyance, or assignment of any part of the property of the corpora- tion; e. to do all acts and things necessary or proper for the accomplishment of the purposes Of the corporation, subject, however, to the provisions of the Membership Corporations Law and of the Internal Revenue Code. THIRD: No part of the net earnings of the corporation shall inure to the benefit of any member, director, officer, or employee of the corporation, or to the benefit of any other private individual; no member, director, officer, or employee of the corporation shall receive or be lawfully entitled to receive any pecuniary benefit of any kind, except reasonable compensation for services in effecting one or more purposes of the corporation. No substantial part of the activities of this corporation shall consist in carrying on propaganda or otherwise attempting to influence legislation. The corporation shall not participate in, nor intervene in (including the publishing or distributing of statements), any poltical campaign on behalf of any candidate for public office. The purposes of the corporation shall not include any ( 202 of the purposes specified in Section 1 1 of the New York Membership Corporations Law or Section 35 of the New York Social Welfare Law. FOURTH: In the event of the dissolution of the corpora- tion, subject to the approval of the Supreme Court of the State of New York, no distribution of any of the property or assets of the corporation shall be made to any member, director, officer, or employee of the corporation, or other private individual, but all of such property and assets shall be applied, in the discretion of the director, to accomplish the public charitable and educational purposes for which this corporation is organized by distributing such property and assets for the futherance of the work of institutions with similar purposes and objects which are exempt from Federal income taxation under the provisions of the Internal Revenue Code. FIFTH: The territory in which the operations of the corporation are principally to be conducted is the United States of America. SIXTH: The principal office of the corporation is located in the City, County, and State of New York. SEVENTH: The number of directors of the corporation shall be not less than three and not more than fifty. EIGHTH: The names and places of residence of the persons who shall be the directors of the corporation until its first annual meeting are as follows: [ ]. NINTH: All of the undersigned subscribers to this cer- tificate are of full age, at least two-thirds of them are citizens of the United States, and at least one of them is a resident of the State of New York; and of the persons above named as directors at least one is a citizen of the United States and a resident of the State of New York. IN WITNESS WHEREOF, we have made subscribed and acknowledged this certificate this [ ] day of [ ], [1970]. [Signatures] State of New York, County of New York, ss: On this [ ] day of [ ], [1970], before me per- sonally came [ ] to me known and known to me to be the individuals described in and who executed the foregoing instrument and they duly acknowledged to me that they executed the same. [ 1 State of New York, County of New York, ss: [ ] being duly sworn, deposes and says: That he is an attorney and Counsellor-at-law of the State of New York; that he is of counsel for the persons who have executed the foregoing Certificate of Incorpora- tion; and that no previous application for the approval of this Certificate or of any Certificate of Incorporation of [ ] has been made to any court or judge. [ ] Sworn to before me this [ ] day of [ ], [1970]. [ ] I, [ ], a Justice of the Supreme Court of the State of New York, First Judicial District, hereby approve the foregoing Certificate of Incorporation of [ ]. Dated: New York, New York, [ ]. [ ] Justice of the Supreme Court of the State of New York Notice of Application Waived (This is not to be deemed an approval on behalf of any Department or Agency of the State of New York, nor an authorization of activities otherwise limited by law.) Dated: [ ], [1970] By [ ] Assistant Attorney General 203 Appendix 7— C CERTIFICATION OF INCORPORATION FOR A LOCAL DEVELOPMENT CORPORATION FORMED UNDER THE NEW YORK NOT-FOR-PROFIT CORPORATION LAW, EFFECTIVE SEPTEMBER 1, 1970 CERTIFICATE OF INCORPORATION OF [ ] Under Section 402 Of The Not-For-Profit Corporation Law The undersigned, desiring to form a corporation pursuant to the Not-For-Profit Corporation Law, hereby certifies: FIRST: The name of the proposed corporation is [ ]• SECOND: The corporation is not formed for pecuniary profit or financial gain and shall not make or declare divi- dends nor shall any part of its earnings inure to the benefit of any private individual, except that the corporation shall be authorized and empowered to pay reasonable compen- sation for services rendered and make payments and dis- tributions in furtherance of its purposes. The corporation shall be a Type C corporation as defined by Section 201 of the Not-For-Profit Corporation Law; and the purposes for which it is formed are as follows: To aid poor groups in attaining economic and social freedom by encouraging and assisting members of such minority groups to develop, operate, and own business enterprises and by encouraging members of such minority groups to train for and enter upon business careers. To assure that the oportunities and benefits of business shall be available to members of poor groups through the elimination of prejudice and discrimination in the business community. To obtain for poor groups, within the business commu- nity, their human and civil rights secured by law. THIRD: The principal office of the corporation is to be located in the City, County, and State of New York. FOURTH: The territory in which the operations of the corporation are to be conducted is principally within the United States of America. FIFTH: The names and addresses of the initial directors are as follows: [NOTE: Such names and ad- dresses need not be set forth. However, if they are desig- nated they are required to complete the organization of the corporation and act until their successors are elected in accordance with Section 703 of the Statute.] SIXTH: The post office address to which the Secretary of State shall mail a copy of any notice required by law is as follows: [ ]. SEVENTH: The approval of a Justice of a Supreme Court of the Judicial District in which the office of the corporation is to be located is annexed hereto. IN WITNESS WHEREOF, the undersigned has sub- scribed and acknowledged this certificate as of the [ ] day of [ ], [1970]. [ ] State of New York, County of New York, ss: On this [ ] day of [ ], [1970], before me personally came [ ] to me known and known to me to be the individuals described in and who executed the foregoing instrument and they duly acknowledged to me that they executed the same. [ ] State of New York, County of New York, ss: [ ], being duly sworn, deposes and says: That he is an attorney and Counsellor-at-law of the State of New York; that he is counsel for the persons who have executed the foregoing Certificate of Incorporation; and that no previous application for the approval of this Cer- tificate or of any Certificate of Incorporation of [ ] has been made to any court or judge. [ ] Sworn to before me this [ ] day of [ ], [1970] [ ] I, [ ], a Justice of the Supreme Court of the State of New York, First Judicial District, hereby approve the foregoing Certificate of Incorporation of [ ]. Dated: New York, New York, [ ], [1970] [ ] Justice of the Supreme Court of the State of New York Notice of Application Waived (This is not to be deemed an approval on behalf of any Department or Agency of the State of New York, nor an authorization of activities otherwise limited by law.) Dated: [ ], [1970] Attorney General By [ ] Assistant Attorney General 204 Appendix 7— D ARTICLES OF INCORPORATION OF A JOB DEVELOPMENT CORPORATION PURSUANT TO THE CALIFORNIA JOB DEVELOPMENT CORPORATION LAW ARTICLES OF INCORPORATION UNDER CALIFORNIA JOB DEVELOPMENT CORPORATION LAW, SECTION 14032 The undersigned, desiring to form a corporation pursuant to the provisions of the California Job Development Cor- poration Law, hereby certify: FIRST: The name of the corporation shall be the [ ] Job Development Corporation. SECOND: The corporation is formed for the purpose of promoting the health, safety, and social welfare of the citizens of the State of California served by the corporation and eliminating unemployment in the area served; and to do this by stimulating economic development, employment, minority group entrepreneurship, and job training within the area served by the corporation, by encouraging job- producing industry to locate or expand in the area served by the corporation, and by making available capital, man- agement assistance, and other resources, including loan services, personnel, and business education, to small busi- ness entrepreneurs in the area served by the corporation. THIRD: The principal office of the corporation is lo- cated at [ ] and the area the corporation proposes to serve is that area known as [ ] and bounded by I ]• FOURTH: The names and addresses of the persons who shall be the directors of the corporation until the selection of their successors are: [This shall be seven or more, and the number selected shall constitute the number of di- rectors of the corporation un- til changed by amendment to the articles of incorporation.] FIFTH: The corporation is organized pursuant to the California Job Development Law. Dated: [ ]. Incorporators: [Must be seven or more, Cali- fornia Corporation Code Section 14030.] [NOTE: The Articles of Incorporation are to be filed with the California Job Development Corporation Law Ex- ecutive Board which must endorse its approval of the pro- posed incorporation before forwarding to the Secretary of State for Filing. (California Corporation Code, Sections 14031, 14033).] Appendix 7— E CERTIFICATE OF INCORPORATION OF A LOCAL DEVELOPMENT CORPORATION FORMED UNDER SECTION 1411 OF THE NEW YORK NOT-FOR-PROFIT CORPORATION LAW CERTIFICATE OF INCORPORATION OF [ ] Under Section 1411 of The Not-For-Profit Corporation Law The undersigned, desiring to form a corporation pursu- ant to the Not-For-Profit Corporation Law, hereby certifies: FIRST: The name of the proposed corporation is [ ]• SECOND: The corporation is not formed for pecuniary profit or financial gain; all income and earnings of the corporation shall be used exclusively for its corporate pur- poses or accrue and be paid to The New York Job Devel- opment Auhority; no part of the income or earnings of the corporation shall inure to the benefit or profit of, nor shall any distribution of its property or assets be made to any member or private person, corporate or individual, or any other private interest, except the corporation may repay loans or contributions (other than dues) to the local development corporation only if and to the extent that any such contributions shall not be allowable as a deduction in computing the taxable income of the donor under the Internal Revenue Code of 1954. The corporation shall be a Type C corporation as de- fined by Section 201 of the Not-For-Profit Corporation Law; and is formed for the purposes set forth in paragraph (a) of Section 1411 of the Not-For-Profit Corporation Law. THIRD: If the corporation shall accept a mortgage loan or loans from The New York Job Development Authority, the corporation shall, upon the repayment or other discharge in full of all such loans, be dissolved in accordance with the provisions of paragraph (g) of Section 1411 of the Not-For-Profit Corporation Law. FOURTH: The principal office of the corporation is to be located in the City, County, and State of New York. FIFTH: The territory in which the operations of the corporation are to be conducted is principally within the United States of America. SIXTH: The names and addresses of the initial directors are as follows: [NOTE: Such names and ad- dresses need not be set forth. However, if they are desig- nated they are required to complete the organization of the corporation and act until 205 their successors are elected in accordance with Section 703 of the Statute.] SEVENTH: The post office address to which the Secre- tary of State shall mail a copy of any notice required by law is as follows: [ ]. EIGHTH: The approval of a Justice of a Supreme Court of the Judicial District in which the office of the corpora- tion is to be located is annexed hereto. IN WITNESS WHEREOF, the undersigned has sub- scribed and acknowledged this certificate as of the [ ] day of [ ], [1970]. [ ] [Acknowledgment, Affidavit, and Approval of a Justice of The Supreme Court as in Appendix 7-C] Appendix 8— A AGREEMENT TO FORM A CORPORATION AGREEMENT, dated as of this [ ] day of [ ], I ], between [JOHN SMITH, WILLIAM JONES, and GEORGE BROWN] (herein called "The Community Group"); and [THE FIRST NATIONAL BANK and THE SECOND NATIONAL BANK] (herein called "The Investors Group"). [SMITH, JONES, BROWN, THE FIRST NATIONAL BANK and THE SECOND NATIONAL BANK] are herein collectively called the "shareholders," and each in- dividually called a "shareholder." WITNESSETH: WHEREAS, the Shareholders desire to form a corpora- tion to engage in the economic development of [ ] and its environs, and promoting and assisting the growth and development of business concerns, including small business concerns, in said area, NOW, THEREFORE, the parties hereto agree as follows: ( 1 ) Formation of the Corporation The Community Group and the Investors Group shall forthwith cause a corporation to be formed pursuant to the laws of [ ] to be known as COMMUNITY DE- VELOPMENT COMPANY (herein called the "Company"). (2) Certificate of Incorporation: By-Laws The Certificate of Incorporation and the By-Laws of the Company shall be substantially the same as the forms thereof attached hereto. (3) Issuance of Shares After incorporation shares of capital stock of the Com- pany shall be issued as follows and the Community Group and the Investors Group shall make the payment described herein to the Company for such shares on or before [ ]• (a) To the Community Group: [1,000] shares of the Class A Common Stock of the Company, for which the Community Group shall pay the sum of $[ ]. These [1,000] shares shall be divided among the members of the Community Group in the following proportions: to [John Smith], [ ] shares; to [William Jones], [ ] shares; and to [George Brown], [ ] shares. (b) To the Investors Group: [1,000] shares of Class B Common Stock of the Company, for which the Investors Group shall pay the sum of $[ ]. These [1,000] shares of Class B Common Stock shall be divided among the Investors Group as follows: to the [First National Bank], [ ] shares; and to the [Second National Bank], [ ] shares. (4) Directors and Officers of the Company The initial Class A directors of the Company shall be Messrs. [ ], and [ ], and the initial Class B directors of the Company shall be Messrs. [ ] and [ ]• The initial officers of the Company shall be as follows: President [ ] Vice President [ ] Treasurer [ ] Secretary [ ] The above officers and directors will serve the corpora- tion until new directors are elected and new officers ap- pointed as provided in the Articles of Incorporation. (5) Payment of Organization Expenses Pending Capitaliza- tion The expenses of organization pending capitalization shall be borne by the Investors Group, in such proportions as the members of the Investors Group shall among themselves decide. Upon capitalization of the Company, such organiza- tional expenses shall be repaid by the Company to the Investors Group. (6) Termination of Agreement This Agreement shall be subject to termination upon the happening of any of the following: (a) if the Shareholders mutually agree to the termination of this Agreement; or (b) on a date not later than 3 months after the Share- holders, pursuant to the Articles of Incorporation, shall notify the Company and the other Shareholders of their demand that the Company be wound up. (7) Company To Become A Party The Shareholders will cause the Company to become a party to this Agreement upon its incorporation. (8) Law To Govern This Agreement shall be governed by and construed and enforced in accordance with the laws of the State of I ]• IN WITNESS WHEREOF, the parties hereto have duly executed this Agreement as of the day hereinabove written. [John Smith] [William Jones] [George Brown] [The First National Bank] By [ ] Vice President [The Second National Bank] By [ ] Vice President 206 Appendix 8— B SUGGESTED FORM OF CERTIFICATE OF INCORPORATION FOR A LOCAL DEVELOPMENT COMPANY ELIGIBLE TO APPLY FOR A LOAN UNDER SECTION 502 OF THE SMALL BUSINESS INVESTMENT ACT OF 1958, AS AMENDED [This Form may require technical or formal changes in order to comply with requirements of State laws and State officials. Applicants should consult with their attorney to insure compliance with such requirements.] CERTIFICATE OF INCORPORATION )F [LOCAL ECONOMIC DEVELOPMENT COMPANY] FIRST: The name of the corporation is [ ] De- elopment Company. SECOND: Its principal office in the State of [ ] is seated at [ ], in the City of [ ], County of ]. The name and address of its resident agent is ]■ THIRD: This corporation is organized and chartered for fie purpose of furthering the economic development of area of operations] and its environs, and promoting and ssisting the growth and development of business concerns, lcluding small business concerns, in said area. The primary bjective of this corporation shall be benefit to the com- ity as measured by increased employment, payroll, busi- ess volume, and corresponding factors rather than mone- ary profits to the shareholders. Any monetary profits or ther benefits which flow to shareholders shall be merely icidental thereto. FOURTH: The corporation is authorized and empow- red to do all things necessary to carry on and accomplish lie purpose for which it is organized and chartered, in- luding authority and power: To enter into, make, and perform contracts of every ind and description. To borrow or raise money for any of the purposes of tie corporation and, from time to time without limit as to mount, to draw, make, accept, endorse, execute, and issue romissory notes, drafts, bills of exchange, warrants, bonds, ebentures, and other negotiable or nonnegotiable instru- lents and evidences of indebtedness, and to secure the ayment of any thereof and of the interest thereon by lortgage upon or pledge, conveyance, or assignment in rust of the whole or any part of the property of me cor- oration, whether at the time owned or thereafter acquired, nd to sell, pledge, or otherwise dispose of such bonds or ther obligations of the corporation for its corporate pur- oses. To lend to any person, firm, or corporation any of its inds, either with or without security. To purchase, hold, sell, and transfer the shares of its wn capital stock. To promote and assist the growth and development of nail business concerns and others. To have one or more offices, to carry on all or any f its operations and business and without restriction or mit as to amount to purchase or otherwise acquire, hold, wn, mortgage, sell, convey, or otherwise dispose of, real nd personal property of every class and description. To acquire, construct, convert, or expand plant facili- es for lease or sale. High or Low Shareholder Vote and Quorum Requirements Except with respect to the election, removal, and filling of vacancies of directors, (a) the holders of at least three- quarters [or some other fraction] of the outstanding shares of both Class A and Class B Common Stock of the Corpo- ration shall be present in person or by proxy at any meet- ing of shareholders in order to constitute a quorum for the transaction of business and (b) the votes of the holders of at least three-quarters [or some other fraction] of the outstanding shares of both Class A and Class B Common Stock of the Company shall be necessary at any meeting of shareholders for the transaction of any business, includ- ing amendments to the Certificate of Incorporation. Election of Directors by Classes of Shares The number of directors of the Corporation shall be [four], of which [two] directors shall be Class A directors and [two] directors shall be Class B directors. The number of directors may be changed only by amendment to the Certificate of Incorporation. At least one-half [or three- quarters] of the entire authorized Board of Directors of the Corporation, including at least [one] of the Class A and [one] of the Class B directors, shall be necessary in order to constitute a quorum for the transaction of any business by the Board of Directors. The affirmative votes of one-half [or three-quarters] of the entire Board of Di- rectors of the Corporation, including the affirmative votes of at least [one] Class A and at least [one] Class B director, shall be necessary for the transaction of any business by the Board of Directors. Class A directors shall be elected by the affirmative vote of holders of at least a majority of the shares of Class A Common Stock at that time outstanding. The holders of Class B Common Stock may not vote in the election of Class A directors. The directors of Class B Common Stock shall be elected by the affirmative vote of holders of at least a majority of the shares of Class B Common Stock at that time outstanding. The holders of Class A Common Stock may not vote in the election of Class B directors. Holders of Class A Common Stock shall have the right by affirmative vote of holders of at least a majority of the shares of that Class of stock at the time outstanding to remove any or all of the Class A directors, with or without cause, and shall have the right by that vote to fill any vacancy among the Class A directors, whether arising from removal of a director or from any other cause. Holders of Class B Common Stock shall have the right by the affirma- tive vote of holders of at least a majority of the shares of that Class Stock at the time outstanding to remove any or all of the Class B directors, with or without cause, and shall have power by that vote to fill any vacancy among the Class B directors, whether arising from removal of a di- rector or from any other cause. Amendment of By-Laws by Directors The By-Laws may be altered, amended, repealed, or added to by the affirmative vote of at least three-quarters 207 of the directors. However, any By-Laws adopted by the Board may be altered, amended, or repealed by the affirma- tive vote of the holders of a majority [or three-quarters] of both Class A and Class B shareholders entitled to vote in the election of directors. Preemptive Rights No Class A shareholder and no Class B shareholder of this Corporation shall have a preemptive right because of his shareholdings to have first offered to him any part of any of the presently authorized shares of this Corporation hereafter issued, auctioned, or sold, or any part of any debenture, bonds, notes, or securities of this Corporation convertible into shares hereafter issued, auctioned, or sold by the Corporation. Thus, any and all of the shares of this Corporation presently authorized, and any and all deben- tures, bonds, notes, or securities of this Corporation con- vertible into shares and any or all of the shares of the Corporation which may hereafter be authorized, may at any time be issued, auctioned and contracted for sale and/ or sold and disposed of by direction of the Board of Di- rectors of this Corporation to such persons, and upon such terms and conditions as may to the Board of Directors seem proper and advisable, without first offering said shares or securities or any part thereof to existing shareholders. Corporate Actions Requiring Approval of Certain Classes of Shareholders The holders of both Class A and Class B Common Stock shall vote as a class by a plurality of the votes cast at a meeting for any corporate action in which a class vote is required by the local corporation law or by these Articles. Cumulative Voting for Directors In all elections of Class A directors of this corporation, each Class A shareholder shall be entitled to as many votes as shall equal the number of votes which (except for these provisions) he would be entitled to cast for the election of Class A directors with respect to his Class A shares multiplied by the number of Class A directors to be elected, and he may cast all of such votes for a single Class A di- rector or may distribute them among the number to be voted for, or among two or more of them, as he may see fit. In all elections of Class B directors of this corporation, each Class B shareholder shall be entitled to as many votes as shall equal the number of votes which (except for these provisions) he would be entitled to cast for the election of Class B directors with respect to his Class B shares multiplied by the number of Class B directors to be elected, and he may cast all of such votes for a single Class B director or may distribute them among the number to be voted for, or any two or more of them, as he may see fit. Indemnification of Officers, Directors, and Agents It is expressly provided that any and every person made a party to any action, suit, or proceeding by or in the right of the Corporation to procure a judgment in its favor by reason of the fact that he, his testator or intestate, is or was a director or officer of this Corporation or of any corporation which he served as such at the request of this Corporation, may be indemnified by the Corporation to the full extent permitted by law, against any and all reasonable expenses, including attorneys' fees, actually and necessarily incurred by him in connection with the defense of such action or in connection with any appeal therein, except in relation to matters as to which it shall be adjudged in such action, suit, or proceeding that such officer or director has breached his duty to the corporation. It is further expressly provided that any and every per- son made a party to any action, suit, or proceeding other than by or in the right of the Corporation to procure a judgment in its favor, whether civil or criminal, including an action by or in the right of any corporation of any type or kind, domestic or foreign, which any director or officer of the corporation served in any capacity at the request of the Corporation, by reason of the fact that he, his testator or intestate, was a director or officer of the corporation, or served such other corporation in any ca- pacity, may be indemnified by the Corporation, to the full extent permitted by law, against judgments, fines, amounts paid in settlement, and reasonable expenses, including at- torneys' fees, actually and necessarily incurred as a result of such action, suit, or proceeding, or any appeal therein, if such person acted in good faith for a purpose which he reasonably believed to be in the best interests of the Cor- poration and, in criminal actions or proceedings, in addi- tion, had no reasonable cause to believe that his conduct was unlawful. Staggered Terms for Directors Each director of this Corporation shall serve a term of [two] years from the date of his election. One-half of each Class of directors shall be elected in even numbered years, and one-half of each Class of directors shall be elected in odd numbered years. Of the original directors, the terms of one-half of them, Messrs. [ ] and [ ], shall expire [one] year from the date of incorporation; and the terms of the other half of them, Messrs. [ ] and [ ], will expire [two] years from the date of incor- poration. Amendment of Articles of Incorporation The holders of the shares of Class A Common Stock and the holders of the shares of Class B Common Stock shall be entitled to vote and to vote as a class upon the authorization of an amendment to the Articles of Incor- poration. No amendment shall be effective unless voted to by the holders of at least %th of the outstanding shares of both Class A and Class B Common Stock. Definition of Those Eligible To Become Shareholders of Class A Common Stock Only low-income people, as defined in the following paragraph, are entitled to purchase Class A Common Stock, and only upon such terms as are set forth in the By-Laws. Income is no bar to the purchase of the Corporation's Class B Common Stock; issue of such stock is based upon the terms and conditions set forth in the By-Laws. Persons who come from families, as families are defined under the laws of this State, with the following composition in income are deemed low-income earning people from low-income neighborhoods, and thus entitled to purchase or hold Class A Common Stock: (a) single individual or family up to two persons, joint income of [$ ]; (b) family of three with a total joint income of [$ ]; (c) family of four with a total joint income of [$ ]; (d) family of five with a total joint income of [$ ]; (e) family of six with a total joint income of [$ ]; (f) family of seven with a total joint income of [$ ]. [The monetary limitations on the terms low-income persons will vary widely depending upon the economic circumstances of the area in which the Corporation is doing business.] Community Advisory Croups The Board of Directors may in its discretion cause to be established a Community Advisory Group. The Community 208 Advisory Group will provide advice to the Board of Direc- tors concerning the relations of the Corporation with the community and such other business and affairs of the Corporation which may be from time to time designated by the Board of Directors. The Community Advisory Group shall consist of [8] members. [Four] shall be appointed by the Board of Direc- tors, and one Director each shall be appointed by each of the following community organizations: [ ], [ ], [ ], and [ ]. [Community groups such as Model Cities Programs, local war-on-poverty committees, and other community action groups.] The term of office of all members of the Community Advisory Group shall be one year and all members shall serve without pay. No member of the Community Advisory Group shall have a substan- tial financial interest in any of the small business concerns to which the Corporation shall give aid. The Community Advisory Group shall counsel the Cor- poration in matters pertaining to public relations in the community and shall plan and supervise efforts to create a dialogue between the Corporation and the community. It shall from time to time review reports from the Board of Directors or officers of the Corporation, and disclose in detail the financial condition of the Corporation and its operations in the community at large. The community board shall assist in the formulation of policy of the Cor- poration with respect to its external affairs and shall exer- cise its powers in the best interests of the community. This article shall not be interpreted so as to relieve the Board of Directors or any member thereof of any responsibility imposed upon it or him by law. Regular meetings of the Community Advisory Group may be held without notice. Special meetings of the Com- munity Advisory Group may be called by the President of the Corporation or at the written request of two or more members of the Community Advisory Group, and notice of such special meetings shall be delivered not less than [3] days before the date of the meeting either personally or by mail, to each member of the Community Advisory Group at his or her home address. Meetings of the Com- munity Advisory Group, at the discretion of the group, may be held open to the public. Mandatory Buy-Out and Right of First Refusal If any shareholder wishes to dispose of his shares during his lifetime, he shall be required first to offer the same to the corporation and the corporation shall have the first option to buy all, but not less than all, of said shares. If the corporation does not exercise the aforesaid option within 30 days after it has been given written notice of the shareholder's desire to sell his shares, then the other share- holders shall have an option for another 30 days, to pur- chase all, but not less than all, of such shares. The purchase price of such shares shall be determined in accordance with the following paragraph. If the shareholders do not exercise the aforesaid option, then the shareholder wishing to do so, may act freely to dispose of his shares. The purchase price per share shall be its book value at the end of the fiscal quarter-year in which the shareholder notifies the corporation of his intention to sell. Such book value shall be determined by the corporation's accountants in accordance with the usual and accepted accounting procedures. Appendix 10— A QUESTIONNAIRE FOR BORROWER [NAME OF SBIC] [Name of Borrower] The answers to this questionnaire will be used in the preparation of papers in this transaction and to determine your firm's eligibility for financing through [name of SBIC]. Accordingly, all questions should be answered accurately and compeltely by an officer or other employee of your firm who is thoroughly familiar with the business and affairs of the firm. 1. Has the Small Business Administration (SBA) spe- cifically determined your firm to be a "small business con- cern" for purposes of the Small Business Act? (Circle one.) Yes No 2. If your answer to question 1 is yes, is a certificate of such determination by SBA still in effect? (Circle one.) Yes No 3. If your answer to question 1 or 2 is no, answer the following questions: (a) Is your firm, together with its "affiliates" (firms which directly or indirectly are controlled by, control, or are under common control with your firm, whether through the ov/nership of voting securities, by contract, or other- wise, other than through a franchise agreement in which the controlled franchisee has the right to profit from his effort and bears the risk of loss or failure; include non- profit and foreign firms but not a firm licensed as a small business investment company), independently owned and operated? (Circle one.) Yes No (b) Is your firm, together with its affiliates (as here- inabove defined), dominant in its field (i.e., does it exer- cise a controlling or major influence on a national basis in a field in which a number of firms are permanently engaged? (Circle one.) Yes No (c) Does your firm, together with its affiliates (as hereinabove defined), have assets exceeding $5 million? (Circle one.) Yes No (d) Does your firm, together with its affiliates (as hereinabove defined), have net worth in excess of $2.5 million? (Circle one.) Yes No (e) Does your firm, together with its affiliates (as hereinabove defined), have average net income (computed without benefit of loss carryovers), after Federal income taxes, in excess of $250,000 for the preceding two fiscal years? (Circle one.) Yes No 209 4. State below the products, field operation or activity (or, if your firm produces a number of products or is engaged in a number of activities or provides a variety of services, each of which is considered a separate indus- try, the industry) which produced the greatest percentage of gross sales or receipts for your firm (not including affiliates) for the past fiscal year, and give the other in- formation called for: Industry, principal product sold or field of operation or activity: [ ], Aggregate annual receipts therefrom and of affiliates for past fiscal year: $[ ]. Average aggregate annual receipts therefrom and of affiliates for past 3 fiscal years: $[ ]. Number of employees* : [ ]. 5. State in detail the end use of uses proposed to be made of the funds to be provided by [name of SBIC] in connection with this financing. 6. If any part of the funds provided by [name of SBIC] in connection with this transaction is to be used or applied, directly or indirectly, to discharge or to free other funds for use in discharging any indebtedness or other obligation of your firm to [name(s) of associate(s) of SBIC], describe such indebtedness or obligation and state the original term thereof. 7. Please give the following information concerning your firm: (a) State the exact name of your firm, indicating the type of business entity (e.g., partnership, corporation, as- sociation, cooperative, sole proprietorship, etc.). (b) Give the date and jurisdiction in which the cer- tificate of partnership, certificate or articles of incorpora- tion, or other document (by which the firm was formed) was filed. After answering, skip to subparagraph ( 1 ) below if your firm is not a corporation. (c) List the jurisdiction or jurisdictions in which your firm is licensed or qualified to do business, if any. (d) List the jurisdiction or jurisdictions (other than those listed in subparagraph (c) above) in which your firm has salesmen, offices, or property or conducts any operations. (e) Describe the classes or series of stock of the cor- poration and the number of shares of each such class or series authorized and outstanding and the par or stated value of the shares of each such class or series. Security designation Number of shares authorized or articles of incorporation of your firm, quote the appli- cable provision of the certificate or articles in full. (i) Has your firm made an election under Section 1372(a) of the Internal Revenue Code to be treated as a small business concern for Federal income tax purposes which is still in effect? (Circle one.) Yes No (j) Describe briefly any outstanding or existing op- tions, warrants, or other securities, contracts, plans, or agreements (i) giving the holder or other person the right to purchase any class of stock of the firm or (ii) con- vertible into shares of stock of the firm or (iii) under which any options, warrants, or convertible securities may be issued in the future. Description of op- tion or contract Purchase or con- version price per share Security subject to option or to be issued Number of shares (k) List the name of each stockholder of the firm as his name appears on the books of the firm, and state the number of shares of each class or series of stock held by each such stockholder (if there are more than ten stock- holders of any class or series, list only the names of the holders of 10 percent or more of the outstanding shares of each class or series). Stockholder Number of shares Class or series (1) List the names and addresses of the members of the board of directors, the partnership, or similar govern- ing body of your firm (if a partnership with both general and limited partners, indicate the type of partner next to each name). Names: Addresses: (m) List the names and addresses of the officers, managing partners, or other persons having primary au- thority to contract for your firm, and the office held by each (the names should appear exactly as such persons sign in their official capacities). Name Address Office Number of shares outstanding Par or stated value (f) State briefly the voting, participation, preference, and other special rights of each class or series of stock mentioned in subparagraph (e) above, and the restrictions on transfer, limitations, and other qualifications applicable thereto, if any. Security designation Rights, limitations, etc. (g) Are stockholders granted pre-emptive rights, either by statute or under the certificate of incorporation? (Circle one.) Yes No (h) If your answer to subparagraph (g) above was yes and pre-emptive rights are granted by the certificate (n) List the exact name and State of incorporation of any corporation (other than a company licensed under the Small Business Investment Act of 1958) of which your firm is the owner of shares entitled to elect a majority of the board of directors. If there is no such corporation, state "None." Corporation State of incorporation (o) If your firm is presently indebted to any partner, stockholder, director, officer, or employee of the firm in an amount exceeding $[ ], give the name of such ♦Where the number of employees is called (or, state the average number of employees employed by your firm and its affiliates (domestic and foreign) on a full-time, part-time, temporary, or other basis during the pay period ending nearest the last day of the third month in each calendar quarter for the preceding 4 quarters or, if your firm has not been in existence for 4 full quarters, the average number of employees employed on such basis during that pay period ending nearest the last day of each month your firm has been in existence. 210 person, his relationship (e.g., stockholder, partner, etc.) to the firm and the balance due on the debt. .Xumc Relationship to firm Balance due (p) Is your firm obligated for borrowed money (other than a debt contracted in the normal course of business involving a line of credit or short-term financing with a maturity of one year or less) to [name(s) of associate(s) of SBIC] or to any officer, director, or employee of [name(s) af associate(s) of SBIC] or to any officer, director, or ;mployee of [name of SBIC] or any close relative of any such officer, director, employee or to any concern of which, to your knowledge, any such officer, director, employee, or dose relative is an officer or director or owns, directly or indirectly, 10 percent or more of the equity stock? Include guaranties where the underlying obligation, if made by your firm, would be covered. (Circle one.) Yes No (q) List all of the firm's outstanding obligations for borrowed money to banks, insurance companies, and other institutional lenders having a maturity in excess of one year (exclude transactions reportable under subparagraphs (o) and (p) above in which title to goods sold is retained in the seller or lender until the price is paid), and, if the debt is secured, describe how (e.g., by real estate mortgage, assignments of accounts, etc.). Include guaranties where the underlying obligation, if made by your firm, would be reportable. Lender How secured Balance due or amount guaranteed (r) List all other outstanding obligations of your firm for borrowed money in excess of $[ ] (exclude trans- actions covered by subparagraphs (o), (p), and (q) above and obligations for the purchase price of goods where title is retained in the seller or lender until the price is paid). Include guaranties where the underlying obligation, if made by your firm, would be reportable. Lender Balance due or amount guaranteed (s) List and describe on Annex I hereto all contracts, agreements, leases, and other instruments (including em- ployment contracts, license agreements, and agreements for sale of goods where title is retained in the seller or lender until the price is paid) to which your firm is a party, under which the firm is obligated to pay to any person, firm, or corporation fees or compensation at an annual rate, or during the life of the contract, exceeding $[ ]. (t) List and describe on Annex II hereto all patents, patent rights, trade marks, trade mark rights, service marks, service mark rights, trade names, trade name rights, fran- :hises and franchise rights, and other business property rights presently owned by the firm or as to which there is pending a patent, trade mark, service mark, franchise, ar other application on behalf of the firm (if business sroperty rights have been previously described on Annex [ hereto in response to subparagraph (s) above, describe such rights by cross-reference to the description contained in Annex I). (u) Give the name or names of any regulatory x>d(y)(ies) or agenc(y) (ies) having jurisdiction over your irm, indicating whether State or Federal if not apparent :rom the name. (v) To your knowledge, will the consummation of his transaction (i) conflict with, violate, or result in the breach of any term, condition, or provision of any law, rule, regulation, order, writ, injunction, decree, determina- tion, or award of any court, governmental body or regula- tory agency, authority, board, commission, or other in- strumentality or arbitrator having jurisdiction over your firm, or the firm's certificate or articles of incorporation or by-laws or of any indenture or bank loan or credit agreement or instrument to which the firm is a party or by which it or its property may be bound or affected, or constitute a default under any such indenture, agreement or instrument, or (ii) require the approval, consent, or authorization of any governmental body or regulatory authority or any other person, firm, or corporation? (Circle one.) Yes No (w) Are there any actions, suits, or proceedings pend- ing or, to your knowledge, threatened against or affecting the firm or any of its properties before any court, govern- mental body or regulatory authority, agency, board, com- mission, or other instrumentality or arbitrator? (Circle one.) Yes No (x) If you have answered yes to subparagraph (w) above, briefly describe the title and nature of the action, suit, or proceeding and the amount in controversy. 8. Has the firm engaged or used the services of any per- son (other than a regular employee of the firm, its regular auditors and/or legal counsel acting for the firm in this transaction) in connection with this financing? (Circle one.) Yes No 9. If your answer to question 8 was yes, give the name and address of such person, describe briefly the services rendered or to be rendered by him in connection with this transaction, and state the fee or other compensation paid or to be paid to such person. 10. Give the name, firm affiliation (if any), complete address (including zip code), and telephone number of your firm's regular auditor. 11. Give the name, firm affiliation (if any), complete address (including zip code), and telephone number of legal counsel who will represent your firm in this trans- tion. 12. Give the address (including zip code) of your firm to which notices, payment, or the delivery of securities under any documents are to be sent. 13. Give the name, title, and telephone number of the person in the firm, if any, who is to receive drafts and other papers in connection with this transaction, and his complete address (including zip code) if different from that stated in paragraph 12 above. 14. When returning this questionnaire, include a copy of the certificate of partnership, certificate or articles of incorporation, or other document by which your firm was formed and include the articles of partnership, by-laws, or other instrument by which your firm is governed. In- clude all amendments thereto made to the date hereof. Dated: [ ] [ ] Officer; Partner; Manager Return to the undersigned: [name and address of SBIC] Attn: Mr. [ ] ANNEX I Description of agreement: Annual or total fees payable: ANNEX II Patents, patent rights, etc.: 211 Appendix 10— B CHECKLIST FOR SBIC STAFF [Name of SBIC| Re: [Name of Small Business Concern] 1. Has [name of SBIC] determined the above concern to be a qualified small business concern? (Circle one.) Yes No 2. Is the above concern an associate* of [name of SBIC]? (Circle one.) Yes No 3. To your knowledge, will any part of the funds pro- vided by [name of SBIC] in this transaction be used or applied by the above concern to or for the benefit of any associate of [name of SBIC]? (Circle one.) Yes No 4. To your knowledge, is the above concern an associate of any other licensed small business investment company? (Circle one.) Yes No 5. To your knowledge, will any part of the funds pro- vided by [name of SBIC] in this transaction be used or applied by the above concern to or for the benefit of any associate of another licensed small business investment company? (Circle one.) Yes No 6. To your knowledge, is [name of SBIC] or any of its associates indebted, directly or indirectly, to the above concern or to any officer, director or owner of 10 percent or more of the stock of the above concern or to any close relative of any such officer, director, or equity owner? (Circle one.) Yes No 7. To your knowledge, will any part of the funds pro- vided by [name of SBIC] in this transaction be used or applied, directly or indirectly, by the above concern to discharge or free other funds for use in discharging an obligation of such concern to an associate of [name of SBIC] (exclude transactions in the ordinary course of business between the above concern and associates of [name of SBIC] involving lines of credit or short-term financing for a term less than 5 years)? (Circle one.) Yes No 8. To your knowledge, will any part of the funds pro- vided by [name of SBIC] in this transaction be used or applied, directly or indirectly, by the above concern to purchase or to free other funds for use in purchasing property from an associate of [name of SBIC] (exclude transactions in the ordinary course of business between the above concern and any such associate of [name of SBIC] involving lines of credit or short-term financing for a term less than 5 years)? (Circle one.) Yes No 9. To your knowledge, has any associate of [name of SBIC] provided financing (other than a line of credit or short-term financing for a term less than 5 years in the ordinary course of business) to the above concern within the last year or is any such financing (other than as stated above) contemplated to be made by an associate of [name of SBIC] during the coming year? (Circle one.) Yes No 10. To your knowledge, will any associate of [name of SBIC] receive, directly or indirectly, from the above con- cern any fee or compensation in connection with this financing or any money or thing of value for procuring or attempting to procure this financing on behalf of such concern or for influencing or attempting to influence [name of SBIC]'s action with respect thereto (exclude fees or compensation paid to such associate for bona fide services performed for such concern at its request, where such fees or compensation have been approved by [name of SBIC])? (Circle one.) Yes No 11. If the answer to any of the questions posed by para- graphs 2-11 above is yes, has the SBA granted [name of SBIC] an exemption with respect to the transaction in- volved, which is still in full force and effect? (Circle one.) Yes No 12. To your knowledge, will any associate, employee, or representative of [name of SBIC] have served as an officer or director of the above concern or in any other managerial capacity for a period of 30 days prior to the date of closing, or is it anticipated that any such person will so serve in any such capacity in the immediate future? (Circle one.) Yes No 13. If the answer to the previous question is yes, does or will any such person have a direct or indirect financial interest in the above concern to your knowledge? (Circle one.) Yes No 14. Does [name of SBIC] (alone or with any of its as- sociates) presently, or will [name of SBIC] (alone or with any of its associates) immediately after consummation of this financing, exercise control over the above concern, either pursuant to management agreements, voting trusts, majority representation on the board of directors, or other- wise? (Circle one.) Yes No Dated: [ ] Signed: [ ] SBIC Staff Member •An "associate" of a concern is an officer, director, general man- ager, investment adviser, or any person or firm regularly serving as legal counsel of such concern; or a person, firm, or corporation which owns or controls, directly or indirectly 10 percent or more of any class of stock of such concern; or any officer, director, partner, general manager, or employee of any such officer, director, general manager, investment adviser, legal counsel, or stockholder; or any person, firm, or corporation which, directly or indirectly, controls, is controlled by, or is under common control with such officer, director, general man- ager, investment adviser, legal counsel, or stockholder; or any close relative of any such officer, director, general manager, investment adviser, legal counsel, or stockholder; or any concern in which any such officer, director, general manager, investment adviser, legal counsel, or stockholder is a director or officer; or any concern of which 10 percent or more of the equity interest is owned or controlled, directly or indirectly, by any such officer, director, general manager, investment adviser, legal counsel, or stockholder. 212 Appendix 10-C SMALL BUSINESS ADMINISTRATION LICENSE APPLICATION (License Application under The Small Business Investment Act of 1958, as amended.) See Information and General Instructions, SBA Form 415B, as well as specific instructions on each item. Date of Application . Item 1. Name of License Applicant as Specified in Charter (Note: The corporate name should be such as not to misinform or mislead the public as to the purpose and function of the company. The name should not include the words "United States," "National," "Federal," "Re- serve," "Bank," "Government," or "Development." The name should not be so similar to that of another organiza- tion as to imply association therewith without prior approval from such organization. The name must be approved by Small Business Administration.) ABC CAPITAL CORPORATION Item 2. (a) Location of License Applicant (Note: See § 107.101(b) of the Regulations. Give full address below, and by separate Exhibit a brief descrip- tion of size and type of space. The office location can be in the same office building as that of another Licensee, but should otherwise be phvsically separated from any other Licensee. If the location is within the offices of another entity, there should be at least one room devoted solely to Licensee use. Licensee's name should appear on a street- level sign or building directory. No branch office or agency should be established without SBA approval.) Street and No. 1500 Park Avenue New York City County NewJork_ Zip Code 10090 Telephone i212^_100-1000_ Item 3. Capitalization (Note: See $ 107.101(d) of the Regulations. The minima therein prescribed are exclusive of organization ex- pense.) ( X ) Proforma ( ) Actual as of Check One Capital Stock No. of shares authorized 300.000 Par value ( X ) or stated value I ) per share J 1.00 No. of shares issued and fully paid 100,000 Issue price per share J|> 3. PC Paid-in capital and paid-in surplus ? 300,000 Less organization expense, actual or estimated Net paid-in capital and paid-in surplus ___^^^^___^ Give a brief summary description of each class of stock, outlining voting rights and any provisions relating to dividends, liquidation, preemption, conversion, redemption, assessments or limitations on disposition. Item 4. Source oj Capital ( a ) Initial Capital (II Describe plans for raising the capital shown in Item 3. Include the manner in which the securities were or are to he offered; e.g., by sale to the general public, or, if no offering was or is to be made to the general public, the number nf persons, or names of persons to whom securities were or are to be offered. Any relationship of such persons to the License Applicant should be stated. Also state whether such persons took or are to take the securities for investment or for resale to others. Describe the manner of offering; e.g., personal contact (indicate whether by paid salesmen or otherwise I, use of printed sales literature, newspapers or other advertising, etc. (2) State the number of beneficial owners of each class of securities as at the completion of the initial fi- nancing reported above. If a corporation owns or will own 10"< or more of the voting securities, state the number of beneficial owners of the equity securities of that corporation. State the percentage of the total assets of the cor- poration accounted for by securities issued by SBICs. Item 5. Operating Area State the geographical area, by State, section of State, or other political subdivision, in which the business of the License Applicant will be principally carried on. Item 6. Need for Licensee in Operating Area Describe the need for the type of financing to be supplied by the License Applicant in the Operating Area. In- clude a description of the economic characteristics of the Area and its predominant income generators. SBA FORM 415(4 70) PREVIOUS EDITIONS ARE OBSOLETE 213 Item 7. Plan of Operations If an exception to the investment policy provision of Section 107.101 Ic I is requested to be authorized, give full detailed description for the reason and rationale for such request. Give any affiliation between the Investment Adviser and any Associate of the Applicant and state if Investment Adviser is connected in any way with any Licensee. Give affiliation or association between any officer, director, or general manager or 10% owner of the Appli- cant and any other Licensee or the Investment Adviser of any other Licensee. Item 8. Management and Control See § 107.101(a ) and (c), and 107.702. (a) Relationship List by name and address the following persons, corporations, partnerships and any other entities, and show in tabular form. I i I the proposed title or relationship of each to the Applicant, (ii I their annual rate of remunera- tion and other emoluments and (iii) the percentage of each class of capital stock and other securities of the Appli- cant owned or to be owned by each directly or indirectly. (1 1 All persons who are or who it is presently contemplated will be officers or directors I including general manager) and any concern which is or will be the general manager or Investment Adviser of the Applicant, and (2 I Each person, corporation, partnership, trust or other entity, which owns or proposes to own, either di- rectly or indirectly 10' < or more of the voting securities issued or to be issued by the Applicant. Where a corpora- tion owns or is to own beneficially 10$ or more of the voting securities of the Applicant, state the names and addresses of all beneficial holders of 10$ or more of the voting securities of that corporation and the percentage of such securities owned by each. Submit as an exhibit a copy of any contract between the Applicant and any person, concern or other entity named in this item. (b) Arrangements Affecting Control Are shares of Applicant set forth in response to (a) above: (11 Owned or to be owned indirectly by other persons; Yes ( ) No ( X) (2| To be transferred, or resold, to others; Yes ( ) No ( X) (3) Now subject, or to be made subject to any loan or pledge incident to the purchase thereof •_ Yes ( ) No ( Xl (4) To be subject to any understanding or commitment as to exercise of voting rights _Yes ( ) No ( X) If the answer to any question is yes, attach an exhibit giving the material and substantive details of all ar- rangements existing or presently contemplated with respect thereto. Item 9. Articles of Incorporation A copy of the Articles of Incorporation, certified by the Secretary of State, or other appropriate authority shall be filed with the SBA. The Articles of Incorporation shall contain in an appropriate place the following pro- vision: This corporation is organized and chartered solely for the purposes of operating under the Small Business Investment Act of 1958, as amended. Item 10. Bylaws of Applicant, certified by appropriate corporate official. Item 11. Certified copies of minutes of corporate meeting at which present Directors were elected. Item 12. Certified copies of minutes of the meeting of Directors at which the present corporate officers were ap- pointed. Item 13. Certified copies of a resolution of the Board of Directors authorizing the execution and submission of this License Application. Item II. Name of bank or banks in which cash is deposited and name of custodian of securities , if any. Item 15. Letter or letters addressed to SBA from bankfsl or custodian(s) to evidence cash or securities on de- posit to the account of the Applicant or in escrow and setting forth therein any encumbrances or restrictions against such deposits. Item 16. Evidence issued by the Securities and Exchange Commission that the securities of the Applicant sold or proposed to be sold, as set forth in its License Application, are not required to be registered under the Securities Act of 1933 and that the Applicant is not required to register as an investment company under the Investment Company Act of 1910; or. if such registration is required, evidence satisfactory to SBA that the Applicant has complied with such requirements. SBA FORM 415 (4 70) 214 Item 17. A written opinion of counsel for the Applicant addressed to SBA stating that: (a) The Applicant has complied with all applicable local, state and federal laws in the formation and organi- zation of the company; (b) The Applicant, in selling its stock to obtain the required capital and surplus, has complied with every law, regulation and obligation relating to or controlling the sale of its stock and is and will be authorized and en- titled to receive and retain the funds paid or to be paid to it by each entity in consideration for said stock issued or to be issued by the Applicant; and (cl The Applicant is chartered by the appropriate authorities to conduct, in its proposed operating territory, or area, only the activities described under Title III of the Small Business Investment Act of 1958, as amended. (d) The Applicant is authorized and entitled to conduct said franchise powers in full in each jurisdiction to be named in its License as part, or all, of its operating territory, or area, immediately upon the issuance of a Li- cense. Item 18. Names of Persons Assisting in Preparation oj this Application In connection with the preparation or presentation of this Application, list the names, addresses, description of services, total compensation paid, or to be paid, of all attorneys, accountants, appraisers, agents, and all other parties engaged by or on behalf of the Applicant for the purpose of rendering professional or other services of any nature whatever to the Applicant. Item 19. Declaration oj Applicant (Note: This Declaration is to be executed by the Applicant Corporation and in their individual capacities by all officers and directors of the Applicant, either proposed or duly elected, and by all persons who own or intend to own, directly or indirectly, 10'/ or more of the voting stock of the Applicant.) (a) We represent that the Licensee will be operated in full conformity with the Small Business Investment Act of 1958. as amended, and the Small Business Administration regulations pertaining thereto. (b) We have not and will not. directly or indirectly, use any funds advanced by any small business invest- ment company to any small business concern, or use any funds available as a result of funds advanced by a small business investment company to a small business concern, to purchase any stock of the Licensee or for the purpose of repaying any obligation incurred in connection with the furnishing of funds to be used for the purchase of any stock of the Licensee. (c) We represent that the Licensee will not engage in any transaction with any of the persons or entities set forth in S 107.1004 of the Regulations except as permitted by the terms of said section. (d) We hereby certify that all information submitted in this Form 415 and in the exhibits submitted there- with, or in connection therewith, is true and correct to the best of the knowledge and belief of each one of us and that it is being submitted for the purpose of obtaining a license to operate as a small business investment company. We further agree that all statements made in this Form 415 and in the said exhibits are to be considered material for the purpose of inducing SBA to issue a license and to disburse SBA funds in reliance on the said statements. SBA FORM 415 (470) 215 Corporate Execution Corporate Seal ATTEST: ( Secretary of Licensee) Individual Execution ABC CAPITAL CORPORATION (Name of Licensee) By: I Signature I John P. Jones I Typed Name I President Dated this (Title) day of , 19_ (Signature) (Signature) (Signature) Nat Hale Elizabeth Tudor Edgar Philanthrop III (Typed Name) (Typed Name) ( Typed Name ) (Signature I (Signature) I Signature) Raymond P. Gladhand Earnest Worker (Typed Name I (Typed Name) (Typed Name I (Signature) (Signature) (Signature) (Typed Name) (Typed Name) (Typed Name) I Signature) I Signature) (Signature) (Typed Name) (Typed Name) (Typed Name) (Signature I (Signature) (Signature) (Typed Name) SBA FORM 415 (4 70) (Typed Name) (Typed Name) 216 ABC CAPITAL CORPORATION Item 2. Location of License Applicant (b) Arrangements have been made for the rental of ap- proximately 450 square feet of office space at the specified location. It is anticipated that the rent for such space will be approximately $180 per month, under a standard com- mercial lease. Applicant's office will be reasonably acces- sible and will be clearly identified in the building. Appli- cant's office will not be shared with any other organization or business. Item 3. Capitalization Applicant has only one class of stock, designated as Common Stock, par value $1.00 per share. The holders of Common Stock of Applicant are entitled to exercise general voting rights at all meetings of stockholders of the corporation, including meetings held for the election of directors, and are entitled to one vote for each share of Common Stock held by them. Stockholders do not have preemptive rights to subscribe to additional issues of shares of stock of the corporation, but have the right to vote cumulatively as provided in the Certificate [Articles] of Incorporation. Holders of Common Stock are entitled to receive such dividends as may be declared by the Board of Directors from time to time on Applicant's Common Stock in accordance with applicable provisions of law. On dissolution, the holders of Common Stock of Applicant share in the balance (if any) of the assets of Applicant remaining after the payment of all debts of Applicant and the expenses of dissolution, in accordance with their then stock holdings without preference or priority of one stock- holder or another. Item 4. Source of Capital (a) Initial Capital (1) The $300,000 of private capital shown at Item 3 will be raised through the sale of shares of Applicant's Common Stock to a maximum of 20 investors. Such shares will be offered privately to investors in the State of New York. Five of said investors will be officers and/or directors of Applicant, as shown in response to Item 8(a); all of said investors will be required to represent at the time of sale that the shares of common stock acquired by them are purchased for investment and not with a view to the resale or distribution thereof. All offerings of Common Stock will be made by personal contact. No salesmen, printed sales literature, or newspaper or other advertising will be used. (2) As of the completion of the initial financing re- ported at Item 4(a)(1) above, there will be no more than 20 beneficial owners of the Common Stock of Applicant. No corporation will beneficially own 10 percent or more of the voting securities of Applicant. One hundred percent of the total assets of Applicant will be accounted for by securities issued by Applicant. (b) Additional Capital (1) Applicant has no plans for raising additional capi- tal during the first year through the sale of Common Stock of Applictant. Applicant does, however, plan to raise addi- tional funds as they are needed through the sale of its debentures to the SBA at such time as 75 percent of Appli- cant's private capital has been invested in qualifying small business concerns. (2) Applicant has no present plans for the expansion of resources in the second or subsequent years except that at such time as 75 percent of Applicant's private capital has been committed to investments in small business con- cerns, Applicant proposes to sell its debentures to the SBA pursuant to the authority contained in Section 107.201 and 107.202 of the Regulations under the Small Business In- vestment Act of 1958, as amended. Item 5. Operating Area Applicant will conduct its operations principally within the City and State of New York, without regard, however, to the residence, domicile, place of business, or location of the property of any small business concern or any other party with which Applicant may be involved or otherwise transact business. Item 6. Need for Licensee in Operating Area According to a recent market survey, there are approxi- mately 232,000 small businesses in the New York City area alone. The financial needs of small businesses in the area are not being met, particularly those operating in the dis- advantaged communities of New York in which Applicant proposes to make the bulk of its investments. Small busi- nesses in general in New York have found it difficult to satisfy their needs for financing through conventional sources because they cannot offer satisfactory security or conform to institutional lending policies. This is particu- larly true in the case of disadvantaged small business concerns. Applicant believes that there is a real need for sources of funds which can be made available to disad- vantaged businesses in New York City and believes that the grant of a license authorizing Applicant to provide long-term loans and equity capital to small business con- cerns operating for the most part in the ghetto is consonant with the Small Business Investment Act of 1968, as amended, and the Regulations thereunder. Item 7. Plan of Operations As indicated in response to Item 6, Applicant proposes to concentrate in financing disadvantaged small business concerns in New York City but may also finance qualify- ing small business concerns doing business outside ghetto areas. Applicant will be prepared to provide both long- term loan and equity funds to small businesses, but to the extent practicable will emphasize "equity" and "venture" capital-type financing with a view to increasing Applicant's borrowing capacity under Section 303(b) of the Small Business Investment Act of 1958, as amended. This policy, it is also thought, will provide the greatest benefit to the bulk of the concerns being financed by Applicant since in all probability, such concerns will be start-up concerns or concerns whose full profit potential, while good, has not yet been realized and which are not in a position to meet the debt service requirements of traditional long-term loan obligations. This policy should also enable small busi- ness concerns to show a better balance sheet and make concerns financed by Applicant more attractive to other financing institutions. Pursuant to the authority contained in Section 308(b) of the Small Business Investment Act of 1958, as amended, and Section 107.601(a) of the Regulations thereunder, Applicant also intends to provide management consulting services to concerns financed by Applicant. Such services will be provided on a fee basis where performed by an employee of Applicant. Where possible, however, Applicant proposes to utilize the volunteer services of business and community leaders, graduate students studying law or busi- ness, and other business and professional associations in counseling small business concerns with respect to manage- 217 ment problems. No fee will be charged any small business concern by Applicant for services provided by volunteers obtained by Applicant to assist small business concerns in the management consulting area. Applicant also plans to employ the services of an invest- ment adviser as permitted under Section 107.809 of the Regulations under the Small Business Investment Act of 1958, as amended. Although the services of such an invest- ment adviser have not yet been contracted for, Applicant will furnish the SBA with a copy of any such contract entered into by Applicant on or before the effective date thereof. Applicant is hopeful that it will be able to share the services of an investment adviser on a volunteer basis through a local bank, investment banking institution, or business school, at no or minimum cost to Applicant. At present, Applicant does not foresee that the investment adviser will in any way be affiliated with any associate of Applicant or any other licensee under the Small Business Investment Act or that there will be any affiliation or asso- ciation between any officer, director, general manager, or 10 percent owner of Applicant and any such licensee or the investment adviser of any such licensee. Item 8. Management and Control (a) Relationship Percentage and class of Annual common stock Proposed rate of owned Name and address title compensation (percent) John P. Jones President and $18,000 10 1223 Park Avenue director New York, N.Y. 10094 Nat Hale Vice president. 12,000 5 1491 Broadway treasurer, New York, N.Y. 10097 and director Elizabeth Tudor Secretary 7,200 None 1400 Madison Ave., New York, N.Y. 10096 Edgar Philanthrop III Director None 25 One Wall Street New York, N.Y. 10097 Raymond P. Gladhand Director None 5 1 Madison Ave. New York, N.Y. 10098 Earnest Worker Director None 5 51 Wall St. New York, N.Y. 10099 Item 14, Depository Banks A small portion of Applicant's capital is in cash on de- posit with [ ] Bank, New York, New York. The bulk of Applicant's capital is invested in U.S. Government ob- ligations in accordance with Section 308(b) of the Small Business Investment Act of 1958, as amended, which securi- ties are held in a custodian account with said Bank. Appendix 10— D [ABC Capital Corporation] MINUTES OF ORGANIZATION MEETING l [Date] The Organization Meeting of [ABC Capital Corporation] was held at [place] on [date] at [ ] o'clock. 1. The following incorporators were present: [list names of incorporators], being all the incorporators of the corpora- tion. Mr. [ ], counsel to the corporation, was also present by invitation of the incorporators. 2. Mr. [ ] called the meeting to order and acted as Chairman. Mr. [ ] acted as Secretary of the meeting. 3. The Secretary read a written Call and Waiver of Notice of the meeting, signed by all the incorporators, which was approved and ordered to be filed with the minutes of the meeting. 4. The Chairman reported that the [Certificate] [Articles] 2 of Incorporation of the corporation was [were] filed in the office of the [Secretary] [Department] 2 of State of [ ] on [ ], 19[ ] and [that a copy thereof, certified by the [Secretary] [Department] of State, was recorded in the office of the [ ] of [ ] County on [ ], 19[ ], as required by law, 3 and the Secretary was in- structed to file a copy of the [Certificate] [Articles] 2 of Incorporation with the minutes of the meeting. 5. The Chairman stated that it would be appropriate for the incorporators to adopt By-Laws for the regulation of the business and affairs of the corporation and presented to the meeting a proposed set of By-Laws for consideration by the incorporators. After discussion, upon motion duly made and seconded, the following resolutions were unani- mously adopted: RESOLVED, that the By-Laws presented to this meet- ing be and the same hereby are approved and adopted as the By-Laws of the corporation; and be it further RESOLVED, that the By-Laws approved and adopted at this meeting be marked for identification by the Secretary of this meeting and filed with the minutes of the meeting. 6* The Chairman then stated that the next order of busi- ness was the election of directors to hold office until the first annual meeting of stockholders of the corporation and until their successors are elected and qualify. The Chairman further stated that the number of directors to be elected were [ ], the number fixed by the By-Laws. There- upon, the following persons were duly nominated to serve as directors of the corporation: [list names of nominees for directors]. There being no other nominations, the Chairman ordered the nominations closed and stated that the meeting should proceed to vote with respect to the persons nominated. After 1 In some States if the initial directors are named in the certificate or articles of incorporation, the first meeting of incorporators and the first meeting of directors may be combined. See Appendix 10-E hereto for additional transactions to be reflected in the minutes of the organization meeting where a combined meeting may be held. - Strike out inapplicable language. 3 In some States the certificate or articles of incorporation must be filed or recorded in the county in which the principal office of the corporation is located and compliance with this requirement should be reflected in the minutes. 4 This paragraph may be omitted if the initial directors are named in the certificate or articles of incorporation and the organization meeting is held by such directors. 218 counting the vote which was orally given, 5 the Secretary reported that the above named persons had been unani- mously elected as directors. Thereupon the Chairman de- clared such persons elected directors of the corporation to serve until the first annual meeting of stockholders and until their respective successors are elected and qualify. 7. 6 The Chairman next stated that since it was a require- ment of law that directors be stockholders, it would be ap- propriate for the incorporators to assign their subscriptions to the capital stock of the corporation to the elected direc- tors. Accordingly, each incorporator subscribed a form of Assignment by which each assigned his subscription to shares of the capital stock of the corporation to an elected director, which Assignments were ordered to be filed with the minutes of the meeting. No further business appearing, upon motion duly made and seconded, the meeting was adjourned. A true record. [ ] Secretary of the Meeting Approved : [ ] Chairman of the Meeting ABC Capital Corporation CALL AND WAIVER OF NOTICE Place of Meeting: [ ] Time of Meeting: [ ] The undersigned, being all the incorporators of [ABC Capital Corporation], a [ ] corporation, do hereby call a meeting of incorporators of [ABC Capital Corpora- tion] to be held at the time and place above stated for the purpose of organizing the corporation and transacting such other business as may come before the meeting, and do hereby waive all requirements, statutory or otherwise, of notice of the time, place and purpose of holding said meet- ing, and of publication of such notice, and consent to the holding of said meeting as called and the transaction thereat of any and all business coming before said meeting. Dated: [ ], 19[ ]. [ ] (L.S.) Signature of Incorporator [ ] (L.S.) Signature of Incorporator [ ] (L.S.) Signature of Incorporator ASSIGNMENT KNOW ALL MEN BY THESE PRESENTS that the undersigned, for value received, hereby sells, assigns, trans- fers, and sets over unto [ ] all right, title, and interest of the undersigned, as a subscriber, in and to [ ] share (s) of the [ ] stock, [par value $ [ ] per share] [without par value]*, of [ABC Capital Corporation], a [ ] corporation, and directs that upon the payment in full of the subscription price for said share(s), the cor- poration issue a certificate or certificates for said share (s) to and in the name of the said [ ]. IN WITNESS WHEREOF, the undersigned has executed this instrument the [ ] day of [ ], 19[ ]. [ ] (L.S.) Signature of Incorporator 5 Some States may require the election of directors to be by ballot, in which event additional provisions respecting the distribution, col- lection, and counting of ballots will have to be included in the minutes. A form of ballot should also be prepared for filing with the minutes. r > This paragraph, and the form of Assignment, may be omitted if directors are not required to be stockholders in the corporation or if the incorporators named in the certificate or articles of incorporation are also to be the initial directors. * Strike out inapplicable language. Appendix 10— E [ABC Capital Corporation] MINUTES OF FIRST MEETING OF DIRECTORS [Date] The first Meeting of the Board of Directors of [ABC Capital Corporation] was held at [place] on [date] at [ ] o'clock. 1. The following directors were present: [list names of directors], being all the directors of the corporation. Mr. [ ], counsel to the corporation, was also present by invitation of the Board. 2. Mr. [ ] called the meeting to order and acted as Chairman. Mr. [ ] acted as Secretary of the meeting. 3. The Secretary read a written Call and Waiver of Notice of the meeting, signed by all the directors, which was approved and ordered to be filed with the minutes of the meeting. 4. 1 The Chairman stated that the first order of business was the acceptance by the corporation of directors' sub- scriptions to the capital stock of the corporation and of payment by the directors of the subscription price therefor. The Chairman stated that each director had subscribed to [ ] shares of the [ ] stock, [par value $[ ] per share] [without par value], 2 of the corporation, at a price equal to $[ ] per share, and that upon receipt by the Secretary of payment for said shares, it would be ap- propriate for the meeting to authorize the issuance of cer- tificates to the directors representing the number of shares subscribed for by each and to provide for the allocation of the consideration for the issuance of said shares between capital and surplus. The Secretary thereupon reported that he had received checks from the directors aggregating $[ ] representing the aggregate of the subscription prices for the shares to be issued to directors [and the minimum amount required for the commencement of business]. 3 i This paragraph may be omitted if directors are not required to be stockholders. 2 Strike out inapplicable language. 3 Seme States have minimum paid-in capital requirements before business may lawfully commence, and the subscription prices should equal in the aggregate at least that amount. If this is not the case in a given State, the bracketed language may be omitted. 219 After discussion, upon motion duly made and seconded, the following resolutions were unanimously adopted: RESOLVED, that this corporation accepts the sub- scriptions of Messrs. [ ], [ ], and [ ], directors of the corporation, to purchase [ ] shares each of the [ ] stock, [par value $[ ] per share] [without par value], of the corporation, at a price equal to $[ ] per share, and acknowledges receipt of payment of the subscription price of said shares; and be it further RESOLVED, that so much of the consideration re- ceived by this corporation for the issuance and sale of said shares as shall be equal to $[ ] 4 shall be capital of the corporation and the excess amount of such consideration shall be surplus; and be it further RESOLVED, that the proper officers of this corpora- tion be and they hereby are authorized to execute and deliver, in the name of and on behalf of the corporation and under its corporate seal, to Messrs. [ ], [ ], and [ ], respectively, a certificate or certificates, in the form hereafter adopted by the Board, representing the num- ber of shares of [ ] stock of the corporation pur- chased by such director. The Chairman then declared that with the payment to the Secretary of the subscription price of the directors' shares the corporation had received the minimum amount re- quired by law for the commencement of business and, ac- cordingly, that the business of the corporation could offi- cially commence. 5. 5 The Chairman then stated that copies of the minutes of the Organization Meeting of the corporation, held on [ ], 19[ ], had been distributed to each director, together with copies of each of the documents ordered filed with the minutes of said meeting, including the By-Laws adopted by the incorporators, and that it would be appropri- ate for the directors to approve the minutes and reaffirm the adoption of such By-Laws. After discussion, upon motion duly made and seconded, the following resolutions were unanimously adopted: RESOLVED, that the minutes of the Organization Meeting of the corporation, and the act of the Secretary of the meeting of incorporators in signing them as a true copy, be and the same hereby is approved; and be it further RESOLVED, that the By-Laws of the corporation adopted by the incorporators at the Organization Meeting of the corporation be and the same hereby are in all re- spects approved and adopted as the By-Laws of this corporation. 6. The Chairman stated that the next order of business was the election of officers of the corporation. [The Chair- man reminded the directors that, in accordance with Sec- tion [ ] of Article [ ] of the By-Laws, the Presi- dent of the corporation must be from among their own number and must be elected by ballot.] Thereupon, the Chairman called for nominations for officers of the corpora- tion, and the following persons were nominated to hold the offices below set opposite their names: [list names of nominees and the offices to be held by each]. There being no further nominations, the Chairman ordered the nominations closed and stated that the meeting should proceed to vote with respect to the persons nominated. After counting the vote which was orally given, the Secretary re- ported that the abovenamed persons had been unanimously elected to hold the offices set opposite their names above. The Chairman thereupon declared the abovenamed persons elected to the office above set opposite their respective names, to hold office until the next election of directors and until their respective successors are elected and qualify. 7 [As required by law and by Section [ ], Article [ ] of the By-Laws, the Secretary of the corporation so elected took and subscribed an oath faithfully to dis- charge his duties as Secretary of the corporation, which oath was ordered filed with the minutes of the meeting. The Chairman stated that the Treasurer of the corporation would not be required to give a separate bond for the faithful per- formance of that office or for the restoration of all books, papers, records, vouchers, monies, securities, and other property of the corporation coming into his hands, but that the corporation would rely upon the fidelity bond covering such officer, which would be the subject of separate action to be taken subsequently during the meeting.] 7. The Chairman then presented to the meeting a corpo- rate seal conforming to Section [ ] of Article [ ] of the By-Laws and stated that it would be appropriate for the Board to adopt the seal. Accordingly, upon motion duly made and seconded, the following resolution was unani- mously adopted: RESOLVED, that the seal presented to this meeting, an impression of which is affixed opposite this resolution, be and the same hereby is adopted as the corpo- rate seal of this corporation. [Corporate Seal] 8. The Chairman then presented to the meeting a form of stock certificate to represent shares of the capital stock of the corporation. The Chairman pointed out that by law each stock certificate was required to state, among other things, the designation of shares represented thereby, the par value thereof or that such shares are without par value and the rights, preferences, and limitations with respect thereto, and to be signed by [ ] and [ ] 8 of the corporation, and that the form of the certificate had been preprinted with the required information and with the titles of the officers selected to sign stock certificates from time to time on behalf of the corporation. After discussion, upon motion duly made and seconded, the following resolutions were unanimously adopted: RESOLVED, that the form of stock certificate pre- sented to this meeting, designated to represent shares of the I ] stock, [par value $[ ] per share] [without par value], 9 of this corporation, be and the same hereby is approved and adopted as the official certificate for shares of [ ] stock of the corporation; and be it further RESOLVED, that the [ ] and the [ ] of this corporation be and they hereby are authorized and di- rected from time to time to sign certificates, in the form adopted at this meeting, evidencing fully paid and non- assessable shares of the [ ] stock of the corporation, [par value $[ ] per share] [without par value], for issuance in accordance with the further resolutions of the & Where the shares issued and sold to directors have par value, the amount allocated to capital must be no less than the aggregate of the par values of the shares sold. ■ r ' This paragraph may be omitted if the organization meeting is held by the directors named in the certificate or articles of incorporation. 11 Some States may require election of some or all of the officers by ballot, in which event additional provisions reflecting the distribution, collection, and counting of ballots will have to be included in the minutes. A form of ballot should also be prepared for filing with the minutes of the meeting. The sentence in brackets should be deleted if not applicable and is inserted here only as a reminder for counsel to check carefully the law on the subject in his own State. " This paragraph may be eliminated if there is no requirement that the Secretary subscribe an oath or the Treasurer furnish the corpora- tion with a bond, but is inserted as a reminder for counsel to check the law on the subject in his own State. A form of oath thought to be satisfactory in States which require an oath of office is annexed to these minutes. N Insert the titles of the officers which the State corporation law designates as the proper officers to execute stock certificates on behalf of the corporation. 11 Strike out inapplicable language. 220 Board authorizing the issuance and sale from time to time of shares of the [ ] stock of the corporation; and be it further RESOLVED, that the form of stock certificate ap- proved and adopted at this meeting be marked for identifica- tion by the Secretary of this meeting and filed with the minutes of the meeting. 9. The Chairman next stated that since the corporation had been formed for the purpose of performing the func- tions and conducting the activities of a small business in- vestment company under Title III of the Small Business Investment Act of 1958, it would be in order for the Board to authorize the execution and submission to the Small Busi- ness Administration of a License Application, SBA Form 415, by the officers of the corporation and the taking of all other necessary steps to qualify the corporation as a licensee under that Act. The Chairman then circulated copies of the License Application and reviewed various provisions thereof with the members present at the meeting, including the provision for the payment of a License Processing Fee of $500 and the requirement of publication under Section 107.103 of the SBA Regulations under the Act. The Chairman pointed out that the $500 fee was not returnable to the corporation regardless of the action taken by the SBA with respect to the corporation's application. After discussion, upon motion duly made and seconded, the following resolutions were unanimously adopted: RESOLVED, that the President or any Vice President of the corporation be and each of them hereby is authorized and directed to execute and submit to the Small Business Ad- ministration (the SBA), on behalf and in the name of this corporation and under its corporate seal attested by the Secretary of this corporation, a License Application, SBA Form 415, for the purpose of qualifying the corporation as a Federal licensee under the Small Business Investment Act of 1958, as amended, to conduct solely the activities con- templated by said Act, as so amended, and the Regulations thereunder; and be it further RESOLVED, that in connection with the submission of said License Application to the SBA, the corporation issue its check payable to the order of the Small Business Ad- ministration in the amount of $500, said check to be drawn on the corporation's imprest bank account by any bonded employee authorized to draw checks on said account and to accompany said License Application; and be it further RESOLVED, that the proper officers of this corpora- tion be and they hereby are authorized and directed to do such further acts and things, to execute such further instru- ments, certificates, plans, statements, agreements, and other documents, and to take all such other action, as they may deem necessary or proper or convenient or advisable in con- nection with the preparation, submission, and consideration of said License Application or as the SBA may request, in- cluding (without limitation) the publication of notice as required by Section 107.103 of the Regulations under the Small Business Investment Act of 1958, as amended, and the appearance on behalf of the corporation or otherwise at any examination or interview conducted by the SBA with respect to said License Application. 10. The Chairman next stated that it would be appropri- ate for the meeting to consider the selection of a bank as depository of the funds of the corporation and as custodian of the securities of the corporation and the establishment of dual control procedures with respect to the disbursement of funds and the withdrawal of securities as contemplated by the Regulations under the Small Business Investment Act. The Chairman stated that, under Section 107.1103(a) of the Regulations, disbursement of funds of the corporation may be made only by means of checks requiring the signa- tures of two or more authorized officers who are covered by a fidelity bond maintained by the corporation, in the form and amount prescribed by the Regulations, except that the Regulations permit checks in an amount not exceeding $1000 to be drawn by a single authorized bonded officer upon an imprest bank account established for the purpose of paying operating expenses. The Chairman also stated that the corporation was required to furnish the bank selected as the depository of funds and as custodian of securities of the corporation with a certified copy of the resolutions adopted by the Board placing the aforementioned control procedures in effect. After discussion, upon motion duly made and seconded, the following resolutions were unanimously adopted: [In nearly all cases, the bank selected as depository of funds of the corporation will require its own resolutions to be adopted with respect to the opening of accounts, the authority of signing officers, etc. Subject to inclusion of the required provisions for maintaining dual signature con- trol over funds in a general bank account and over securi- ties in a custodian account, bank resolutions may be adopted verbatim in the form prepared by the bank. Since each bank's form will differ, no attempt is made here to provide standard resolutions for adoption with respect to bank and custodian accounts.] 11. The Chairman stated that Section 107.1104 of the Regulations under the Small Business Investment Act re- quires that the corporation maintain a fidelity bond, exe- cuted by a surety holding a certificate of authority from the Secretary of the Treasury as being an acceptable surety on Federal bonds, covering each officer and employee of the corporation having control over or access to cash, securities, and other property of the corporation and that it would be in order for the meeting to approve the bond which had been obtained to fulfill the requirements of the Regulations. The Chairman stated that the Regulations require that the bond covering officers and employees be a Brokers Blanket Bond, Standard Form No. 14, and that the amount of the bond was $[ ] which is the minimum coverage per- mitted under the Regulations 10 based upon the total assets of the corporation [plus the unpaid balance of loans and investments which the corporation has contracted to service for others]. 11 The Chairman then submitted to the meeting the surety's written certification that the bond provided the corporation fulfills the requirements for fidelity bonds under the Regulations under the Small Business Investment Act to the best of said surety's knowledge and belief. After cir- culation among the directors, said written certification was ordered to be filed with the minutes of the meeting. After discussion, upon motion duly made and seconded, the following resolution was unanimously adopted: RESOLVED, that the Brokers Blanket Bond, Standard Form No. 14, issued to this corporation by [ ] 12 on [ ], 19[ ], protecting the corporation against loss by theft or other misappropriation of the cash, securities, and other property of the corporation by the officers and em- ployees of the corporation having control over or access thereto in an amount equal to $[ ], be and the same hereby is in all respects approved. 12. The Chairman stated that it would be appropriate for the Board to authorize the officers of the corporation to invest from time to time the idle funds of the corporation not then employed in the financing of small business con- 10 See Addendum I to the Audit and Examination Guide for Small Business Investment Companies (revised January 8, 1968) for the minimum coverage requirements for fidelity bonds. n This bracketed language may be omitted if the corporation will not be servicing loans made by other SBICs. i- Insert name of issuer of Blanket Bond. 221 cerns in a manner consistent with the Small Business Invest- ment Act and the Regulations thereunder. Accordingly, upon motion duly made and seconded, the following resolution was unanimously adopted: RESOLVED, that the President or any Vice President and the Treasurer of this corporation, acting jointly, be and they hereby are authorized and directed to invest from time to time, in a manner consistent with Section 308(a) of the Small Business Investment Act of 1958, as amended, and Section 107.808 of the Regulations thereunder, the idle funds of the corporation not then being used in the current financing of small business concerns. 13. The Chairman stated that it would be appropriate for the meeting to consider the selection of independent public accountants to perform the annual audit and such other ac- counting services as the corporation may from time to time request. The Chairman stated that, in accordance with the Regulations under the Small Business Investment Act, the accountants selected would have to execute and file with the SBA IPA Statement, I Form 56, certifying as to their qualification and independence and that the Board's selec- tion would be considered as having SBA approval unless the corporation was otherwise advised after notifying the SBA of the choice made. After discussion, upon motion duly made and seconded, the following resolutions were unanimously adopted: RESOLVED, that the firm of [ ], independent public accountants, having an office at [ ], be and the same hereby is appointed as the corporation's accountants for the purpose of performing the annual audit with respect to the corporation in accordance with the Regulations under the Small Business Investment Act of 1958, as amended, and such other accounting services as the corporation may from time to time request; and be it further RESOLVED, that the President or any Vice President or the Treasurer of this corporation be and each of them hereby is authorized to enter into such contracts and agree- ments with said accounting firm respecting the services to be performed by said accountants and the compensation to be paid therefor as such officer shall deem necessary or appro- priate and in the best interests of the corporation, such contract or agreement to provide that any information con- tained in the working papers of such accountants respecting the annual audit to be performed pursuant to the Regula- tions under the Small Business Investment Act shall be made available to the corporation or the SBA upon re- quest; and be it further RESOLVED, that the proper officers of this corpora- tion be and they hereby are authorized and directed to furnish the Office of Chief Accountant, Small Business Ad- ministration, 1441 L Street, N.W., Washington, D.C. 20416, with notification of the Board's selection of [ ] as independent public accountants for the corporation. 14. The Chairman stated that it would be appropriate for the Board to fix the time and place for holding regular meetings of the Board of Directors in accordance with Sec- tion [ ] of Article [ ] of the By-Laws. After dis- cussion, upon motion duly made and seconded, the following resolutions were unanimously adopted: RESOLVED, that regular meetings of the Board of Di- rectors of the corporation be held immediately following the annual meeting of stockholders in each year at the place specified in the notice or call of such annual meeting; and be if further RESOLVED, that, except as may be required by law, no notice of the time, place, or purpose of holding regular meetings of the Board of Directors need be given to any director. No further business appearing, upon motion duly made and seconded, the meeting was adjourned. A true record. [ ] Secretary of the Meeting Approved: [ ] Chairman of the Meeting [ABC Capital Corporation] CALL AND WAIVER OF NOTICE Place of Meeting: [ ] Time of Meeting: [ ] The undersigned, being all the directors of [ABC Capital Corporation], a [ ] corporation, do hereby call the first meeting of directors of [ABC Capital Corporation] to be held at the time and place above stated for the purpose of electing officers of the corporation and transacting such other business as may come before the meeting, and do hereby waive all requirements, statutory or otherwise, of notice of the time, place, and purpose of holding said meet- ing, and of publication of such notice, and consent to the holding of said meeting as called and the transaction thereat of any and all business coming before said meeting. Dated: [ ], 19[ ]. [ ] (L.S.) Signature of Director [ ] (L.S.) Signature of Director [ ] (L.S.) Signature of Director OATH OF SECRETARY State of [ ], County of [ ], ss: I, [ ], having been duly elected Secretary of [ABC Capital Corporation], a corporation organized and existing under the laws of the State of [ ], do solemnly prom- ise and swear that I will faithfully, impartially, and hon- estly perform the duties of said office according to the best of my ability, skill, and understanding. [ 1 Secretary Subscribed and sworn to before me this [ ], day of [ ]• 19[ ]. [ 1 Notary Public 222 Appendix 16— A CHECKLIST OF TERMS OF LEASE PURCHASE AGREEMENT BETWEEN LOCAL ECONOMIC DEVELOPMENT COMPANY (Landlord) AND INDIVIDUAL MEMBER STORE OPERATOR (Tenant) (A) General Provisions of Lease Purchase Agreement (1) identification of the parties and the premises (2) duration of term of lease (3) agreed-upon rent for term (4) designated use of premises (B) Duties and Obligations of Tenant (1) maintain and repair premises (2) carry property and public liability insurance for land- lord's benefit during term of lease (3) pay all real estate and personal property taxes during term of lease (4) discharge all liens due to improvements or alterations of premises (5) indemnify landlord against all claims and damages arising during term of lease (C) Rights of Landlord ( 1 ) no assignment or subletting of premises without writ- ten consent of landlord (2) right of reentry upon default of tenant or termina- tion of term (3) remedies of landlord cumulative and not waived ex- cept in writing (4) clauses covering damage by fire, condemnations, and bankruptcy (D) Special Terms Growing out of Community Relationship ( 1 ) Tenant has right and obligation to use designated chain store name during lease of premises. (2) Tenant has right and options to purchase premises on completion of term of lease or on tenant's voluntary termination of management agreement in compliance with its terms. (3) Lease is contingent upon approval of tenant and of financing by SBA. Appendix 16— B AGREEMENT BETWEEN SUPPLIER AND MANAGEMENT COMPANY (A) General Terms of Agreement (1) assistant management company in selection, acquisi- tion and development of sites (2) provide services to set up and operate member store (a) design and lay out store (b) design and operate training program for all per- sonnel (c) provide retail pricing program, all promotions and advertising material, and complete accounting services for each store (d) fee of up to [$ ] per month to be charged for accounting and personnel training service (3) provide supervisory personnel for member stores (4) supply opening inventory on agreed-upon financing terms (a) provide access to accredited suppliers (b) no sales to other customers on terms more favor- able than those offered to member store (B) Duties and Rights of Management Company Management company will cause its member stores to ( 1 ) observe set standards of cleanliness (2) have all employees attend all classes of training pro- gram (3) purchase all merchandise from supplier or its ac- credited supplier (4) secure all inventory financing by financing statements and security agreements Appendix 16— C CHECKLIST FOR PROVISIONS OF MANAGEMENT AGREEMENT BETWEEN MANAGEMENT COMPANY AND INDIVIDUAL MEMBER STORE OPERATOR (A) General Provisions ( 1 ) identification of the parties and their relationship (2) duration of term of contract tied to duration of lease purchase agreement (3) agreement between management company and sup- plier made part of this contract and binding upon both parties thereto 223 (B) Duties and Rights of Management Company (1) act as management agent for individual store operator (a) set all standards for quantity and quality of goods, services, equipment, and operations (b) retain checkbook and pay all bills from entire proceeds deposited by operator (c) have complete access to premises at all times for supervision and inspection (d) be responsible for provision of all services to op- erator specified in management company contract with supplier (C) Duties and Rights of Operator (1) agrees to buy only from authorized supplier specified by management company (2) inventory to be paid for on specified terms (3) maintain and repair premises and signs as directed by management company (4) hiring or firing of employees completely within opera- tor's control except he may not hire those employed by another member store (5) amount of operator's compensation limited until open- ing inventory note fully paid to supplier (6) operator must provide public liability insurance for benefit of management company, and indemnify company for liability due to operator's omissions and commissions (7) may not sell, assign, or transfer business without prior written consent of management company (8) fees and charges for accounting, employee training, and advertising to be paid by operator are limited to set amount unless prior approval by operator (D) Termination of Agreement ( 1 ) conditions for termination (a) by operator (b) by management (2) If management agreement is terminated, lease pur- chase agreement terminates. Operator appoints management company as trustee to acquire assets and operate business until sold. Appendix 17— A CHECKLIST OF FACTORS IN DEVELOPING A SHOPPING CENTER (A) Evaluating the Site ( 1 ) market survey of size of shopping center (a) population and per capita income (b) accessibility to area to be drawn from (c) competition from other shopping districts (d) nearby housing developments (e) nearby vacant land available to future competition (2) title conditions (a) zoning and necessary changes; objecting neighbors (b) possible existing easements (c) riparian rights if streams must be diverted (d) building codes and local governmental require- ments (3) physical conditions (a) soil conditions, water, rock, etc. (b) topography (c) availability of utilities (B) Approaches to Acquiring Control of the Site ( 1 ) options to buy or lease (2) outright purchase (long- or short-term contracts); conditional contract; down payments (3) ground lease (4) purchases from separate owners and assemblage, con- ditional purchases (C) Store Lease Clauses Which Require Special Treatment in a Shopping Center ( 1 ) description of the demised premises (2) commencement of the term (3) landlord's title (4) parking areas — the rights and obligations of the land- lord and all the tenants with respect thereto (5) construction of the shopping center and of the de- mised premises — the work to be done by landlord and tenant, respectively (6) business signs (7) business purpose and non-competition clause (8) the "radius" clause (9) Merchants' Association (10) tenant's share of maintenance of common areas (11) tenant's share of real estate tax increases ( 12) minimum standards for tenant's operation (13) depletion of shopping center (loss of land by emi- nent domain, loss of tenants by fire, lease cancellations, etc.) Appendix 20— A MODEL PLAN FOR EMPLOYEE BENEFIT PROGRAM [NAME OF COMPANY] [Profit Sharing Plan] 1 Purpose The purpose of the Plan is to provide an additional incen- tive for Employees to remain with the Company and to increase their efforts for its success and to provide through deferred compensation additional security for Employees on their retirement. 1 Bracketed text can be revised to adapt plan for another type of plan or to provide for different terms appropriate under circumstances for any particular plan. 224 Article I. Definitions Wherever used in the Plan the following terms shall have the respective meanings set forth below: Company: [name of company], a [ ] corporation, and any successor thereto. Effective Date : [ ]. Plan: [Profit Sharing Plan] for Employees of [name of company]. Employee: Any individual regularly employed by the Company not including (a) an individual employed by the Company on an occasional, or temporary basis or whose regularly scheduled work week is less than [20] hours [or (b) any officer or director or any key employee whom the board of directors of the Company may exclude]. Participant: A person who at the time shall be a Participant in the Plan in accordance with the provisions of Article II hereof. Beneficiary: Any person or persons (including trustees) designated by a Participant or otherwise determined pur- suant to Article VIII. [Board]: [The Employee Benefit Board described in Article IX, which shall administer the Employee Benefit Program.] 2 Trust Agreement: The agreement of trust between the Company and the Trustee, as amended from time to time. Trust: The trust established under the Trust Agreement. Trustee: [Bank], the trustee under the Trust Agreement. Trust Fund: The property from time to time held by the Trustee under the Trust Agreement. Compensation: The compensation of an Employee for a calendar year or any part thereof, including overtime but excluding bonuses, commissions, and other special payments. Profits: The net earnings of the Company for any calen- dar year as computed for Federal income tax purposes and as determined by independent public accountants appointed by the Company, before making deductions for (i) appli- cable provisions for Federal and State taxes based on income and (ii) any amount to be contributed by the Company under the Plan [and under the Company's Stock Bonus Plan for such year]. Continuous Service: An employee's period of service with the Company determined in accordance with uniform rules the Board shall adopt and which at the time of the determination shall be in force. Credited Service: The period of Continuous Service of a Participant exclusive, however, of any period of Continu- ous Service during which the Participant was on temporary leave or performing his military service. Aggregate Allocation Credits: 3 The number determined as provided in Section 1 of Article IV which shall be used as provided in Section 2 of Article IV in arriving at the interest of each Participant in the Company contribution in respect of such year. Normal Retirement Date: The first of the month fol- lowing (or coinciding with) the Employee's 65th birthday. Disability: Permanent and total disability as determined by the Board under uniform rules prescribed by it, and on the basis of medical evidence, which determination shall be final. Valuation Date: The last business day of each calendar quarter and such other days as the board determines. Masculine word forms shall be deemed to include the feminine. Article II. Requirements for Participation I. Each Employee who is in the service of the Company on [date], shall become a Participant as of such date. There- after, each Employee shall become a Participant as of the Valuation Date next following the date of his commence- ment of employment by the Company. 4 2. The participation in the Plan of any Participant shall cease when his entire interest in the Trust Fund has been distributed. The Board shall determine under uniform rules prescribed by it whether temporary leave from the employ- ment of the Company constitutes termination of employment; provided, however, that no such temporary leave (other than for military service) shall exceed 3 years. Article III. Contributions For each calendar year the Company shall contribute to the Trust Fund an amount in cash equal to not less than [10] percent 5 of the Company's profits for such year and may contribute such additional amount as the Company may determine subject to the approval of the Board; provided, however, that such contribution, [together with the contribu- tion by the Company for such year under its Stock Bonus Plan,] shall not exceed 15 percent of the compensation of Participants in this Plan [and Participants in such Stock Bonus Plan]. Article IV. Allocation of Contributions and Forfeitures 1. As of the end of each year there shall be awarded to each Participant who shall have been an Employee at the end of such year and to each Participant who shall have terminated his Continuous Service at any time during such year for reasons of retirement on or after his Normal Re- tirement Date, Disability, or death, an Aggregate Alloca- tion Credit which shall be the sum of the allocation credits determined as follows: (a) such Participant shall be awarded [one] allocation credit for each $1,000 of his Compensation for such year or part thereof (calculated to the nearest 1/ 10th of a credit); and (b) such Participant shall be awarded [two] alloca- tion credits for each full year of Credited Service (includ- ing V2 of a credit for each completed calendar quarter). 2. The value of the contribution of the Company to the Trust Fund for each calendar year and the value of the balance as of the end of such year in the forfeiture account, referred to in Section 2 of Article VI, shall be allocated to the accounts of the Participants in the Plan who were em- ployed by the Company during such year or any part thereof in the proportion which bears the same ratio to the total amount so to be allocated as the Aggregate Allocation Credit awarded to each such Participant for such year bears to the Aggregate Allocation Credits awarded to all such Par- ticipants for such year. The amount so allocated to each such Participant shall be applied as of the end of such year to the purchase for him of units in the Trust Fund and such units shall be credited to a separate account maintained for him. 2 This Model Plan provides substantial discretionary authority to be exercised by a Board on which the employees would have equal representation with the employer. This is highly unusual for corporate benefit plans, but is strongly recommended for development corpora- tions or companies with a high percentage of disadvantaged workers as a means of enhancing the educational and participatory benefits of the plan. 3 This Plan provides for administration based on a units-of-credit system. While there are many methods of providing for the mechanical operation of the plan, this system is as simple as any. 4 Where contribution by an Employee is a condition for participa- tion this fact should be reflected in this paragraph. 5 This figure is certainly the most critical in the plan. The figure inserted here is a high figure probably not feasible for publicly held companies. An employer might wish the figure here to be lower than the amount which the employer would informally agree to contribute. 225 Article V. Investment of the Trust Fund 1. The Trustee shall invest and reinvest amounts in the Trust Fund, together with the income on and the proceeds of sales of investments of the Trust Fund, in such securities or other properties [as the Trustee in its sole discretion shall from time to time determine, subject to any written direc- tions of the Board as to the purchase or sale of specific investment]. 6 The Trustee may hold in the Trust Fund amounts in cash pending investment thereof or for the purpose of making payments under the plan. 2. Initially, the value of each unit in the Trust Fund shall be $1. Thereafter, [the Board] shall determine the value of a unit in the Trust Fund as of each Valuation Date by divid- ing the fair market value (as determined by the Trustee) of all property in the Trust Fund as of such Valuation Date (after deducting any expenses or other amounts properly chargeable against the Trust Fund but before crediting any Company contribution accrued but unpaid) by the number of all such units then outstanding. The value so determined shall be the basis for purchasing for Participants additional units in the Trust Fund and for redeeming their units from the Trust Fund. Disbursements in payment of benefits shall be effected through the redemption of units in the Trust Fund as of the Valuation Date next following (or coincid- ing with) the receipt by the Trustee of written directions from the Board with respect to such disbursements. Frac- tions of units to the nearest four decimal places as well as whole units may be purchased or redeemed. 3. An account shall be maintained for each Participant in which shall be recorded the number of units in the Trust Fund purchased for him, his allocable share of Company contributions and the number of units and dollar amount of each payment made in redemption of his units in the Trust Fund by payments to him. Article VI. Vesting 1. The interest of each Participant in the Trust Fund shall vest at the rate of 33.3 percent at the end of each full year of his participation; provided, however, that any previously unvested portion of such interest shall become fully vested immediately upon his death or Disability during employ- ment or his retirement at his Normal Retirement Date. 2. The total value of all units in the Trust Fund repre- senting the amounts forfeited by Participants on the Valua- tion Date next following such forfeiture shall be credited as of such date to a forfeiture account held in the Trust Fund. Amounts in such forfeiture account shall be invested and reinvested as part of the Trust Fund. Article VII. Payment of Benefits 1. The vested interest of a Participant shall, regardless of his earlier termination of employment, be distributed to him in cash in quarterly installments, 7 each made as of a Valuation Date over a period not in excess of [5] years and commencing on the Valuation Date next following (or co- inciding with) his Normal Retirement Date or date of Disability, as the case may be, all as determined by [the Board], through the quarterly redemption of such number of units as may be specified by the Board, with a lump sum payment in cash to his Beneficiary of the remainder of his interest as of the Valuation Date next following (or coincid- ing with) his death; provided, however, that in the event of termination of employment (i) prior to Normal Retirement Date for reasons other than Disability or death, his vested interest shall be distributed to him after such termination in a lump sum in cash as of the Valuation Date next follow- ing (or coinciding with) his termination of employment (ii) upon his death, such interest shall be distributed to him or his Beneficiary in a lump sum in cash as of the Valuation Date next following (or coinciding with) his death, and (iii) on or after his Normal Retirement Date or in the event of Disability, his vested interest may be distributed to him, in the sole discretion of [the Board], in a lump sum in cash as of the Valuation Date next following (or coinciding with) his Normal Retirement Date or date of Disability, as the case may be. 8 [2. The Board may, in its sole discretion under uniform rules prescribed by it, direct the Trustee to make payments from the Trust Fund to a Participant during his employment by the Company as of a Valuation Date on a showing by him of financial emergency or economic hardship. Such payments shall not exceed the vested interest of such Par- ticipant and shall be effected by the redemption of his units from the Trust Fund.] [3. Upon 15 days' prior written notice (which notice shall be irrevocable) to the Board, on a form provided by it, each Participant while he is still in the employment of the Company may apply to the Board to withdraw, such applica- tion to be approved by the Board only upon a showing of financial emergency, economic hardship, or exceptional justi- fication, in cash as of the Valuation Date next following the expiration of such 15-day period (but not more often than once during each 6 calendar months) all or a part of his vested interest in the Trust Fund; provided, however, that (i) any such amount so to be withdrawn shall be subject to a 5 percent penalty, the amount of which shall be added to the forfeiture account provided for in Section 2 of Article VI and (ii) the amount so to be withdrawn shall be reduced to the extent, if any, necessary in order that the amount re- maining in his account after such withdrawal is at least equal to his allocable share of contributions to the Trust Fund made by the Company in respect of the 2 calendar year period contributions immediately prior to the date of such withdrawal.] 4. The right of any person to receive any benefit which shall be payable under the Plan shall not be subject in any manner to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance or charge, and any attempt to antici- pate, alienate, sell, transfer, assign, pledge, encumber, or charge any such benefit shall be void, and any such benefit shall not in any manner be liable for or subject to the debts, contracts, liabilities, engagements, or torts of the person who shall be entitled to such benefit, nor shall it be subject to attachment or legal process for or against such person. 5. If for any reason [the Board] shall determine that it shall not be desirable, because of the physical condition or other incapacity of the person who shall be entitled to receive any payment or distribution in accordance with the provi- sions of the Plan, to make such payment or distribution directly to such person, [the Board] may direct the Trustee to apply such payment or distribution for the benefit of such person in any way that [the Board] shall deem advisable, or [the Board] may direct the Trustee to make such payment or distribution to any third person who, in the judgment of [the Board], will apply such payment or distribution for the benefit of the person entitled thereto. Such payment or distribution for the benefit of the person entitled thereto, or to a third person for his benefit, having been made, the Trustee shall be discharged from all further liability for such payment or distribution. [The Board] may direct the Trustee ° If it is desired that the Trust Fund, for a stock bonus plan, for example, be invested exclusively in company stock, or if any other restrictions on investment are desired, the details should be included in this Article. " Specific provision should be made if distribution is to be made in stock of the Company or some other security or investment medium. H These critical provisions governing distribution under the plan will be tailored to suit the needs and circumstances of each company. 226 to withhold the payment of any amount or distribution that shall be payable or distributable in accordance with the provisions of the Plan to a person under legal disability until a representative of such person competent to receive such payment or distribution on his behalf shall have been ap- pointed pursuant to law. Article VIII. Designation of Beneficiary Each Participant may designate one or more persons as the Beneficiary of his interest under the Plan in such pro- portions as he may designate. Such Beneficiary may be changed by the Participant at any time or from time to time during his lifetime. Such designations shall be made by him on a form provided for that purpose by [the Board] and shall be effective upon delivery thereof to [the Board]. If no person shall be designated by a Participant as his Beneficiary or if no one of the persons designated by him as his Beneficiary survives him, his Beneficiary shall be (a) his spouse, if then living; or (b) his child or children, if then living, in equal shares, if his spouse is not living; or (c) his estate, if none of the foregoing is living. Article IX. Employee Benefit Board [1. The plan shall be administered by the Employee Bene- fit Board (the "Board") consisting of three individuals, one designated by the Company, one elected by the Employees and the third appointed by the other two. The original mem- bership, and subsequent changes in the membership of the Board, shall be certified in writing to the Trustee by the Company. [2. The Board shall have the power to administer and construe the Plan; determine questions of fact arising under the Plan; in its discretion direct investments and disburse- ments by the Trustee; and exercise the other rights and powers specified herein. The Board may, in its discretion, formulate a method for the valuation of property, or of certain property held in the Trust Fund and, if the Trustee elects to follow such method of valuation he shall not be liable for such valuation. No member of the Board shall, however, participate in any decision which constitutes an exercise of discretion by the Board relating specifically to such member. All such action taken by it shall be conclusive as to all parties. [3. In administering the Plan, neither the Board nor any member thereof nor any person to whom it may delegate any power or duty in connection therewith nor the Company shall be liable for any loss in the Trust Fund or for any depreciation of principal or loss of income resulting from the purchase or retention of any investment or the retention of any uninvested money or for any action or any failure to act except for its or his own willful misconduct or bad faith.] Article X. Expenses 1. All expenses and charges in respect of the Plan and the Trust, including, but not limited to, taxes of any kind upon or with respect to the Funds shall be paid out of the Trust Fund, except that the Company agrees to pay the fees charged by the Trustee including out-of-pocket expenses of the Trustee. Article XI. Amendment and Termination 1. The Company may from time to time, amend the Plan; provided, however, that no amendment may divest a Par- ticipant of any part of his interest under the Plan vested in him at the time of such amendment nor may any amend- ment cause a diversion of assets in the Trust Fund to any person or persons other than Participants or their Bene- ficiaries. 2. The Company, subject to the approval of the Board, may terminate the Plan at any time, or permanently dis- continue Company contributions thereunder, in which event the interests of all Participants shall fully vest and shall, in the discretion of the Board, be distributed, under uni- form rules applicable to all Participants, in lump sum cash payments or in quarterly installments over a period not ex- ceeding 15 years to Participants or their Beneficiaries. Article XII. Miscellaneous 1. All benefits payable under the Plan are to be paid or provided for solely from the Trust Fund, the Company assumes no liability or responsibility therefor. 2. The Board shall render periodic reports (not less often than once each year) to each Participant or, after his death, to his Beneficiary of the status of his account under the Plan. 3. In order to receive any benefits under the Plan, a Participant must furnish to the Company such information as it may request for the purpose of the proper administra- tion of the Plan. 4. All questions pertaining to the construction, validity and effect of the Plan shall be determined in accordance with the laws of the State of [ ]. Appendix 24— A SAMPLE SOCIAL INVESTMENT REQUIREMENT To induce the [ ] Foundation to agree to make loans to the Company, the Company agrees to organize and fund a nonprofit development corporation which shall provide venture capital, at rates favorable to borrowers, for minority group and disadvantaged area economic development in situations where commercial lending institutions are unwill- ing to lend funds; and the Company further agrees that: (1) The development corporation and the Company shall provide technical assistance and management advice to the persons or organizations to which it provides such venture capital. (2) The development corporation shall make capital available for business ventures which provide employment opportunities for disadvantaged groups, increase minority group employment at management levels, and make sig- nificant contributions to the economic development of dis- advantaged areas. (3) The development corporation shall not make ven- ture capital available to persons or organizations connected directly or indirectly with the Company (or any subsidiary of the Company) or its officers, shareholders, or employees. (4) The Company shall begin to fund the development 227 corporation no later than one year after repayment of the loan. (5) The Company shall fund the development corpora- tion by contributing to it each year at least 5 percent cf the Company's annual after-tax profits until the Company's aggregate contributions equal $100,000. If the Company contributes less than $5,000 in any year, it shall make addi- tional contributions in the following years in which it has after-tax profits to the extent necessary to maintain an aver- age contribution rate of $5,000 per year. Appendix 24— B SAMPLE PRELIMINARY LETTER AGREEMENT This will confirm the understanding that the [ ] Foundation will lend Community Development Corporation (the "Corporation") $100,000 upon receipt of its promissory note bearing interest at the rate of [ ] percent per annum. The Corporation is playing a key role in promoting com- munity economic growth, developing economic self suffi- ciency, and providing entrepreneurial opportunities for minority group members. You have indicated that you are willing to lend the Corpo- ration $100,000, therefore, the Corporation hereby agrees that: (1) The Corporation shall issue to you its promissory note upon receipt of payment from you of $100,000. (2) The Corporation shall use the $100,000 to provide venture capital to establish small business as part of pro- gram to further community economic development. ( 3 ) The Corporation shall pay no dividends on any class of stock while the promissory note remains unpaid, in whole or in part. (4) The Corporation shall not participate in any merger, consolidation, liquidation, or sale of substantially all of its assets without your prior written consent while the promissory note remains unpaid, in whole or in part. (5) The Corporation shall submit to you an annual financial report certified by an independent certified public accountant and quarterly reports that shall reasonably dis- close the financial condition and business activities of the Corporation, and, in particular, the disposition of the $100,- 000 loaned by you. Appendix 24— C SAMPLE RESTRICTIONS Until payment in full of the indebtedness of the Com- munity Development Corporation (the "Corporation") to the [ ] Foundation and performance of all other ob- ligations of the Corporation, the Corporation covenants and agrees that, without the prior written consent of the [ ] Foundation, it will not: ( 1 ) Sell or transfer all or any substantial part of its assets, acquire all or any substantial part of the assets of any corporation or entity, merge or consolidate with any other corporation. (2) Incur any indebtedness for money borrowed. (3) Have or make any investments in any person, except investments which directly or indirectly further the Corporation's program for encouraging minority group eco- nomic development. The term "investment" shall mean the purchase or other acquisition by the Corporation or its sub- sidiaries of any stock or indebtedness of, or the making of any loan, advance, transfer of property, or other capital contributions to, or the incurring of any liability, contingently or otherwise, in respect of the indebtedness of any person. (4) Declare or pay any dividend or make any other distribution on any class of its stock (other than a dividend payable solely in shares of its stock) or purchase, redeem, or otherwise acquire for a consideration any shares of its stock, or permit any subsidiary to purchase or acquire any shares of the Corporation's stock. (5) Make any payment on account of the principal of, or otherwise discharge, any indebtedness owed to stock- holders; make any payment on account of the principal of, or otherwise discharge, any other indebtedness for borrowed money of the Corporation except at the times and in the amounts specifically required by the terms of such other indebtedness. (6) Increase in any one fiscal year by more than 10 percent the compensation (salary, bonus, and other pay- ments) of any executive officer of the Corporation. 228 Appendix 24— D FORMS OF INVESTMENT Investments may take the form of stock (voting or non- voting, common or preferred), short-, medium-, or long- term loans, secured and unsecured, subordinated or deferred payment convertible debt instruments, guarantees of loans by third parties, matching loans by third parties. For ex- ample, a foundation may agree to participate with a bank in making a line of credit available to a company — each ad- vancing one half of the loans under a credit agreement and sharing losses equally. Subordinated debentures may be pur- chased where a foundation, for policy reasons, prefers not to take an equity position. Appendix 24— E SAMPLE ADMINISTRATIVE AGREEMENT Reference is made to the Loan Agreement, dated 1969, among Community Development Corporation (the "Cor- poration"), the [ ] Bank, and [ ] Foundation, which provides for a series of loans to be made to the Corporation by [ ] Bank and [ ] Foundation. The Bank undertakes at the time of each loan to advise the [ ] Foundation in writing (a) whether conditions precedent to the obligation to make such loan have been met; and (b) whether the [ ] Bank intends to advance its share of such loan, and if its intention changes it shall notify [ ] Foundation. It is understood that [ ] Bank will be required to exercise only such care as it would exercise in the handling of loans for its own account and it shall have no responsibility for the performance by the Corporation of its obligations under the Loan Agreement. The [ ] Bank and the [ ] Foundation agree that all interest and principal payments made by the Cor- poration on the Notes and losses, if any, in respect thereto, are to be divided equally. Appendix 25— A GUIDE SHEET FOR LOAN APPLICATION FROM MELIC Applicants for a loan from Mission Enterprise Loan and Investment Committee will need to do the following things and forward them to our offices (Room 313, 475 Riverside Drive, New York, N.Y. 10027): (1) Fill out in duplicate the application blanks we provide. Keep copy. (2) Send the application in with any supporting mate- rial you can provide to make clear what you are going to do with the proposed loan. (3) Give us an idea of what you think the proposed business can do in sales and income, and how much it will have to spend in operating costs. We want to know whether the business has a fair chance to succeed. (4) We will want to know that you have not been able to get a bank loan and to prove this we will need two letters. A bank that cannot make the loan is generally quite willing to provide a letter if you do not already have one. (5) If you are buying an existing business, we would like to have a statement on its operations, so that we can know how much it has earned or lost. (6) Your biography is important to us: where you were born, how old you are, how much schooling you have had, how many children, what business you are in. This is helpful whether you are applying for yourself alone or for a corporation. We would like to feel that we know something about the people with whom we are doing business. (7) Because MELIC (Mission Enterprise Loan and Investment Committee) is a ministry of the United Metho- dist Church, we need to be sure that the proposed business is consistent with our announced principles. For example, we will not become involved in liquor stores, night clubs, or certain other types of establishments. (8) To make it easier for an applicant to know where the church stands we request a visit with one of our local District Superintendents, who will call on the applicant at a mutually convenient time. (9) In order to make it easier for the applicant to abide by the above requests we suggest that they be done one at a time and in order. Mission Enterprise and Investment Loan Fund BOARD OF MISSIONS OF THE UNITED METHODIST CHURCH Room 313 475 Riverside Drive New York, N.Y. 10027 (Type or print legibly) (1) Name of organization: [ (2) Address: [street & no. Telephone-area code: [ ]. Date: [ ]. ]■ city, state, zip code]. 229 (3) Incorporated: [ ]. [Unincorporated?] [Date organized?] [Where?] [Business started?] (4) List organization's officers, trustees, directors, prin- cipal stockholders if any. Include name, title, home address, occupation. Continue on separate sheet if necessary: [ ]• (5) Purpose of loan? [Describe your operation or pro- posal; if additional space is needed, please continue on back of this sheet.] (6) Check box which most nearly describes types of business: Credit union [ ]; Manufacturing [ ]; Retail [ ]; Personal services [ ]; Small loan company [ ]; Nonprofit housing corporation [ ]; Other [ ]. (7) Amount of loan requested? $[ ]. At what pro- posed interest rate?* (8) Length of loan:* 1 year [ ]; 2 years [ ]; 3 years [ ]; 5 years [ ]; Other [ ]. (9) Proposed repayment plan:* Monthly [ ]; Quar- terly [ ]; Other [ ]. (10) Equity participation of Board of Missions United Methodist Church — Amount $[ ]. Form: [Preferred stock, Common stock, Debentures, Other]. Upon success of venture what proposal do you have for Board's withdrawal? [ ] (11) How will operation benefit community? [ ] (12) How will profits be distributed or used? [ ] (13) What assets does business now have? Cash : [ ]. Value of property or lease: [ ]. Inventory: [ ]. (List or attach statement of assets and liabilities. List state- men of income and expenses — current operating budget.) (14) What is indebtedness if any? [ ] (15) Are there any judgments or legal proceedings against you? Yes [ ] No [ ]. If yes, explain: [ ]. Do you have any current legal proceedings against others? Yes [ ] No [ ]. If yes, explain: [ ]. (16) Has loan or investment been sought locally? Yes [ ] No [ ]. If available — terms and interest rate: [ ]. List and show evidence of refusals: [ ]. (17) If housing seed loan please complete the following: Sponsoring group: [ ]. Under what program is loan being sought? [ ]. Name of consultant: [ ]. Type of program: [ ]. Rental: New [ ]; Rental: Rehab. [ ]; Rehab, and resale [ ]. No. of units? [ ]. Site available: [ ]. Under option? [ ] Already owned? [ ] Urban renewal land? [ ] Number of acres? [ ] Cost: $[ ]. Does site have HUD or FHA approval? [ ]. Amount of mortgage commitment: [ ]. State of HUD-FHA processing: [ ]. Estimated cost of construction: [ ]. Estimated start of construction: [ ]. Completion target date: [ ]. What community rooms are available? [ ] Are commercial facilities included? [ ] What job training opportunities are provided? [ ] Are fair employment practices being followed? [ ] What auxiliary services will sponsoring institution render? (Make check below). Homemaking? [ ] Family Planning? [ ] Family counselling? [ ] Credit union? [ ] Budgeting? [ ] Buying? [ ] Legal aid? [ ] Tenant's organization? [ ] Recreation? [ ] Tutorial? [ ] Other? [ ] (18) List other contributors or investors in project: [ ]• (19) Name and title of person making application: [ ]. (Signature) [ ] (20) Name and address of attorney for borrower: [ ]. Name and address of person to whom all correspondence is to be directed: [ ]. I, We agree to furnish additional information as requested. Yes [ ] No [ ]. Date: [ ]. (21) Local endorsement or recommendation: Signature: [ ]. Title: [ ]. Date: [ ]. * Not binding on either party until formally agreed to. Appendix 25— B NAMES AND ADDRESSES OF RELIGIOUS ORGANIZATIONS THAT PROVIDE FUNDS FOR INVESTMENT Listed below are the names of various churches or related organizations which have initiated some form of investment program for economic development. THIS LIST IS NOT DEFINITIVE AND IS SUBJECT TO CHANGE. (1) Protestant Churches The Episcopal Church Ghetto Investment Program 815 Second Avenue New York, N.Y. 10017 The above is strictly an investment vehicle. In addition, the Episcopal Church has instituted a "General Convention Special Program" with the aim of making grants in the field of community and economic development. It is administered by the Executive Council of the Episcopal Church (815 Second Avenue, New York, N.Y.). United Presbyterian Church U.S.A. 475 Riverside Drive New York, N.Y. 10027 $9,000,000 has been allocated for investment of which ap- proximately $1,000,000 is already invested. In addition, the Presbyterian Church in the United States, a related but separate church, has established a corporation (Pedco, Inc.) for the express purpose of investing in eco- nomic development projects. Its address is: 347 Ponce de Leon Avenue, N.E. Atlanta, Georgia 30303. United Methodist Church 475 Riverside Drive New York, N.Y. 10027 The United Methodist Board of Missions has established Mission Enterprises Loan and Investment Committee (MELIC) to coordinate all investments in the economic development area. As of July 1, 1969, $3,000,000 was com- mitted to this program. Lutheran Church in America Foundation Church in America 231 Madison Avenue New York, N.Y. 10016 230 United Church Board for Homeland Ministries (United Church of Christ) 287 Park Avenue South New York, N.Y. 10010 Church of the Brethren, General Brotherhood Board 1451 Dundee Avenue Elgin, 111. 60120 American Baptist Home Mission Associates Valley Forge, Pa. 19481 The National Council of Churches 475 Riverside Drive, New York, N.Y. 10027 (2) Roman Catholic Churches. Because the Roman Catho- lic Church is organized on a basis of separate dioceses which operate independently, there is no one agency which coordi- nates its many and diverse efforts in the areas of social and environmental betterment. The Church has concerned itself with problems of housing, health, employment, and educa- tion for many years and has engaged in many projects in this area, but at this writing there is no large-scale invest- ment undertaking in economic development projects. How- ever, the United States Catholic Conference (1312 Massa- chusetts Avenue NW., Washington, D.C. 20005) is a source of information about the Church's activities in these fields. Another source of information is the Council on Urban Life, 2200 N. 3rd Street, Milwaukee, Wis. 53212. (3) Jewish Religious Organizations. American Jewish Committee (165 East 56th Street, New York, N.Y. 10022) is the principal clearing house for information about anti- poverty efforts by the Reform, Orthodox, and Conservative congregations throughout the country. Through its local chapters the Committee has participated alone or in conjunc- tion with others in such projects as job training of hard-core unemployed and the sponsorship of LEDCs which will in turn assist business enterprises. Appendix 27— A LIST OF STATE BUSINESS DEVELOPMENT CORPORATIONS (1969) First Arkansas Development Finance Corporation, 621 Pyramid Life Building, Little Rock, Arkansas 72201 Colorado Business Development Corporation, 837 Equitable Building, Denver, Colorado 80202 The Connecticut Development Credit Corporation, 99 Colony Street, P.O. Box 714, Meriden, Connecticut 06450 The Industrial Development Corporation of Florida, 1010 Executive Center Drive, Orlando, Florida 32803 Kansas Development Credit Corporation, 802 First National Bank Building, Topeka, Kansas 66603 Business Development Corporation of Kentucky, Common- wealth Building, Louisville, Kentucky 40202 Development Credit Corporation of Maine, 15 Grove Street, P.O. Box 227, Augusta, Maine 04330 Development Credit Corporation of Maryland, 1301 First National Bank Building, Baltimore, Maryland 21202 Massachusetts Business Development Corporation, 45 Milk Street, Boston, Massachusetts 02109 Mississippi Business and Industrial Development Corpora- tion, Deposit Guaranty National Bank Building, P.O. Box 825, Jackson, Mississippi 39205 New Hampshire Business Development Corporation, 3 Capitol Street, Concord, New Hampshire 03301 New Jersey Business Development Corporation, 54 Park Place, Newark, New Jersey 07102 New York Business Development Corporation, 41 State Street, Albany, New York 12207 The Business Development Corporation of North Carolina, 401 Oberlin Rd., P.O. Box 10665, Raleigh, North Carolina 27605 Pennsylvania Development Credit Corporation, State Street Building, Third and State Streets, Harrisburg, Pennsyl- vania 17101 RIDC Industrial Development Fund, 471 Union Trust Build- ing, Pittsburgh, Pennsylvania 15219 Southeastern Pennsylvania Development Fund, Philadelphia National Bank Building, Philadelphia, Pennsylvania 19107 Business Development Company of Rhode Island, 609 Howard Building, 10 Dorrance Street, Providence, Rhode Island 02903 Business Development Corporation of South Carolina, Palmetto State Life Building, Columbia, South Carolina 29202 Vermont Development Credit Corporation, P.O. Box 660, Montpelier, Vermont 05602 Virginia Industrial Development Corporation, 1405 State- Planters Bank Building, Richmond, Virginia 23219 Industrial Development Corporation of Eastern Washington, 419 Hyde Building, Spokane, Washington 99201 Wyoming Industrial Development Corporation, P.O. Box 612, Casper, Wyoming 82601 231 Appendix 28-A REGULATION A SCHEDULE I-INFORMATION TO BE INCLUDED IN THE OFFERING CIRCULAR REQUIRED BY RULE 256 The offering circular required by Rule 256, or statement required by Rule 257, shall be dated and shall contain the following informa- tion: 1. The following statement shall be set forth on the outside front cover page of the offering circular in capital letters in type as large as that used generally in the body of the circular : THESE SECURITIES ARE OFFERED PURSU- ANT TO AN EXEMPTION FROM REGISTRATION WITH THE UNITED STATES SECURIIES AND EXCHANGE COMMISSION. THE COMMISSION DOES NOT PASS UPON THE MERITS OF ANY SECURITIES NOR DOES IT PASS UPON THE AC- CURACY OR COMPLETENESS OF ANY OFFER- ING CIRCULAR OR OTHER SELLING LITERA- TURE. 2. State the exact name and address of the issuer, the name of the State or other jurisdic- tion under the laws of which it was incor- porated or organized and the date of its in- corporation or organization. 3. (a) Give the following information, in the tabular form indicated, on the outside front cover page of the offering circular on a per- share or other unit basis. Offering price Underwriting Proceeds to issuer to public discounts or or other persons commissions (b) If any of the securities are to be offered for the account of any person other than the issuer, give the name and address of each such security holder, the total amount he owns and the amount to be offered hereunder for his ac- count. 4. (a) State the amount of securities to be offered pursuant to this regulation, the aggre- gate offering price to the public, the aggreagate underwriting discounts or commissions, the amount of expenses of the issuer and the amount of expenses of the underwriters to be borne by the issuer, and the aggregate pro- ceeds to the issuer or security holders for whose account the securities are to be offered. (b) If the securities are not to be offered for cash, state the basis upon which the offer- ing is to be made. 5. Describe briefly the method by which the securities are to be offered and if the offering is to be made by or through underwriters, the name and address of each underwriter and the amount of the participation of each such un- derwriter, indicating the nature of any ma- terial relationship between the issuer and such underwriter. 6. (a) Furnish a reasonably itemized state- ment of the purposes for which the net cash proceeds to the issuer from the sale of the securities are to be used and the amount to be used for each such purpose, indicating in what order of priority the proceeds will be used for the respective purposes. (b) Describe any arrangements for the re- turn of funds to subscribers if all of the securi- ties to be offered are not sold; if there are no such arrangements, so state. 7. Give a brief description of the securities to be offered pursuant to this regulation. In- clude the following information: (a) In the case of shares, the par or stated value, if any; the rate of dividends, if fixed, and whether cumulative or noncumu- lative; a brief indication of the preference, if any; and if convertible, the conversion rate. (b) In the case of debt securities, the rate of interest; the date of maturity, or if the issue matures serially, a brief indication of the serial maturities, such as "maturing serially from 1965 to 1975" ; if the payment of principal or interest is contingent, an appropriate indi- cation of such contingency; a brief indication of the priority of the issue ; and if convertible, the conversion rate. (c) In the case of any other kind of securi- ties, appropriate information of a comparable character. 8A. Mining business. If the issuer is engaged or proposes to engage in mining or exploratory mining operations, briefly describe the business or proposed business of the issuer in accord- ance with the following instructions: (a) Give the location and means of access to the mining properties now held or intended 232 Sched. I 8A(a) SECURITIES AND EXCHANGE COMMISSION to be acquired and the nature of the title under which such properties are held or intended to be held. Indicate any known risks to which such title may be subject. (b) Identify the principal metallic or other constituents of the deposits to be ex- plored or developed and describe the char- acteristics of such deposits. No claim shall be made as to the existence of a body of ore unless it has been sufficiently tested to be properly classified as "proven" or "probable" ore, as defined below. If the work done has not estab- lished the existence of proven or probable ore, a statement shall be made that no body of com- mercial ore is known to exist on the property. (c) The term "proven ore" means a body of ore so extensively sampled that the risk of failure in continuity of the ore in such body is reduced to a minimum. The term "probable ore" means ore as to which the risk of failure in continuity is greater than for proven ore, but as to which there is sufficient warrant for assuming continuity of the ore. (d) If statements are made as to the exist- ence of proven or probable ore, furnish sep- arately for the information of the Commis- sion copies of the pertinent maps and other supporting data, including calculations, with respect to such ore. Geologists' and engine- ers' reports, if used in an offering circular, shall be written in a clear and concise form. (e) If the properties are known to have been previously explored, developed or mined by anyone and that fact or the results of such previous work is material, furnish information as to such work insofar as it is known and material. 8B. Oil or gas business. If the issuer is en- gaged or proposes to engage in the oil or gas business, briefly describe the business or pro- posed business of the issuer in accordance with the following instructions: (a) State the area and location of the vari- ous properties proposed to be developed or exploited by the issuer and the nature of the issuer's interest therein. (b) State the development which has oc- curred to date on or near the properties held. If no such development has occurred, a state- ment to that effect shall be made. (c) State (in tabular form), for all pro- ductive properties, net production of oil and gas to issuer's interest from each of the properties by years for the past 4 years prior to the latest year, and by months for the latest year, as well as the number of net producing wells owned by the issuer which contributed to the production during each of the time periods involved. (d) State the estimated future reserves net to issuer's interest in such properties which are proved. (e) If statements concerning geology or engineering are made, furnish separately for the information of the Commission copies of the pertinent reports and other supporting data. Geologists' and engineers' reports, if used in an offering circular, shall be written in a clear and concise form. 8C. Other business. If the issuer is engaged or proposes to engage in any business other than those specified in Items 8A and 8B, brief- ly describe the business or proposed business of the issuer in accordance with the following in- structions : (a) State the nature of issuer's present or proposed products of services, the principal market therefor and the length of time issuer has been in commercial production. (b) State the location and general character of the plants or other physical properties now held or presently intended to be acquired and the nature of the title under which such prop- erties are held or proposed to be held. (c) If the issuer intends to exploit or de- velop any new invention or process, state how such invention or process is to be applied com- mercially and whether or not it is covered by any patent, issued or pending. Identify by serial number and date any applicable patents or patent applications. (d) Engineers' and other technical reports, if used in the offering circular, shall be written in a clear and concise form. 9. (a) Give the full names and complete resi- dence addresses of all directors and officers of the issuer and of any person or persons con- trolling the issuer. If the issuer was incorpo- rated or organized within the last 3 years, 233 REGULATIOX A Sched. I 8C 11(b) furnish similar information as to all promoters of the issuer. (b) State the aggregate annual remunera- tion of all directors and officers of the issuer as a group and the annual remuneration of each of the three highest-paid officers of the issuer. (c) Describe all direct and indirect interests (by security holdings or otherwise) of each person named in answer to (a) above (i) in the issuer or its affiliates and (ii) in any ma- terial transactions within the past 2 years or in any material proposed transactions to which the issuer or any of its predecessors or affiliates was or is to be a party. Include the cost to such persons of any property or services for which any payment by or for the account of the is- suer has been or is to be made. (d) If the issuer was incorporated or or- ganized within the last 3 years, state the per- centage of outstanding securities of the issuer which will be held by directors, officers and promoters, as a group, and the percentage of such securities which will be held by the public, if all of the securities to be offered un- der this regulation are sold, and the respective amounts of cash (including cash expended for property transferred to the issuer) paid there- for by such group and by the public. 10. A brief description of all options or war- rants presently outstanding or proposed to be granted to purchase securities of the issuer, including the names of the principal holders of such options or warrants, the cost of the options or warrants to them, the terms and conditions upon which they may be exercised and the price at which the securities may be acquired pursuant to such options or warrants. 11. Furnish appropriate financial statements of the issuer, or of the issuer and its predeces- sors, as required below. Such statements shall be prepared in accordance with generally ac- cepted accounting principles and practices but need not be certified. (a) If the issuer is a commercial, industrial or extractive company in the promotional, ex- ploratory or development stage, the following statements shall be furnished: (1) Separate statements of (i) assets, (ii) liabilities, and (iii) capital shares, as of a date within 90 days prior to the filing of the notification, or such longer period of time, not exceeding 6 months, as the Commission may permit at the written request of the issuer upon a showing of good cause therefor. (2) A statement of cash receipts and dis- bursements for each of at least 2 full fiscal years prior to the date of the statements fur- nished pursuant to paragraph (1) above, and for the period, if any, between the close of the last full fiscal year and the date of such statements, or for the period of the issuer's existence if less than the period specified above. In such statements, dollar amounts shall be extended only for cash transactions and trans- actions involving amounts receivable or payable in cash. Amounts due to or from, or paid to or received from, underwriters, promoters, direc- tors, officers, employees and principal stockhold- ers, shall be stated separately for each such class of persons, if significant in amount. The statement of assets shall include as a separate item unrecovered promotional, exploratory and development costs. The statement of cash re- ceipts and disbursements shall be itemized as appropriate to the nature of the enterprise. (b) If paragraph (a) does not apply to the issuer, there shall be furnished a balance sheet of the issuer as of the date specified in sub- paragraph (a)(1) and profit and loss state- ments and analyses of surplus for the periods specified in subparagraph (a)(2). Even though paragraph (a) may apply to the issuer, a balance sheet in conventional form may never- theless be furnished in lieu of the statements specified in subparagraph (a) (1) if the assets reflected therein which were acquired in ex- change for capital stock are not carried at an amount in excess of identifiable cash cost to promoters, predecessor companies or other transferors. 234 Appendix 28— B OUTLINE OF A PROSPECTUS (OR OFFERING CIRCULAR) FOR AN INTRASTATE OFFERING If the offering is exempt from registration under the Securities Act because it is wholly intrastate, the prospectus (or offering circular) will have to comply with the appro- priate State blue sky law. The following is a list of the types of disclosures required in State offering circulars or prospectuses: ( 1 ) Ordinarily the front page must bear a statement to the effect that the attorney general (or other appropriate authority) of the State has not passed on or endorsed the merits of the offering and that any representation to the contrary is unlawful. (2) The front page also ordinarily includes: name and address of the issuer, date of incorporation or organization, type of issuer, type of security being offered, price per unit and amount of the unit being offered to each purchaser, total amount of the offering, offering expenses, date of the prospectus and date after which it may not be used, and name and address of the principal distributor or under- writer (if any) of the securities. (3) The front page should also contain a statement to the effect that "the securities being offered by this pro- spectus are speculative in that they involve a high degree of risk." (4) In the body of the prospectus, an introductory statement should contain a summary description of the Company and a section entitled "risk factors" in which the following disclosures should, if appropriate, be made: (a) The Company is newly organized without his- tory or past business. Suggested language: "Since the Company has recently been formed and has not commenced actual operations it will be subject to all the risks inherent in a new business enterprise. Included in these risks are the possibility that the Company may operate at a loss for an uncertain period of time and that it may not have estimated properly its need for and the availability of required capital or its ability to obtain personnel with the necessary experience." (b) The nature of competition to be faced by the Company and the relative size and financial resources of the Company's competitors. Suggested language: "The business in which the Com- pany will engage is highly competitive. There are many companies in the same business which have greater financial resources and larger and more experienced staffs than the Company." (c) The manner in which the offering price has been determined and whether it has been arbitrarily determined. (d) The fact that there is no public market for the securities being offered and that there is no assurance that such a public market will ever develop. (e) The background, experience, and business his- tory of the promoters, directors, or officers of the Company, particularly if any of them have criminal records or have been subject to professional disciplinary proceedings, have been adjudicated bankrupt, or if there is any other fact in their business or personal history which might be relevant to an investor. (f ) A statement disclosing the fact (if true) that the current assets of the issuer are less than the current liabilities or that it has a capital deficit. (g) That there is a risk that less than all of the offered securities will be sold and that if that happens the risks to the investor will be increased. (h) A statement as to the dividend policy that the Company will follow in the future. Suggested language: "The Company does not expect to pay cash dividends on its Common Stock in the fore- seeable future. The Company presently intends to apply any earnings to the development of its business." (5) The prospectus should indicate the direct or in- direct interest of any of the promoters, directors, or officers of the LEDC in transactions or proposed transactions with the LEDC, setting forth the approximate dollar amounts involved in those transactions and describing the transactions. (6) The prospectus should state the proposed use of proceeds in as much specificity as possible. A general state- ment to the effect that funds to be raised will be used for "working capital" is not generally sufficient. (7) There should be a tabular presentation of the capitalization of the issuer as of a very recent date prior to the date of the prospectus, showing, in addition, the pro- posed capitalization if all of the securities being offered by the prospectus are sold. (8) The prospectus should contain a description of the business, or proposed business, of the LEDC and of the properties owned or leased by the LEDC. (9) The prospectus should contain a list of the officers, directors, principals, and principal stockholders of the LEDC and should disclose, with respect to the officers, directors, and principals, the percentage of time to be devoted by them to the LEDC, their business background, their experi- ence with respect to the LEDC's business, the amount of stock they own in the LEDC, and their compensation, or proposed compensation. (10) The prospectus should contain a brief description of the securities of the issuer, outlining briefly such things as dividend rights, voting rights, liquidation rights, pre- emptive rights, conversion rights, outstanding options, etc. (11) The prospectus should contain a description of any pending material legal proceedings against or by the LEDC setting forth the nature of the proceedings, and, if possible, a judgment as to the materiality of any adverse result of the proceedings. (12) There should be a brief description of the pro- posed method of the offering, indicating what persons are to solicit purchasers on behalf of the issuer, any compensa- tion to be received by them, and how the proposed issue is to be offered. (13) The prospectus or offering circular should contain the financial statements required by the appropriate State law and any other material information which might be relevant to a prospective investor in the LEDC. It should be noted that the preparation of a State pro- spectus or offering circular, while ordinarily not as com- plicated or expensive as the preparation of a registration statement under the Securities Act, is a complicated and often time-consuming process. Counsel familiar with the requirements of the State law should be retained to assist in the preparation of the prospectus or offering circular. In addition, the appropriate State authorities should be asked to furnish copies of other offering circulars or prospectuses which have become effective in that State, the format of which might be used as precedents. 235 Appendix 29— A LONG-TERM DEBT FINANCING The attached detailed Note Agreement and Note, pre- pared by a leading insurance company specifically for a Local Economic Development Company, contains special refer- ences to FHA financing and a specifically related use of proceeds (Section 6.1) for an LEDC. The lawyer for an LEDC seeking long-term debt financing from insurance com- pany sources should examine carefully the Note Agree- ment to review the terms and types of restrictions which will have to be negotiated. 1. A FORM OF NOTE AGREEMENT WITH INSTITU- TIONAL LENDER [DEVELOPMENT CORPORATION, INC.] [Street Address] [New York, New York] As of [February 1, 1968] [X Insurance Company] [New York, NY.] Attention: Bond Department Re: [ ] percent [Senior Notes Due 1983] Gentlemen: [DEVELOPMENT CORPORATION, INC.], a corpora- tion organized under the laws of [New York] (the "Com- pany"), hereby confirms its agreement with you as follows: 1. The Notes The Company has authorized and proposes to issue and to sell to you its [ ] percent [Senior Notes] due [April 1, 1983] in the original aggregate principal amount of $[ ]. Notes shall be printed and shall be in substantially the form of Exhibit 1 hereto and are herein referred to as the "Notes" which shall also include any notes delivered in exchange or replacement therefor pursuant to Section 6.3 or 6.4; and the term "Note" shall mean any of the Notes. Each Note shall be dated its date of issue, shall mature on [April 1, 1983], shall bear interest from its date at the rate of [ ] percent per annum, payable on [the first day of April and October in each year], commencing on the first of such dates after its date of issue, and interest at the rate of [ ] percent per annum so far as the same may be legally enforceable on all overdue principal and installments of interest and shall be in the denomination of [$1,000] or any integral multiple thereof. 2. Purchase and Sale of the Notes Subject to the terms and conditions and in reliance upon the representations and warranties set forth in this Agree- ment, the Company agrees to issue and sell to you and you agree to purchase from the Company at each of the [five] closings specified below (the "Closings") $[ ] aggre- gate principal amount of the Notes at a price equal to 100 percent of such principal amount. One Closing shall be held on [February 27, 1968], and one Closing shall be held on such date in each of the months of [April, lune, Septem- ber, and November 1968] as the Company shall specify to you by written notice delivered to you not less than 15 business days in advance of the date to be set for the Closing. The term "Closing Date" shall mean each date upon which a Closing is held. Each Closing shall be held at your office at [Street, New York, New York], at [11:00 a.m. New York time], or at such other place and time as the Company and you may mutually agree upon. At each Closing you shall pay for the Notes then to be sold to you by delivering to the Company a certified or official bank check in funds in the principal amount of the Notes then to be sold to you against receipt thereof by you. Unless otherwise requested by you the Company will at each Closing initially issue to you one Note payable to your order in the principal amount of the Notes then to be sold to you. 3. Representations and Warranties of the Company The Company represents and warrants that: 3.1. Organization and Good Standing of Company and Subsidiaries, etc. The Company has all requisite corporate power and authority to enter into this Agreement, to borrow money as contemplated hereby, to issue the Notes and to carry out the provisions hereof. The Company is a duly organized and validly existing corporation in good standing under the laws of the State of New York and its Subsidiaries are duly organized and validly existing corporations in good standing under the laws of their respective jurisdictions of incorporation, and the Company and its Subsidiaries are entitled to own their respective properties and assets, and to carry on their respective businesses, all as, and in the places where, such properties and assets are now owned or operated or such businesses are now conducted. The Com- pany and its Subsidiaries are duly qualified and in good standing as foreign corporations in all jurisdictions in which the nature of their respective businesses or properties makes such qualification necessary. 3.2. Business and Properties. Exhibit [ ] to this Agreement correctly sets forth a brief description of the business of the Company and its Subsidiaries and lists the states in which they conduct their respective businesses. The Company owns all of the outstanding capital stock of each class of each Subsidiary indicated in Exhibit [ ], sub- ject to no lien, pledge or other encumbrance which will remain in effect after the Closing and all such stock has been duly authorized and validly issued and is fully paid and nonassessable. Neither the Company nor any Subsidiary owns capital stock of any other corporation, except as indi- cated in Exhibit [ ]. 3.3. Financial Information. There have heretofore been furnished to you copies of the following financial statements: (i) Unaudited combined balance sheet of the Com- pany, [its Subsidiaries, and ] as at [May 31, 1966], and the related statement of combined profit and loss and retained earnings; (ii) Combined balance sheet of the Company, [its Subsidiaries, and Redevelopment Corporation of New Jersey] as at [May 31, 1967], and the related statement of operations and retained income, certified by [Messrs. ], inde- pendent public accountants; (iii) Unaudited combined balance sheet of the Com- pany, [its Subsidiaries, and Redevelopment Corporation of New Jersey] as at [November 30, 1967], and the related combined statement of operations and retained earnings; and (iv) Unaudited consolidated balance sheet of the Company [and its Subsidiaries] as at [November 30, 1967], 236 and the related consolidated statement of operations and retained income for the [six-month period] then ended. Such financial statements present fairly the financial position of the Company and its Subsidiaries at the respec- tive dates therefor and the results of their operations for the periods covered thereby, in conformity with generally accepted accounting principles applied on a consistent basis. Neither the Company nor any Subsdiiary has any known indebtedness, commitment, obligation, or liability, contin- gent or otherwise, not disclosed in such financial statements, or in the notes thereto or elsewhere herein. 3.4. Changes in Condition. Since [November 30, 1967], there has been no material adverse change in the business or condition, financial or other, of the Company or of its Subsidiaries on either an individual or a combined basis, and neither their properties nor business has been ad- versely affected in any material manner as the result of any fire, windstorm, explosion, accident, flood, drought, blight, earthquake, strike, embargo, lockout, riot, sabotage, or con- fiscation, condemnation, or purchase of any property by governmental authority, activities of armed forces, or acts of God or the public enemy, or other similar event or development. Since [November 30, 1967], neither the Com- pany nor any Subsidiary has entered into any transaction or made any distribution or investment which would not have been permitted by this Agreement if the Notes had been outstanding since that date. 3.5. Title to Properties. The Company and its Sub- sidiaries, respectively, have good and merchantable title to the assets reflected in their consolidated balance sheet at [November 30, 1967], referred to in clause (iv) of Section 3.3, or acquired since that date, subject to no mortgage, pledge, charge, lien or other encumbrance which will re- main in effect after the first Closing, except such as would be permitted by this Agreement. The Company and its Subsidiaries enjoy peaceful and undisturbed possession under all leases under which they are operating, and all said leases are valid and subsisting and in full force and effect. 3.6. Franchises, etc. The Company and its Subsidiaries possess sufficient franchises, permits, licenses, patents, trade- marks, and trade names to conduct their respective busi- nesses as now operated, with no known conflict with those of others which is likely to affect such businesses adversely in any material manner. 3.7. Litigation. There is no litigation at law or in equity and no proceeding before any Federal, State, or municipal board or other governmental or administrative agency pending, or to the knowledge of the Company threatened, which may involve the possibility of any judg- ment or liability not fully covered by insurance against the Company or any Subsidiary or which may otherwise result in any material adverse change in the business or assets or in the condition, financial or otherwise, of any of the fore- going, and no judgment, decree, or order of any court, board, or other governmental or administrative agency has been issued against any of the foregoing which has a mate- rial adverse effect upon the business or assets or upon the condition, financial or otherwise, of any of the foregoing except as reflected in the consolidated balance sheet referred to in clause (iv) of Section 3.3 hereof. 3.8. Tax Returns. The Company and its Subsidiaries have filed all Federal, State, local, and other tax returns required by law to be filed by them, and all taxes shown to be due and all additional assessments have been paid. All filed returns were prepared in accordance with applicable statutes and generally accepted principles applicable to taxation, and reserves for taxes in the consolidated balance sheet at [November 30, 1967], referred to in clause (iv) of Section 3.3 are sufficient for the payment of all accrued and unpaid taxes of the Company and its Subsidiaries. 3.9. No Default or Legal Obstacle. Neither the Com- pany nor any Subsidiary is in default under or is violating any provision of its charter or by-laws, or of any applicable law, decree, order, rule, or regulation, or of any indenture, agreement, lease, or other instrument by which it is bound, so as to affect adversely its business or condition, financial or otherwise, in any material manner. Neither the consum- mation of the transactions contemplated by the Agreement nor compliance with this Agreement will result in any breach or violation of or constitute a default under any such provision which will remain in effect after the first Closing, or result in the creation of any security interest or encumbrance which will remain in effect after the first Closing (other than the security interest created hereby) upon any of the assets of the Company or any Subsidiary. 3.10. Contracts, etc. Neither the Company nor any Subsidiary now is, and immediately after the first Closing none of them will be, bound by any indenture, agreement, lease, or other instrument, or will be subject to any charter, by-law, or other corporate restriction, or any law, decree, order, rule, or regulation which adversely affects, or in the future may (so far as the Company can now foresee) adversely affect in any material manner the business or condition, financial or otherwise, of the Company or any Subsidiary. 3.11. Not a Foreign National; Interest Equalization Tax, etc.; Government Regulation. 3.11.1. Not a Foreign National. The Company is not a person included within the definition of "designated foreign country" or "national" of a "designated foreign country" in the Foreign Assets Control Regulations or in the Cuban Assets Control Regulations of the United States Treasury Department, Title 31, Subtitle B, Chapter V, Code of Federal Regulations, as amended, within the meanings of said Regulations or of any regulations, interpretations, or rulings issued thereunder. 3.11.2. Interest Equalization Tax. The Company is a United States person within the meaning of Chapter 41 of the Internal Revenue Code of 1954 as amended, and the Company will not, directly or indirectly, apply any part of the proceeds of the Notes for the acquisition of stock of a foreign issuer or a debt obligation of a foreign obligor within the meaning of such Chapter. 3.11.3. No Foreign Direct Investment. The Company will not, directly or indirectly, apply any part of the pro- ceeds of the Notes to the making of any foreign direct investment prohibited by Executive Order No. 11387 of the President of the United States, or the Foreign Direct In- vestment Regulations of the Secretary of Commerce there- under (Title 15, Part 1000, Code of Federal Regulations, as amended), or any regulations, interpretations, or rulings thereunder. 3.11.4. Not a "Purpose Credit." Neither the Com- pany nor any Subsidiary presently owns any "registered equity security," as defined in Regulation G of the Federal Reserve Board, Title 12, Part 207, Code of Federal Regula- tions or any security issued by any investment company registered pursuant to Section 8 of the Investment Company Act of 1940, as amended. Neither the Company nor any Subsidiary will, directly or indirectly, apply any part of the proceeds of the Notes for the purpose (whether im- mediate, incidental, or ultimate) of purchasing or carrying any such "registered equity security" or security issued by any such investment company, or for the purpose of repay- ing any indebtedness which was originally incurred for any such purpose. 237 3.11.5. Government Regulation. Neither the Com- pany nor any Subsidiary is subject to regulation under the Public Utility Holding Company Act of 1935, the Federal Power Act, the Investment Company Act of 1940, the Interstate Commerce Act, or to any statute or regulation re- lating to common or contract carriers or to the sale of electricity, gas, steam, water, or other public utility services. No approval or authorization of, or registration, qualifica- tion, or filing with, any governmental authority is required in connection with the execution, delivery, or performance by the Company of this Agreement or the Notes. 3.12. Private Sale. Neither the Company nor anyone acting on its behalf has offered or will offer, or has made or will make any attempt, by preliminary conversations or negotiations, to dispose of any of the Notes or similar notes to, or has solicited or will solicit any offers to purchase any of the Notes or similar notes from, any person, firm, or corporation other than you. 4. Representation and Warranty of the Purchaser You represent and warrant to the Company that you will acquire the Notes to be purchased by you for your own account for investment and not with a view to the distribu- tion thereof, and that you have no present intention of mak- ing any distribution or disposition of them, provided that the disposition of your property shall at all times be and remain within your control. Your acquisition of such Notes at each Closing shall constitute your confirmation of said repre- sentation and warranty. 5. Conditions to Purchaser's Obligations Your obligations to purchase and pay for the Notes shall be subject to compliance by the Company with its agree- ments herein contained and to the satisfaction of the follow- ing further conditions at or prior to each Closing: 5.1. Legal Opinions. You shall have received opinions dated as of each Closing and addressed to you of Messrs. [ ], counsel for the Company, and of your special counsel, Messrs. f ], in substantially the forms of Exhibits [ ] and [ ] hereto, respectively, and with respect to such other matters relating to the trans- actions contemplated by this Agreement as you may reason- ably request. 5.2. Representations and Warranties True; No Default. The representations and warranties contained in this Agree- taent shall be true and correct at and as of the date of such Closing with the same force and effect as though made at and as of such Closing, and no event which, had any Notes been outstanding from the date hereof, would be an Event of Default hereunder, or which with the giving of notice or passage of time or both would become such as Event of Default, shall have occurred and be continuing at such Closing. At such Closing you shall have received a certificate to these effects signed by the President or any Vice President and the Treasurer or any Assistant Treasurer of the Company. 5.3. Required Approvals. All necessary approvals and authorizations of any governmental or administrative agency of the transactions contemplated by this Agreement shall have been obtained and shall be in full force and effect at the date of each Closing. 5.4. Subordination. The payment by the Company and its Subsidiaries of all indebtedness to the [ ] Corpo- ration shall have been subordinated to your satisfaction to the payment of the Notes. 5.5. General. All instruments and legal and other proceedings in connection with the transactions contem- plated by this Agreement shall be satisfactory in form and substance to you and your counsel, and you and your counsel shall have received copies of all documents, in- cluding records of corporate proceedings and opinions of counsel, which you or your counsel may have reasonably requested in connection therewith, such documents where appropriate to be certified by proper corporate or govern- mental authorities. 6. Use of Proceeds, Payment, and Excliange of the Notes 6.1. Use of Proceeds. The Company covenants that it will use the net cash proceeds received from the sale of the Notes solely to finance (by payment of overhead or other- wise) the development of low- and middle-income housing projects under the National Housing Act, as amended, and community development facilities. 6.2. Payment at Home Office. So long as any Note shall be held by you, or by any other holder of 10 percent or more in principal amount of the Notes at the time out- standing, or by a nominee of yourself or such holder, the Company will make all payments on account of principal of such Note, with premium, if any, and interest thereon, directly by check duly mailed or delivered to your address, or to the address of such holder designated pursuant to Section 15, without any presentment or notation of pay- ment, notwithstanding the provisions to the contrary in such Note with respect to the place and manner of payment. The amount of principal so paid on any Note shall be regarded as having been retired and cancelled at the time of payment. The holder of any Note, before any transfer thereof, will Tnake a notation thereon of the date to which interest has been paid and of the amount of all principal payments theretofore made thereon and will notify the Company in writing of the name and address of the transferree. Any Note with respect to which interest and principal shall have been fully paid shall be surrendered to the Company and shall be retired and cancelled. 6.3. Exchange. The holder of any of the Notes may at any time and from time to time prior to maturity or redemption thereof surrender any Note held by it for ex- change at the principal office of the Company. Within a reasonable time after notice to the Company from a holder of its intention to make such exchange, and without ex- pense (other than transfer taxes, if any) to such holder, the Company shall issue in exchange therefor another Note or Notes for the same aggregate principal amount as the unpaid principal amount of the Note or Notes so surren- dered, having the same maturity and rate of interest, con- taining the same provisions and subject to the same terms and conditions as the Note or Notes so surrendered, and the Note or Notes so issued shall be in denominations of [$1,000] or any integral multiple thereof. Each such new Note shall be payable to such person or persons, or order, as the holder of such surrendered Note or Notes may des- ignate in writing, and such exchange shall be made in such a manner that no gain or loss of principal or interest shall result therefrom. The Company will pay shipping and in- surance charges, from and to your main office, involved in the exchange or transfer by you of any Note held by you. 6.4. Replacement. Upon receipt of evidence satisfac- tory to the Company of the loss, theft, destruction, or mu- tilation of any Note and, if requested in the case of any such loss, theft, or destruction, upon delivery of an in- demnity agreement or security reasonably satisfactory to the Company, or, in the case of any such mutilation, upon surrender and cancellation of such Note, the Company will issue a new Note, of like tenor and amount, in lieu of such lost, stolen, destroyed, or mutilated Note. 7. Redemption Provisions So long as any Note is outstanding: 7.1. Required Redemptions Without Premium. The Company covenants and agrees that on [April 1] in each 238 of the years [1970 to 1983], both inclusive, it will redeem without premium the aggregate principal amount of the Notes set opposite the period in which such redemption is made in the following table, and that it will pay on the stated or accelerated maturty date of the Notes the entire principal amount thereof theretofore unpaid: Amount to be Redeemed (Period of Redemption:) each [April 1] [1970 to 1973], both inclusive $[ ] [1974 to 1977], both inclusive $[ 1 [1978 to 1983], both inclusive $[ ] 7.2. No Voluntary Redemptions. Except as required by Section 7.1 hereof, the Company covenants that it will voluntarily redeem or prepay, in whole or in part, any of the Notes prior to its stated or accelerated maturity. 7.3. Permanent Retirement of Notes. Notes redeemed in full or otherwise acquired by the Company shall be per- manently retired and cancelled and shall not under any circumstances be reissued or resold. 7.4. Selection of Notes for Redemption. Each redemp- tion required by this Agreement shall be made so that the Notes then held by each holder shall be redeemed in a principal amount [$1,000] or multiple thereof which shall bear the same ratio, as nearly as may be, to the total prin- cipal amount being redeemed as the principal amount of such Notes shall bear to the aggregate principal amount of all Notes then outstanding. 7.5. Notice of Redemptions. Notice of each redemp- tion of Notes required by this Agreement (except so long as you hold all of the Notes) shall be given not less than 30 nor more than 90 days before the redemption date by mailing to each holder a notice of intention to redeem speci- fying the date of redemption, the aggregate amount of Notes to be redeemed on such date, the principal amount of the Notes to be redeemed on such date held by the holder to whom such notice is sent, and the accrued interest applicable to such redemption. Notice of redemption having been given as aforesaid the amount of Notes specified in such notice shall become due and payable on the redemp- tion date. 7.6. Payment. Upon each redemption of Notes, in whole or in part, pursuant to this Agreement, the Company will pay to the holders thereof the amount of their Notes to be redeemed together with unpaid interest in respect thereof accrued to the redemption date. In the case of re- demption of all the Notes in whole, or in the case of a redemption of any Note held by a holder to whom direct payment is not required by Section 6.2, the Company shall be deemed to have paid all amounts then due in respect of such redemption of such Notes or Note if it shall have deposited such amounts irrevocably on or before the re- demption date at the principal office of [National Bank of New York] in [New York, New York] for the purpose of making such payment, such amounts to be available for payment immediately upon such deposit. 8. Security As security for the payment of the Notes and the per- formance of its obligations hereunder, the Company hereby creates in you, for the benefit of all holders of the Notes, a security interest in all of its right, title, and interest in and to the items and types of property described or referred to in Sections 8.1 and 8.2 (whether now owned or hereafter acquired), and the proceeds and products thereof (all of which shall be included within the term "Security") free and clear of all security interests and other encumbrances and restrictions. 8.1. Pledged Notes. All evidences of indebtedness rep- resenting any Investments in any person or entity (includ- ing but not limited to promissory notes) now owned or hereafter acquired by it beneficially or of record (the "Pledged Notes"), including without limitation all evidences of indebtednes issued by any Subsidiary, officer, or em- ployee, together with all security therefor, other than the notes in the principal amount of [$260] as at [November 30, 1967] evidencing the item carried as Notes Receivable on the consolidated balance sheet referred to in clause (iv) of Section 3.3. Promptly upon receipt by the Company of any evidence of Indebtedness constituting a part of the Pledged Notes, the Company will deliver such evidence to duly endorsed in blank or accompanied by an instrument of transfer duly executed in blank. 8.2. Accounts. All rights to receive the payment of money, whether now existing or hereafter arising, including without limitation rights to receive the payment of money under present or future contracts (whether or not earned by performance) or evidenced by or set forth in or arising out of any present or future document, chattel paper or general intangible, each as defined in the Uniform Com- mercial Code as in effect in [New York] on the date hereof (the "Accounts"). Neither you nor the holder of any Note hereby assumes or shall become liable for the performance of any obligation under any Account or any contract or (Other item included in the Security. 8.3. Attachment of Security Interests. The security interests created and intended to be created in any item of Security hereafter acquired by the Company shall attach upon the acquisition by it of rights in such item and, in the case of a contract right, upon the making of the con- tract, and in the case of an account (as defined in the Uni- form Commercial Code), when the account has come into existence. 8.4. Administration of Security. Until there shall have occurred an Event of Default hereunder, the Company shall be entitled to receive all ordinary interest paid on the Pledged Notes and to collect, compromise, and amend the Accounts and use, commingle, and dispose of the proceeds thereof in the ordinary course of business. All other distri- butions and principal payments made or paid on the Pledged Notes and, if there shall have occurred a default or an Event of Default hereunder, all distributions and payments with respect to the Pledged Notes and the Accounts shall be retained by you (or, if received by the Company, shall forthwith be paid by it to you in the original form received) and held by you as a part of the Security and applied by you in such order or manner to the payment of the Notes as you may determine in your sole discretion or as may be otherwise required or permitted by the laws of [New York] at the time in effect. The Company covenants that forthwith upon your re- quest and in confirmation of the security interests hereby created, it will execute and deliver to you such further acts, deeds, transfers, assurances, and agreements in form and substance satisfactory to you and your counsel. You shall have no duty as to the collection or protection of the Se- curity or any part thereof or any income thereof or pres- ervation of any rights pertaining thereto beyond the safe custody of any Security actually in your possession. The Company warrants that its records concerning the Pledged Notes and the Accounts are kept in [New York] and cove- nants that such records shall continue to be kept in [New York]. 9. Certain Covenants Without limiting any other covenants and provisions hereof, the Company covenants and agrees that, so long 239 as any of the Notes is outstanding or your commitment hereunder is outstanding, it will perform and observe the following covenants and provisions and will cause each Subsidiary to perform and observe such of the following covenants and provisions as are applicable to such Sub- sidiary: 9.1. Punctual Payment. The Company will pay the principal of and interest on each of the Notes at the times and place and in the manner mentioned in the Notes and herein. 9.2. Prompt Payment of Taxes, etc. The Company and its Subsidiaries will each promptly pay and discharge, when due and payable, all lawful taxes, assessments, and govern- mental charges or levies imposed upon it or its property, provided, however, that any such tax, assessment, charge, or levy need not be paid if the validity thereof shall cur- rently be contested in good faith by appropriate action or proceedings, if the Company or the Subsidiary concerned shall have set aside on its books adequate reserves with respect thereto, and if no proceedings shall have been commenced to foreclose any lien as security therefor. 9.3. Conduct of Business and Corporate Existence. The Company will continue to engage directly or through Sub- sidiaries in the businesses now conducted by the Company and its Subsidiaries as described in Exhibit [ ] on a combined basis, and in no other business. The Company and its Subsidiaries will each do all things necessary to preserve, renew, and keep in full force and effect its corpo- rate existence and its rights and franchises by it deemed necessary to continue its business, except as permitted by Section 9.12 in the case of Subsidiaries. The Company and its Subsidiaries will each comply with all applicable laws, ordinances, and regulations in respect of the conduct of its business and the ownership of its property, except to the extent that noncompliance therewith would not affect ma- terially and adversely its business or condition, financial or other. 9.4. Maintenance of Property and Leases. The Com- pany and its Subsidiaries will each keep its properties in such repair, working order, and condition as shall be in the best interest of its business, and from time to time will make all needful and proper repairs, renewals, replace- ments, additions, and improvements thereto, and will com- ply with the provisions of all leases to which it is a party or under which it occupies property so as to prevent any loss or forfeiture thereof or thereunder; but nothing in this Section 9.4 shall prevent the Company or any Subsidiary from selling, abandoning, or otherwise disposing of any property or lease if such property or lease is no longer useful in the business of the Company or the Subsidiary. 9.5. Insurance. The Company and its Subsidiaries will each keep its assets which are of an insurable character insured by financially sound and reputable insurers against loss or damage by fire or explosion in amounts sufficient to prevent the Company or any Subsidiary from becoming a co-insurer and not in any event less than 80 percent of the insurable value of the property insured; and will main- tain, with financially sound and reputable insurers, insurance against other hazards and risks and liability to persons and property to the extent and in the manner customary for companies in similar businesses, provided, however, that the Company and any Subsidiary may self-insure against liability to workmen in any State or jurisdiction, or may effect workmen's compensation insurance therein through an insurance fund operated by such State or jurisdiction, if the liability of the Company cannot exceed the limita- tions upon liability imposed by the applicable workmen's compensation law. 9.6. Accounts and Reports. The Company and its Subsidiaries will each keep true records and books of ac- count in which full, true, and correct entries will be made of all dealings or transactions in relation to its business and affairs in accordance with generally accepted account- ing practice. 9.7. Restrictions on indebtednes of the Company and Subsidiaries. Neither the Company nor any Subsidiary will create, assume, or guarantee, or otherwise become or re- main liable, directly or indirectly, upon or in respect of any indebtedness except the following: (a) Indebtedness in respect of the Notes; (b) Current liabilities of the Company and its Sub- sidiaries (other than for money borrowed) incurred in the ordinary course of business; (c) Current liabilities of the Company in respect of borrowings made from any of the [ ] corporations which liabilities shall be subordinated to your satisfaction to the prior payment of the Notes; (d) Contingent liabilities in respect of letters of credit issued in compliance with the applicable rules and regulations of the United States Federal Housing Adminis- tration, provided, however, that the aggregate amount of all such liabilities outstanding at any one time shall not exceed an amount equal to 2 percent of the aggregate principal amount of indebtedness secured by Federal Hous- ing Administration insured mortgages on projects being developed or managed by the Company; (e) Unsecured indebtedness to banks and institu- tional lenders in respect of borrowings made or guaranteed by the Company to finance the development of low- and middle-income housing projects by the Company in com- pliance with all applicable rules and regulations of the United States Federal Housing Administration; (f) Indebtedness of any Subsidiary payable to the Company or to another Subsidiary; and (g) Indebtedness for taxes, assessments, govern- mental charges or levies to the extent that payment thereof shall not at the time be required to be made in accordance with Section 9.2. 9.8. Restrictions on Liens. Neither the Company nor any Subsidiary will create, incur, or suffer to exist any mortgage, pledge, lien, charge, security interest, or other encumbrance of any kind upon any of its property or assets of any character, whether now owned or hereafter acquired; or transfer any of such property or assets for the purpose of subjecting the same to the payment of indebtedness or performance of any other obligation in priority to payment of its general creditors; or acquire or agree or have an option to acquire any property or assets upon conditional sale or other title retention agreement, device, or arrange- ment; or suffer to exist for a period of more than 90 days after the same shall have been incurred any indebtedness or claim or demand against it which if unpaid might by law or upon bankruptcy or insolvency, or otherwise, be given any priority whatsoever over its general creditors; or sell, assign, pledge, or otherwise transfer any of its accounts or notes receivable, provided, however, that the foregoing provisions of this Section 9.8 shall not be appli- cable to the following: (a) The security interests created pursuant to Sec- tion 8 hereof; (b) Liens in respect of attachments, judgments, or awards which have been in force for less than the appli- cable appeal period (or less than 90 days if that expires sooner) so long as execution is not levied thereunder, or in respect of which the Company or the applicable Subsid- iary at the time shall in good faith be prosecuting an appeal 240 or proceedings for review and in respect of which a stay of execution shall have been obtained pending such appeal or review; (c) Liens for taxes or assessments or governmental charges or levies if payment shall not at the time be re- quired to be made in accordance with Section 9.2; (d) Liens of mortgages or pledges by Subsidiaries of all or part of their assets as security for indebtedness owing to the Company; and (e) Liens in respect of pledges or deposits to secure public or statutory obligations or to secure performance in connection with bids or contracts; materialmen's, mechan- ic's, carrier's, workmen's, repairmen's, or other like liens not then delinquent, or deposits to obtain the release of such liens; deposits to secure surety, stay, appeal, or customs bonds; or other similar liens, pledges, or deposits; but as to all of the foregoing, only if the same shall transpire and continue in the ordinary course of business, are not in- curred in connection with the borrowing of money or the obtaining of advances or credits and do not in the aggregate materially detract from the value of the property of the Company or any Subsidiary or materially impair the use thereof in the operation of its business. 9.9. Net Current Assets. The Company and its Sub- sidiaries will at all times after [November 30, 1968], main- tain their Consolidated Current Assets at not less than 125 percent of their Consolidated Current Liabilities. 9.10. Restrictions as to Distributions. Neither the Company nor any Subsidiary will make any Distribution if, after giving effect to any such Distribution, the sum of (x) all such Distributions declared or paid during the current fiscal year of the Company plus (y) the amount of all investments acquired by the Company and its Sub- sidiaries during such fiscal year would exceed an amount equal to 50 percent of the Consolidated Net Income of the Company and its Subsidiaries for the next preceding fiscal year of the Company. Notwithstanding the foregoing, nothing in this Section 9.10 shall prevent the Company from declaring and paying dividends payable solely in shares of its common stock, or, so long as there shall have occurred no Event of De- fault hereunder or event which, with the passage of time or giving of notice, or both, would become such an Event of Default, from making payments in respect of Current Liabilities permitted by Section 9.7(c). 9.11. Limitation on Investments and New Projects. (a) Neither the Company nor any Subsidiary will purchase or otherwise acquire any investment in any cor- poration or other entity which is not a Subsidiary, or which will not thereupon become a Subsidiary, if, after giving effect to any such investment, the sum of (x) the amount of all investments acquired by the Company and its Sub- sidiaries during the current fiscal year of the Company plus (y) all Distributions declared or paid during such fiscal year would exceed an amount equal to 50 percent of Consolidated Net Income of the Company and its Subsidi- aries for the next preceding fiscal year of the Company. (b) Neither the Company nor any Subsidiary will acquire a Subsidiary if, immediately after giving effect to any such acquisition, there would exist an Event of Default hereunder or an event or condition which, with the passage of time or giving of notice or both, would become such an Event of Default. (c) Neither the Company nor any Subsidiary shall commit itself, prior to [January 1, 1972], to develop any housing or other construction project other than those specified in a schedule of such projects set forth in Exhibit [ ] hereto. 9.12. Consolidation, Merger, and Sale of All Assets. Neither the Company nor any Subsidiary will merge or consolidate with any other corporation or sell, lease, or otherwise dispose of all or substantially all of its assets to any person, firm, or corporation, except that a Subsidiary or another corporation may merge into, or sell, lease, or dispose of its assets to the Company or a Subsidiary, pro- vided, however, that in any such transaction the rights and powers of the holders of the Notes will not be adversely affected and that immediately after giving effect to any such transaction there shall exist no Event of Default here- under and no event or condition which, with the passage of time or giving of notice or both, would become such an Event of Default. 9.13. Lease-Backs. Neither the Company nor any Sub- sidiary will rent or lease any fixed asset which either (i) was owned by it on or after [November 30, 1967], and was thereafter sold or transferred by the Company or any Subsidiary, or (ii) is to be used for substantially the same purposes as any fixed asset so owned and sold or trans- ferred. 9.14. Miscellaneous Information; Inspection. From time to time upon request, the Company will furnish to you so long as you hold any of the Notes and to each holder of 10 percent or more in principal amount of the Notes at the time outstanding such information regarding the business and affairs and condition (financial and other) of the Company, its Subsidiaries, and their respective prop- erties in such detail as may reasonably be requested; and any representative authorized by you or by any such holder shall also have the right at its expense to visit and inspect any of such properties, to examine books of account and records of the Company and its Subsidiaries and to take notes and make transcripts therefrom, and to discuss their affairs, finances, and accounts with, and be advised as to the same by, their officers, all at such reasonable times and intervals as may be requested. 9.15. Expenses and Indemnity. Whether or not the transactions contemplated hereby shall be consummated, the Company will pay all expenses (including fees and expenses of counsel referred to in Section 5 ) in connection with the preparation of this Agreement and the issuance and delivery of the Notes, and also in connection with any modification hereof and thereof; and will indemnify and save you harmless against and from all broker's and finder's fees, if any, and will pay all your out-of-pocket expenses incurred in connection with the matters contemplated by this Agreement. In the event that it subsequently is deter- mined by competent authority that any tax or levy is due on the issue of the Notes or the acquisition or ownership thereof (including any interest equalization tax or any other similar levy designed to restrict investments in foreign securities), the Company will pay and save you harmless from any and all such taxes and levies and also all losses or liabilities (including interest and penalties) in respect thereof and income taxes resulting from any reimburse- ment to you on account thereof. 10. Information and Reports to be Furnished by the Com- pany The Company will furnish to you in duplicate so long as any of the Notes are held by you, and will furnish (in duplicate if requested) to each holder of 10 percent or more in principal amount of the Notes at the time outstanding: 10.1. Quarterly Reports. As soon as available and, in any event, within 30 days after the end of each of the first 3 fiscal quarters in each of the Company's fiscal years, the consolidating and consolidated balance sheet of the Com- pany and its Subsidiaries as of the close of such quarter, 241 and the related consolidating and consolidated statements of income and surplus for the quarter and for the expired portion of the fiscal year then ended, together with com- parative consolidated figures for the same periods of the preceding year, all in reasonable detail and accompanied by a certificate of the Executive Vice President and the Treasurer of the Company stating that such statements present fairly the financial position of the Company and its Subsidiaries at the dates thereof and the results of their operations for the periods covered thereby, subject to nor- mal year-end adjustments. 10.2. Annual Statements. As soon as available and, in any event, within 90 days after the end of each fiscal year, the consolidating and consolidated balance sheet of the Company and its Subsidiaries as at the end of such year, and the related consolidating and consolidated state- ments of income and surplus for such year, together with comparative consolidated figures for the immediately pre- ceding fiscal year, all in reasonable detail and accompa- nied by (i) reports or certificates of independent public accountants of recognized standing and, so long as you hold any of the Notes, satisfactory to you, and (ii) the statement of such public accountants that they have caused the provisions of this Agreement and the Notes to be re- viewed and have no knowledge of any default by the Com- pany in the performance or observance of any of the pro- visions of this Agreement or the Notes or, if they have such knowledge, specifying such default and the nature thereof. Each such statement of public accountants shall set forth computations in reasonable detail showing, as of the end of the year covered by such statement, compliance with Sections 9.7(d), 9.9, 9.10, and 9.11. 10.3. Compliance Certificate and Computations. At the time of delivery of each quarterly and annual statement furnished pursuant to Sections 10.1 and 10.2, a certificate signed by the Executive Vice President and the Treasurer of the Company, stating that they have caused the provi- sions of this Agreement and the Notes to be reviewed and have no knowledge of any default by the Company in the performance or observance of any of the provisions of this Agreement or the Notes or, if they have such knowledge, specifying such default and the nature thereof. Each such annual certificate shall set forth computations in reasonable detail showing, as of the end of the year covered by such statement, compliance with Sections 9.7(d), 9.9, 9.10, and 9.11. 10.4. Audits. Promptly after receipt, all detailed audits or reports submitted to the Company by independent public accountants in connection with any annual or interim audits of the books of the Company or any Subsidiary. 11. Events of Default, Consequences, etc. 11.1. Events of Default. The occurrence of one or more of the following events shall constitute an "Event of Default" under this Agreement: (a) if default shall be made in the payment of any part of the principal of, or interests on, any of the Notes when and as the same shall become due and payable (whether at their stated maturity, at a date fixed for re- demption, by acceleration, or otherwise); or (b) if default shall be made in the observance or performance of any covenant or provision in Sections 9.7 to 9.13, both inclusive; or (c) if default shall be made in the observance or performance of any other covenant or provision of the Notes or of this Agreement, and such default shall con- tinue for a period of 30 days; or (d) if default shall be made under the terms of any other note, agreement, or other instrument relating to indebtednes for money' borrowed, incurred, or guaranteed by the Company or a Subsidiary, and such default shall continue beyond the period of grace, if any, specified therein; or (e) if any representation or warranty made by the Company herein or in any certificate delivered pursuant hereto shall prove to have been untrue in any material respect as of the date made; or (f) if the Company or any Subsidiary shall be in- volved in financial difficulties as evidenced (i) by its admitting in writing its inability to pay its debts generally as they become due; or (ii) by its filing a petition in bankruptcy or for reorganization or for the adoption of an arrangement under the Federal Bankruptcy Act, or any similar applicable bankruptcy or insolvency law, as now or in the future amended (herein collectively called "Bankruptcy Laws"), or an answer or other pleading admitting the material alle- gations of such a petition or seeking, consenting to, or acquiescing in relief provided for under such Bankruptcy Laws; or (iii) by its making an asignment of all or a sub- stantial part of its property for the benefit of its creditors; or (iv) by its seeking or consenting to, or acquies- cing in the appointment of a receiver, liquidator, or trustee of it or for all or a substantial part of its property; or (v) by its being adjudicated a bankrupt or in- solvent; or (vi) by the entry of a court order which shall not be vacated, set aside, or stayed within 30 days from the date of entry, appointing a receiver, liquidator, or trus- tee of it or for all or a substantial part of its property, or approving a petition filed against it for, or effecting an arrangement in, bankruptcy or for a reorganization pursu- ant to said Bankruptcy Laws or for any other judicial modification or alteration of the rights of creditors; or (vii) by the assumption of custody or sequestra- tion by a court of competent jurisdiction of all or a sub- stantial part of its property, which custody or sequestration shall not be suspended or terminated within 60 days from its inception. 11.2. Rights of Holders and Acceleration of Notes. If any Event of Default shall occur and shall be continuing, the holder of any Note may proceed to protect and enforce its rights by suit in equity, action at law, and/or other appropriate proceeding either for specific performance of any covenant or provision contained in such Note or herein or in aid of the exercise of any power granted in such Note or herein, and (unless there shall occur an Event of Default under Section 11.1(f) hereof, in which case the entire un- paid principal amount of all Notes shall automatically be- come immediately due and payable) and by notice in writ- ing to the Company declare the unpaid balance of such Note, and interest accrued and unpaid thereon, to be forth- with due and payable, and thereupon such balance and such interest shall become so due and payable without presentation, protest, or further demand or notice of any kind, all of which are hereby expressly waived. 11.3. Annulment of Defaults. Section 11.2 is subject to the condition that, if at any time after the principal of any of the Notes shall have become due and payable, and before any judgment or decree for the payment of the money so due, or any thereof, shall have been entered, all arrears of interest upon all the Notes and all other sums payable under the Notes and under this Agreement (except the principal of the Notes which by such declaration shall have become payable) shall have been duly paid, and every other default and Event of Default shall have been made 242 good or cured, then and in every such case the holders of 75 percent or more in principal amount of all Notes then outstanding may, by written instrument filed with the Com- pany, rescind and annul such declaration and its conse- quences; but no such rescission or annulment shall extend to or affect any subsequent default or Event of Default or impair any right consequent thereon. 11.4. Notice of Default. If any holder of a Note or of any other indebtednes of the Company or any Subsidiary for borrowed money shall demand payment because of, or take any other action of which the Company shall have actual knowledge in respect of, an alleged default or Event of Default, the Company will forthwith give written notice, specifying such action and the nature of the alleged default or Event of Default, to each holder of the Notes then out- standing, and the Company will also give written notice to each such holder if any written instrument of rescission or annulment as aforesaid shall be filed with it under the provisions of Section 11.3 hereof. 11.5. Costs and Expenses. The Company covenants that if default be made in any payment of principal of or interest on any Note, it will pay to the holder thereof, to the extent permitted under applicable law, such further amount as shall be sufficient to cover the cost and expense of collection, including reasonable compensation to the attorneys and counsel of the holder thereof for all services rendered in that connection. 11.6. Rights to Realize upon Security. If an Event of Default shall occur, you shall have all of the rights of a secured party (for the benefit of the holders of the Notes) under the Uniform Commercial Code as then in effect in [New York] and you may sell or otherwise dispose of or collect or enforce the Security and apply the proceeds of any such sale, collection, or enforcement as provided in this Agreement or in the laws of [New York] at the time in effect. 11.7. Course of Dealing. No course of dealing between the Company and any holder of any Note and no delay on the part of any such holder in exercising any rights under such Note or hereunder shall operate as a waiver of the rights of any holder of any Note. 12. Amendments, Waivers, and Consents Any provision in this Agreement or in the Notes to the contrary notwithstanding, changes in or additions to this Agreement may be made, and compliance with any cove- nant or provision herein set forth may be omitted or waived, if the Company (i) shall obtain consent thereto in writing from the holder or holders of at least 75 percent in principal amount of all Notes then outstanding, and (ii) shall deliver copies of such consent in writing to any holders who did not execute the same, provided, however, that no such consent shall be effective to reduce or to postpone the date fixed for the payment of the principal (including any required redemption) of or interest payable on any Note, without the consent of the holder thereof, or to reduce the percentage of the principal amount of Notes the consent of the holders of which is required under this Section 12. Any consent may be given subject to satisfac- tion of conditions stated therein. 13. Certain Terms Defined The terms defined in this Section shall, for all purposes of this Agreement and of the Notes and of any agreement supplemental hereto, have the meanings herein specified unless the context requires some other meaning: 13.1. The terms "Closings" and "Closing Date" are defined in Section 2. 13.2. The term "Company" shall include and mean not only [Development Corporation, Inc.] but also its suc- cessive successors and assigns. 13.3. The term "Consolidated," when used with refer- ence to any term defined herein, shall mean that term as applied to the accounts of the Company and its Subsidiaries consolidated in accordance with generally accepted account- ing principles as reflected in the annual financial statements furnished pursuant to Section 10.2. 13.4. The term "Current Assets" shall be determined in accordance with generally accepted accounting practice, but in any event shall include only: cash, evidence of in- debtedness issued or guaranteed by the United States of America at not in excess of cost or current market, which- ever is less; accounts receivable (not for money loaned or advanced to officers or employees of the Company or a Subsidiary or any person, firm, or corporation controlling or under common control with the Company) in the ordinary course of business, less reserves for doubtful accounts; pre- paid items; and inventories at not in excess of cost or cur- rent market, whichever is less. Investments (whether in the form of loans, advances, stock ownership, or otherwise) other than investments represented by evidences of indebt- edness of the United States of America shall not be included in Current Assets. 13.5. The term "Current Liabilities" shall mean all indebtedness which should, in accordance with generally accepted accounting principles, be classified as current liabilities, and in any event including all Indebtedness payable on demand or within one year from the date of determination without any option on the part of the ob- ligor to extend or renew such year, all accruals for Federal and other taxes based on or measured by income and pay- able within such year, and all redemptions and payments of long-term indebtedness required to be made within such year. 13.6. The term "Default" shall mean an Event of Default, or an event which with the lapse of time or the giving of notice, or both, would constitute an Event of Default. The term "Event of Default" shall have the mean- ing given is Section 11.1 hereof. 13.7. The term "Distribution" shall mean any dividend on, or purchase, redemption, or retirement of, and any other payment or distribution in respect of, any share of any class of capital stock of the Company or any indebted- ness of the Company owed to any stockholder of the Com- pany or to a relative of any such stockholder. For pur- poses of Sections 9.10 and 9.11 hereof, the amount of any Distribution shall be the cost or fair value thereof at the time such Distribution is made, whichever is higher. 13.8. The term "Fiscal Year" shall mean the period of 12 consecutive calendar months beginning [lune 1] in each year. 13.9. The term "Holder of any Note" or "Holder" shall mean the payee of any Note unless a subsequent holder shall have presented such Note to the Company for inspection, shall have delivered to the Company notice of acquisition thereof, and shall have designated an address to which notices in respect thereof shall be mailed, in which case the term shall mean such subsequent holder. 13.10. The term "Indebtedness" shall mean all obliga- tions, contingent and otherwise, which in accordance with generally accepted accounting principles should be classi- fied upon the obligor's balance sheet as liabilities, and in any event including liabilities secured by any mortgage, pledge, security interest, or lien existing on property owned or acquired subject to such mortgage, pledge, security in- terest, or lien, whether or not the liability secured thereby shall have been assumed, and all guarantees, endorsements 243 (other than endorsements for collection or deposit in the ordinary course of business), and other contingent obliga- tions in respect of indebtedness of others, whether or not the same are or should be so reflected in said balance sheet. 13.11. The term "Investments" shall mean any shares of stock, bonds, notes, or other evidences of indebtedness or securities issued by, and any loans, advances, or exten- sions of credit to, and any contributions to capital of, any corporation or other person, excluding, however, (a) advances or extensions of credit to customers made in the ordinary course of business and payable within one year after the date made, (b) capital stock of the Company or of a Subsidiary, (c) obligations issued or guaranteed by the United States of America having a maturity of not over 3 years, (d) time deposits with banks or bankers, (e) letters of credit issued by banks, and (f) loans and ad- vances to officers and employees of the Company and affiliates, not exceeding $[ ] in the aggregate at any one time outstanding. For purposes of clause (f) of this Section 13.11, the term "loans and advances to officers and employees" shall not include loans and advances to affiliates to the extent that such loans and advances do not exceed the amount of Current Liabilities permitted by Section 9.7(c). For purposes of Sections 9.10 and 9.11 hereof, the amount of any investment shall be the value of the consideration paid therefor by the Company and its Subsidiaries. 13.12. The term "Consolidated Net Income" for any period shall mean the net income (or deficit) of the Com- pany and its Subsidiaries for such period, after all ex- penses, taxes, and other proper charges, determined in accordance with generally accepted accounting principles and by excluding gains and losses derived from extraor- dinary and nonrecurring sales of assets, if and to the extent that such gains and losses may be excluded in ac- cordance with generally accepted accounting principles. 13.13. The term "Subsidiary" or "Subsidiaries" shall mean any corporation which is organized under the laws of any State of the United States of America, which has substantially all its assets and business operations in the United States, and all of the outstanding capital stock of every class (other than directors' qualifying shares) of which is at the time owned by the Company or any of its other Subsidiaries, as the case may be. 14. Survival of Covenants All covenants, agreements, representations, and warran- ties made herein and in certificates delivered pursuant hereto shall be deemed to have been material and relied on by you, notwithstanding any investigation made by you or on your behalf, and shall survive the Closings and shall con- tinue in full force and effect until all the Notes shall have been paid in full; and the covenants and agreements made in Section 9.15 shall survive payment and redemption of the Notes or any of them. 15. Notices, etc. Any notice or demand which by any provision of this Agreement is required or provided to be given shall be deemed to have been sufficiently given or served for all purposes by being sent as registered mail, postage and registration charges prepaid, to the following addresses: if to the company to [Development Corporation, Inc., X Street, New York, New York, Attention: Mr. lohn Smith, Executive Vice President] or, if any other address shall at any time be designated by the Company in writing to all persons who are holders of the Notes at the time of such designation, to such other address; if to you, to your address set forth on page 1 hereof marked "Attention: Bond Department" or to such other address as you may designate by notice to the Company, except that until you notify the Company to the contrary, all payments to you, including principal and interest on the Notes held by you, shall be made to your said address but marked "Attention: Treasury Department C-l." Any notice given by the Com- pany shall be signed by its President or any Vice President and by its Treasurer or any Assistant Treasurer. 16. Entire Agreement; No Oral Change This Agreement, together with any other writing signed by the parties expressly stated to be supplementary hereto and together with the instruments and certificates to be delivered to you pursuant to this Agreement constitutes the entire agreement between you and the Company with respect to the subject matter hereof, superseding all prior understandings and writings relating thereto, and may not be changed orally. 17. Benefits All of the terms and provisions of this Agreement shall bind and inure to the benefit of the parties hereto and their respective successors and assigns, including as your assigns (except as otherwise expressly provided herein) all assignees and subsequent holders of the Notes, provided, however, that despite any assignment or transfer of the Notes the Company shall be entitled to treat any holder as the owner of all Notes in which such holder is designated as payee unless and until the Company shall have received the notice provided for in Section 13.9. 18. Controlling Law This Agreement shall be governed by and construed in accordance with the law of [New York]. 19. Counterparts This Agreement may be executed in any number of counterparts, each of which, when executed and delivered, shall be an original, but such counterparts shall together constitute one and the same instrument. If you agree with the foregoing, please sign the form of acceptance on the enclosed counterpart of this Agreement and return the same to the Company, whereupon this Agreement will become and evidence a binding agreement between the Company and you as of the date and year first above written. Very truly yours, [Development Corporation, Inc.] 'By [ ] President and Treasurer « By [ ] Executive Vice President The foregoing Agreement is hereby accepted as of the date thereof. [X Insurance Company] By [ ] 244 Appendix 29— B A FORM OF NOTE [DEVELOPMENT CORPORATION, INC.] [ ] percent [Senior Note due April 1, 1983] No. [ ] $[ ] [February 1, 1968] For value received, [Development Corporation, Inc.], a [New York] corporation (hereinafter, with its successors and assigns, generally called the "Company"), hereby promises to pay to [X Insurance Company], or order, on [April 1, 1983] (or earlier as hereinafter referred to), the principal amount of [ ] dollars ($[ ]) and to pay fixed interest on the unpaid balance of such principal amount from the date hereof at the rate of [ ] per- cent per annum semiannually in arrears on the [first] day of [April and October] of each year commencing on the first of such dates following the date until the principal amount hereof shall be due and payable (whether at ma- turity, at a date fixed for redemption, by declaration, or otherwise), and, to the extent permitted by law, to pay interest at the rate of [ ] percent per annum on any overdue principal, premium (if any), payable semiannually as aforesaid or, at the option of the holder hereof, on demand. Payments of principal, premium, and interest shall be made in lawful money of the United States of America at the principal office of the Payee, or registered assign. Interest shall be computed on a 360-day year, 30-day month basis. This Note is one of a duly authorized issue of Notes of the Company, limited in aggregate principal amount to $[ ] issued pursuant to and entitled to the benefits and security of a certain Agreement, dated as of [Feb- ruary 1, 1968] (herein generally called the "Agreement") by and between the Company and the Payee, to which Agreement reference is hereby made for a statement of the nature and extent of the protection thereby afforded, the rights under the Agreement of the Payee or registered assign hereof, and the rights and obligations under the Agreement of the Company; but neither the foregoing reference to the Agreement, nor any provision of this Note or of the Agreement shall affect or impair the absolute, unconditional, and unalterable obligation of the Company to pay the principal of and interest on this Note as herein provided. This Note is subject to required redemption without premium and the principal may be declared due and pay- able before the stated maturity hereof, at the time and in the manner and upon the conditions specified in the Agreement. The Company waives diligence, demand, presentment, notice of nonpayment, and protest. IN WITNESS WHEREOF [Development Corporation, Inc.] has caused this Note to be executed by its officers thereunto duly authorized. [Development Corporation, Inc.] By [ ] President and Treasurer and [ ] Executive Vice President Appendix 30— A LETTER AGREEMENT BLANKET LOAN GUARANTY Agreement between [ Bank] (Bank) and Job Loan Corporation (JLC) [Date] This letter of intent will establish in general terms the working relationship between Bank and Job Loan Cor- poration with regard to loans by Bank to disadvantaged businessmen sponsored by Job Loan Corporation. Job Loan Corporation shall authorize Bank to make certain loans to businessmen by sending Bank a loan Authorization setting forth the amount, rate, maturity, and other conditions under which the guaranty of Job Loan Corporation shall be effective. Bank shall make the loan according to the Authorization and service the loan according to Bank's regular practices. Any amounts loaned in excess of the dollar amount stated in the Authorization shall be at the Bank's sole risk. If the borrower should default in repaying the loan, Bank will make its regular efforts to effect repayment, and if the loan is uncollectible, Job Loan Corporation agrees to purchase the outstanding principal balance of the loan, and Bank will assign its position to Job Loan Corporation. Accepted: [signature] [Title] [ ] Bank Accepted: [signature] [Title] Job Loan Corporation 245 Appendix 30— B GUARANTY (BETWEEN MEMBER OF CREDIT POOL, COMMERCIAL BANK, AND 501(c)(3) ORGANIZATIONS) The purpose of this guaranty is to provide a means through which money can be obtained to develop new small business enterprises which are owned and operated by minority underprivileged groups. This guaranty shall be in effect for a period of 10 years unless the total dollar amount of the guaranty is sooner reduced by cash payments made in honor of this guaranty. Further, this guaranty is made in consideration of other guaranties which together represent a combined total guar- anteed dollar amount of at least $100,000 which serves to indemnify the [Commercial Bank] against any loans desig- nated by the 501(c)(3) organization which are in default with the Bank. This guaranty is made with the under- standing that any cash payments necessary within the 10-year period of this indemnification will not exceed $10,000 and that all cash payments honoring loans which have been designated by the 501(c)(3) organization and which are in default with the Bank will be prorated among the total number of guarantors indemnifying the Bank under similar agreement, to the extent of the dollar amount of each loan which is in default. This commitment of in- demnification will be reduced by all such payments which are so prorated. Further, it is understood that the 501(c)(3) organization will assist in collecting, for the Bank, the prorated share of money from each guarantor to cover any loan which has been quaranteed under this and similar indemnification agreements and which is in default, satisfying the outstand- ing principal and accrued interest charges. Such payment of any loan in default will be made on or before the 90th day following the due date of the note with the Bank. It is understood that during the 10-year period of this commitment, periodic financial statements must be sub- mitted by the guarantor to the Bank. It is further understood that a group life insurance policy or some other insurance mechanism will be obtained by the 501(c)(3) organization which will cover the guarantor to the extent of this guaranty commitment in the event of death during the 10-year commitment period. [ ] [ ] Date Member of Credit Pool This is acknowledged and agreed to by the 501(c)(3) Organization [ ] [ 1 Date 501(c)(3) Organization This is acknowledged and agreed to by the Commercial Bank [ ] [ J Date [Commercial Bank] Appendix 30— C LIMITED POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that I, I ], residing at [ ], have made, constituted, and appointed, and by these presents do hereby make, constitute, and appoint [ ], residing at [ ], and [ ], residing at [ ], my true and lawful Attorneys-in-Fact, and each of them my Attorney-in-Fact, for me and in my name, place, and stead, from time to time and at all times until this authority shall be revoked in the manner de- scribed herein, for the following purposes and no others: ( 1 ) Upon receipt of a written request of The [name of the 501(c)(3) organization] (hereinafter referred to as the Association), a nonprofit membership corporation or- ganized and existing under the laws of the State of [ ] and having its principal office at [ ] Street, [ ], to execute on my behalf and deliver to either (i) The [ ] Bank of [ ], a corporation organized and existing under the laws of the United States of America and having its principal office at [ ] Street, [ ], or (ii) such other banking corporations, if any, organized and existing under the laws of the United States or of the State of [ ], as shall from time to time be designated by the Association and approved by my Attorneys-in-Fact (both (i) and (ii) are hereinafter referred to as the Bank), a Guaranty of Payment in substantially the form annexed hereto (with such changes therein as shall be approved by my Attorneys-in-Fact) with respect to each and every loan made by the Bank to a person, firm, or corporation (hereinafter referred to as a Borrower) recommended by the Association, provided, however, that such a Guaranty of Payment shall not be executed and delivered as afore- said unless: (a) my Attorneys-in-Fact shall also be acting under all, but in any event not less than nine (9), other Limited Powers of Attorney, substantially similar in form to this instrument (with respect to which Limited Powers of At- torney, no written notice of revocation or of the death of a principal shall have been received by the Bank and my Attorneys-in-Fact), and executed by other financially re- sponsible Guarantors (the determination of financial re- sponsibility in this regard is to be in the sole discretion of my Attorneys-in-Fact); and (b) the term of any such loan, including any exten- sions thereof, shall not exceed ten (10) years from the date of this instrument; and (c) the principal amount of any such loan, includ- ing any renewals thereof, shall not exceed Fifty Thousand Dollars ($50,000); and 246 (d) in the event of default on any such loan, my liability under such Guaranty shall be several and not joint and shall not exceed Five Thousand Dollars ($5,000) of the principal indebtedness thereof; and (e) the sum of (i) the aggregate amount of my share of Guaranties of Payment outstanding at any time and (ii) any payments made by me in respect of any Guaranties of Payment entered into pursuant to the au- thority conferred herein, shall not exceed Ten Thousand Dollars ($10,000); provided, however, that if, through in- advertence or other cause, my Attorneys-in-Fact shall make Guaranties of Payment for my account in excess of the authority conferred hereunder, such Guaranties shall never- theless inure to the benefit of the Bank as if fully author- ized hereunder. (2) In the event of a default in the payment of prin- cipal or interest on any such loan by a Borrower, to re- ceive from the Bank (i) the Borrower's note and (ii) any property, or any interest of the Bank in any property, of the Borrower securing the repayment of such loan, and to sign any receipts or other instruments in connection there- with, and to transfer any such note or property to the Association as a charitable contribution. (3) Pursuant to [ ], of the [ ] Civil Prac- tice Law and Rules, to act as the persons upon whom a summons, or any other legal process may be served by the Bank in connection with any proceedings which may be instituted by the Bank or its successors or assigns in con- nection with the enforcement of my obligation under any Guaranty of Payment executed and delivered in accordance with the foregoing authority. The approval by my Attorneys-in-Fact of a banking corporation or of changes in the form of Guaranty re- quired under paragraph ( 1 ) hereof shall be evidenced by his execution, on my behalf, of the proffered Guaranty of Payment. The authority granted herein may be revoked at any time by an instrument, signed, acknowledged, and delivered by the undersigned to either or both of my Attorneys-in- Fact, and to the [ ] Bank of [ ] and to such other banking corporation as shall have been approved by my Attorneys-in-Fact. As used in this instrument, the term "property" shall mean and include real, personal, and mixed property of every kind and wherever situate and shall include every kind of right, title, and interest, legal or equitable, and whether beneficial or otherwise, in or to any of the fore- going. Each of said Attorneys shall have all the powers, includ- ing discretionary powers, which are granted to said At- torneys by any of the provisions of this instrument and, acting alone and without notice to anyone, may exercise any or all of said powers in the same manner and with the same effect as if appointed by this instrument as my sole Attorney-in-Fact. In consideration of other Guarantors executing substan- tially similar Limited Powers of Attorney and lending Banks making loans in reliance thereon, the undersigned agrees that this instrument shall be irrevocable until no- tice of revocation thereof (by receipt of written notice of revocation or of the death of the undersigned, or other- wise) shall have been received by each lending Bank and my Attorneys-in-Fact. IN WITNESS WHEREOF, I have hereunto set my hand and seal this [ ] day of [ ] 197 [ ]. [ ] [L.S.] In the presence of: [ ] Witness [ ] Witness Appendix 30— D BLANKET LOAN GUARANTY AGREEMENT BETWEEN [LEDC] AND LENDER [LOCAL ECONOMIC DEVELOPMENT COMPANY] An agreement, made the [ ] day of [ ], [ ] by and between [name of lender] [Lender] and [name of LEDC] (LEDC) : WITNESSETH: WHEREAS, it is the intention of the parties to estab- lish a mutual arrangement and understanding for the mak- ing by Lender and the guaranteeing by LEDC of loans to business concerns in the furtherance of their respective interests and the interest of the business economy of the [name of community]; NOW, THEREFORE, in consideration of the mutual promises contained herein, the parties represent and agree, as follows: (1) Application for Guaranty. This agreement shall relate only to any new loan which has been approved by Lender and LEDC in accordance with their respective credit policies. Any loan approved by Lender contingent upon LEDC's guaranty under this agreement shall be re- ferred to LEDC authorization upon separate applications x of Lender. (2) Approval of Guaranty. LEDC shall either author- ize the guaranty by returning a copy of the application showing written approval of such authorization, or decline the guaranty by written notice to the Lender. If the appli- cation for any guaranty is not approved as submitted by the Lender but can be approved by modifying the written loan conditions in a manner acceptable to both Lender and LEDC, the guaranty may be authorized by LEDC. Any change thereafter in the authorized loan conditions shall be subject to prior written approval by LEDC. ( 3 ) Closing and Disbursement of Loans. Lender shall close and disburse each loan in accordance with the terms and conditions upon which the loan and guaranty were approved. Lender shall cause to be executed a note and any additional instruments and take such other actions which shall, consistent with prudent closing practices, be required in order fully to protect or preserve the interests of Lender 1 Form to be furnished by LEDC. 247 and LEDC in the loan. Immediately after a loan is closed, Lender shall furnish LEDC with a copy of the executed note and loan agreement. Upon its request, LEDC shall also be entitled to examine copies of other security instruments or loan documents held by Lender which relate to loans guaranteed hereunder. (4) Loan Servicing. Lender or LEDC, whichever is the holder of any note, shall not without the prior written consent of the other party: (a) evidencing a loan guaran- teed hereunder, make or consent to any transfer or assign- ment of such note or to any alteration in its terms or the terms of security instruments; (b) make or consent to any release, conveyance, substitution, or exchange of any col- lateral having a value, as reasonably determined by the holder, which is more than 10 percent of the outstanding loan balance; or (c) waive any claim against any borrower or guarantor, standby creditor, or other obligor arising out of such note or any security instrument. All other servicing action shall be the responsibility of the holder. (5) Notice of Borrower's Default and Demand for Purchase. Lender shall have the right to make demand in writing for the purchase by LEDC of its guaranteed per- centage of any loan guaranteed hereunder, provided that such loan is in default (as "default" is defined in this para- graph), and such default has continued for not less than 60 days. The 60-day period may be waived if the parties agree that such waiver is in their best interests. Default means nonpayment of principal or interest on the due date, or the breach by the borrower of any loan covenant (in the note, in loan agreement, or in any instrument securing the loan) which the Lender determines to constitute an adverse change in the borrower's ability to repay the guar- anteed loan. Lender shall notify LEDC in writing within 30 days of any such default in payment or within 30 days of the date when Lender shall have determined such a breach of a loan covenant, and such notification to LEDC shall be a condition precedent to the Lender's right to demand purchase by LEDC. (6) Purchase by LEDC. In making its written demand for LEDC to purchase its guaranteed percentage of any loan, Lender shall thereby certify that such loan has been disbursed and serviced in compliance with this agreement and that the provisions of this agreement remain in full force and effect with respect to such loan. Within 20 days after receipt of Lender's demand, LEDC shall pay to Lender the guaranteed percentage of the then outstanding principal amount of such loan together with interest thereon, and Lender shall issue to LEDC a participation certificate evidencing LEDC's interest. Lender shall hold the note, all the collateral therefor, and all instruments in connec- tion therewith; provided, however, that subsequent to the purchase by LEDC of its guaranteed percentage in any loan and upon written demand by LEDC, Lender shall within 5 days after receipt of said demand transfer to LEDC, without recourse, the note, collateral, and instru- ments for such loan and simultaneously evidencing Lender's interest retained in such loan; and further provided, that after LEDC's purchase, Lender may elect to transfer such loan to LEDC pursuant to the transfer procedure set forth in this paragraph. (7) Fees or Commissions. Lender shall not directly or indirectly charge or receive any bonus, fee, commission, or expense in any form in connection with the making or servicing of any loan guaranteed hereunder, except charges or expenses incurred or for actual services rendered. (8) Sharing of Repayment Proceeds. Any and all repayments, security, or guaranty of any nature, including but not limited to rights of setoff and counterclaim, which Lender or LEDC, jointly or severally, may at any time receive or have in any loan guaranteed hereunder, shall repay and secure the interests of Lender and LEDC in the same proportion as such interests bear respectively to the entire unpaid balance of such loan. In the event Lender makes any loan or advance to a borrower subsequent to a loan guaranteed hereunder, Lender shall notify LEDC of such loan or advance and, if circumstances require, enter into a written agreement with LEDC providing for the application of collateral (or any money realized there- from) to the respective loans in a manner satisfactory to the parties hereto. (9) Payment of Expenses. All reasonable expenses incurred by LEDC or Lender which relate to a loan guar- anteed hereunder and which are not recoverable from the borrower shall be shared ratably by LEDC and Lender in accordance with their respective interests in such loan. (10) LEDC Purchase Privilege. When any loan guar- anteed hereunder shall be in default in payment for more than 90 days, LEDC may at its option give written notice to the Lender that LEDC will purchase its guaranteed per- centage, or the loan in its entirety, 10 days after receipt of said notice by the Lender. Upon such purchase date, the transfer of the note and related instruments, without recourse, to LEDC and of a certificate of interest to the Lender shall be simultaneously completed. (11) Termination. Either party hereto, by giving not less than 10 days prior written notice by certified mail to the other party, may terminate the provisions of this agree- ment; such termination shall not apply to any loan pre- viously authorized by LEDC to be guaranteed hereunder. Lender may at any time prior to purchase by LEDC ter- minate the provisions of this agreement as to any individual loan upon receipt of notice of termination by LEDC. The provisions of this agreement shall be terminated in the case of any loan if demand for LEDC to purchase is not made within 60 days following the stated maturity date of the note evidencing such loan. IN WITNESS WHEREOF, Lender has caused this agreement to be executed on its behalf by its duly author- ized officers and its corporate seal to be hereunto affixed, and LEDC has caused this agreement to be executed on its behalf by its duly authorized officers the day and year first above written. [Seal] Attest: J [ ] Lender ] Title Title [Local Economic Development Company] By: [ ] Title 248 Appendix 30— E APPLICATION FOR LOAN UNDER BLANKET GUARANTY [LEDC] LOAN NO. [ ] [LOCAL ECONOMIC DEVELOPMENT COMPANY] Pursuant to provisions of the Blanket Loan Guaranty Agreement executed between the Lender and [name of LEDC], dated [ ], 19[ ], it is requested that the loan described below be included under the provisions of the said Agreement and that [LEDC] guarantee said loan to the extent of [ ] percent. Name and address of loan applicant (Include ZIP Code) : [ ]• Telephone: [ ]. Amount of loan: [ ]. Maturity: [ ]. Interest rate: [ ]. Product or service furnished: [ ]. Proprietorship [ tion [ ]. Purposes of loan: [ Amount: [ ]. Total: [ ]. ]. Partnership [ ]• ]. Corpora- Additional information requested on the reverse side hereof is enclosed. Lender believes that there is reason- able assurance of repayment but is unwilling to make the loan unless [LEDC] authorizes the guaranty requested herein. [ ] Lender Date: [ J 1 ] Title Appendix 30— F AUTHORIZATION OF LOAN GUARANTY [LOCAL ECONOMIC DEVELOPMENT COMPANY] Your request for [LEDC] guaranty of [ ] percent of the above loan to be made and serviced by you is hereby approved subject to the loan conditions, if any, stated on the reverse side of this form, subject to the terms of the Blanket Loan Guaranty Agreement referred to above. [Local Economic Development Company] By: [ ] Title Date: [ ].. Additional Loan Conditions Required by [LEDC]: [ ]• INSTRUCTIONS (1) An original and two executed copies of this form are to be submitted to [LEDC]. If the guaranty is approved, an executed copy will be returned showing that the guar- anty is in effect. (2) Attach with the application: (a) Pertinent credit information developed on appli- cant, noting any receivership or bankruptcy action. (b) A copy of the loan terms Lender intends impos- ing (e.g., proposed loan agreement or similar document). (3) The first disbursement of the loan must be made not later than 6 months, and no disbursement shall be made later than 12 months, from the date of LEDC's Authoriza- tion of Loan Guaranty (see obverse), unless such periods are extended by written consent of [LEDC]. 249 i-SV*/. / A';st* n Appendix 32- A SMALL BUSINESS ADMINISTRATION APPLICATION FOR LEASE GUARANTEE PART I OF III Lease Guarantee No. INSTRUCTIONS: To Be Completed By Lessee- Applicant. Failure To Submit Required Information Delays Processing. Use Separate Sheets If More Space Is Needed. Submit 2 copies to participating insurance firm which proposes that SBA participate; or Submit I copy to SBA if there is no participating insurance firm. A APPLICANT-LESSEE I. Eligibility - Does applicant have affiliates or subsidiaries? [J^" I I No. If yes, give name(s). relationship to applicant number of employees if manufacturing concern, dollar sales volume for past full fiscal year if wholesale, retail or service, and items produced or sold; combined assets, net worth, and average net profit after taxes for past two fiscal years. 2. Name of Lessee(s) (If proprietorship or partnership, show name(s) followed by d/b/a and trade name used, if any): 3. Present Mailing Address (St.. City, State 8, ZIP Code) 4. Address of Premises to be Leased (St.. City, State & ZIP Code) 5. Telephones Business: B. BUSINESS I. Type (drug, variety, etc.) 2. No. of Employees 3 Years Ago: Now At Opening: ^Proprietorship ^Limited Partnershi Partnership ] Corporation 4. Existing Business?] |Yes | } No Sq. Ft. in Bldg.: Rent (per mo): $ 5. Date Established 7. Number of Business Locations 6. Present Managemen Business Since Before this Lease After Lease C. OWNERSHIP (Furnish the following information for a single proprietor, all partners, all corporate officers and directors, and all holders of 20% or more corporate stock) 1. First, Middle and Last Name IN FULL: 2. Residence Address: 3. Date of Birth: 4. Place of Birth: 5. U.S. Citizen' 6. % of Ownership : 7. Office/Position: 8. Annual Pay: 9. Outside Net Worth (Personal Net Worth Less Investment in Firm): 10. Social Security No.: I I. Face Value of Life Insurance: $ 5 SBA FORM 600 (8-681 EDITION OF 4-6B WILL BE USED UNTIL STOCK IS EXHAUSTED 250 D. FINANCIAL I . Additional Investment and Non-recurring expenses to be incurred in leasing new premises: a. Moving expenses: b. Furniture and fixtures: , c. Additional inventory and stock: d. Promotion and advertising: e. Working capital first 3 months' operation: f. Lease Guarantee Insurance Premium: g. Escrow Deposit: h. Other (Itemize; include funds to carry A/R, if any): TOTAL 2. Source(s) and amount(s) of capital for additional investment and non-recurring expenses: Source Amount Repayment Terms (If none, so state) (Must agree with Total under "D.I.") 3. References of Lessee (List name, position and address): a. Banking Business Suppliers (3 largest accounts) c. Major Customers (3 largest; show % of gross business obtained from each) d. Personal (List 3) ish narked with asterisk only.) Submit the following with this application (MUST BE SIGNED) (If new business, fun a. Balance sheets for the past 3 fiscal years. b. Balance sheet for end of period which is not more than 60 days from date of application. c. Explanation of all major balance sheet items and contingent liabilities, if any. d. Details of notes, contracts, and mortgages payable, if any, including: (1) To whom payable; (2) Original Amount; (3) Present Balance; (4) Repayment Terms; (5) How Collateralized; (6) Current or Past Due (Extent). e. Age accounts receivable and accounts payable on 30-60-90-day basis. Profit and Loss Statement for past three fiscal years and for as much of current year as is available. (If operating statements are not available, explain why not and enclose corresponding Federal income tax returns in lieu thereof.) If lease is to be personally guaranteed, furnish current net worth statement(s) of the guarantor(s). Signed statement regarding bankruptcies, suits, judgments, indicating none, if so. Personal balance sheets of all holders of 20% or more stock of corporate applicant. Cash budget and projected sales and profits, considering all new location factors. I. SBA FORM 800 (8-68) 251 E. MANAGEMENT EXPERIENCE AND EVALUATION No. of Years No. of Years No. of Years I . How many years of business experience have you had? a. Working in the same line of business b. Managing in the same line of business c. Working in unrelated line of business d. Managing in unrelated line of business 2. a. How many years of schooling have you completed? b. Certificates, diplomas or degrees received: 3. Has your health limited or interfered with the operation or management of the business during past 3 years? 4. Are you active in the following? a. Chamber of commerce: b. Trade association: c. Other organizations (specify): YES □ □ NO □ YES □ CD □ NO □ □ □ YES □ □ □ NO □ □ □ 5. Has keyman succession been planned' If Yes: a. Successor's name and present position: □ Yes 1 [No b. Is successor presently sharing in planning and decision making? □ Yes | |No 6. Does the company advertise? If Yes, by what method(s): . □ Yes | |No 7. a. Which products, lines of merchandise, or services were: (I) The most profitable? Reason: (2) The least profitable? Reason: b. Did you add any new products or services during the past year? If Yes. what? □ Yes | )No 8. A management interview will be conducted. To assist the interviewer, please comment on your management abilities as they relate to this proposed project, e.g., background, training, experience, education, special attributes, character and other factors. Also explain the strengths and weaknesses of your financial statements as a reflection on your management capabilities. (Use additional sheet(s) if necessary) SBA FORM 800 18-68) 252 DISCLOSURE OF SPECIAL INFORMATION REGARDING PRINCIPALS List below the names of any Small Business Administration employees or SBA advisory board members who are related by blood, marriage or adoption to, or who have any present or have had any past, direct or indirect, financial interest in or in association v the applicant, or any of its partners, officers, directors or principal stockholders (such interest to include any direct or indirect financial interest in any other business entity or enterprise) (Use separate sheet if necessary.) If none, check here: Name Address Details of Relationship or Interest AGREEMENT OF NONEMPLOYMENT OF SBA PERSONNEL In consideration of the issuance of the lease guarantee applied for in this application, applicant-lessee hereby agrees that for a period of 2 years after the effective date of the lease guarantee, applicant-lessee will not employ, or tender any office or equipment to, or re- tain for professional services, any person who, on the effective date of such lease guarantee or within one year prior to such date, (a) shall have served as an officer, attorney, agent, or employee of SBA and (b) as such, shall have occupied a position or engaged in activities which SBA shall have determined, or may determine, to involve discretion with respect to the granting of a lease guarantee under the Small Business Investment Act, or said Act as may be amended from time to time. H. AGREEMENTS (1) Pursuant to the provisions of Section 401 of the Small Business Investment Act of 1958, as amended, the undersigned hereby applies to SBA for the guarantee of payments of rent under a certain proposed lease, a copy of which is submitted herewith. The undersigned hereby expressly agrees that this application is made pursuant to Title IV of the Small Business Investment Act of 1958, as amended, 15 U.S.C. 692, and Title 13, Part 106, Code of Federal Regulations and that the cited law and regulations shall control transactions between the insurer and the applicant, and with respect to the requested lease guarantee that in the event the guarantee herein applied for is granted by SBA to: (a) Pay to guarantor a fee not in excess of % of the guaranteed rent under the proposed lease in accordance with the reg- ulations of SBA, the first fee payment to be made simultaneously with the granting of such guarantee. (b) Deposit into an interest-bearing escrow account with the guarantor an amount not less than one-fourth of the minimum guaranteed annual rental required under the lease. (2) The undersigned applicant permits SBA to release any or all information in this application or that developed by SBA to any insurance company participating with SBA . Check one: ]J Permits ^j Disapproves NOTE: It is not required that an applicant employ representatives in order to file this application with SBA. I CERTIFICATION The undersigned applicant-lessee(s) hereby certifies(y) that all information contained in this application and in the documents attached hereto are true and correct to the best knowledge of the applicant and are submitted for the purpose of inducing SBA to guarantee to the lessor(s) rental payments due or portions thereof pursuant to its lease. The undersigned hereby certifies that: (1) The applicant has not paid or incurred any obligation to pay, directly or indirectly, any fee or other compensation for obtaining the guarantee herein applied for except for the insurance premium. (2) The guarantee herein requested is needed to induce the lessor to lease the premises to lessee and that a guarantee meeting the requirement of the applicant is not available from other sources on reasonable terms. (3) (To Be Used Only By Displaced Firms) The applicant was physically displaced on ^^^^^^^^^____^^^^____^___^_^^_^_^_^__^^___ by Federally aided project described as Project No. . As a result of such displacement, applicant was paid $ by (City) (Individual, general partner, trade name, or corporation) By (Title) Whoever makes any statement knowing it to be false for the purpose of obtainlnq for himself or for an applicant any lease guarantee or for the purpose of influencing in any way the action of SBA, or for the purpose of obtaining a lease guarantee under the Small Business Invest- ment Act, as amended, shall be punishable under Section 16(a) of the Small Business Act, as amended, by a fine of not more than $5,000 or by imprisonment for not more than two years, or both. SBA FORM 800 18-68) 6P0 861-537 253 Appendix 32-B SMALL BUSINESS ADMINISTRATION APPLICATION FOR LEASE GUARANTEE PART II OF III Lease Guarantee Number: INSTRUCTIONS: To Be Completed By Lessor-Landlord. Failure To Submit Required Information Delays Processing. Use Separate Sheets If More Space Is Needed. Submit 2 copies to participating insurance firm which proposes that SBA participate, or submit I copy to SBA if there is no participating insurance firm. Name of lessor(s) Telephone No. 2. Present mailing address (Street, City. State and ZIP Code) 3 OWNERSHIP (Furnish the following infoi holders of 20% or more corporate stock) for a single proprietor, all partners, all corporate officers and directors, and all 1. First. Middle and Last Name IN FULL: 2. Residence Address: 3. Date of Birth: A. Place of Birth: 5. U. S. Citizen? 6. % of Ownership: 7. Office Held: 4. Facts pertaining to property of which premises to be leased is a part Address (Street. City. State and ZIP Code) b. Fronting on Q^j North Q^] East (^ South Q^West side of stree' between ____^^_^^___^__^^__^___^_^__^______ Street and Street. c. Lot dimensions Frontage d. Type of building (apt. or office bldg., shopping center, store, etc.) e. Number of apartments consisting of Number of stores f. Kinds of stores rentable area h. Parking Number of spaces Zoning and permitted use □ Existing Building ] Proposed Construction | In Process of Construction (I) If existing building. Date of completion Date lessor(s) purchased Building Improvements, if any. since purchase (2) If proposed or in process of construction, estimated date of completion 5. Facts pertaining to financing of building or complex of which premises to be leased is a part a. Name and address of each holder of an outstanding real estate or chattel mortgage on the property of which the premises to be leased is a part b. Will the lease be assigned or a rent assignment executed by the lessor to any mortgage or other lender? f^ yes | I No If yes. identify the lender and explain the arrangement. c. Will the lease be subordinated to any mortgage loan or sale of the property of which premises to be leased is a part? | | Yes | | No If yes, describe. 6. Facts pertaining to lease for which guarantee Is sought _J Existing Lease _^ Proposed Lease If proposed, estimated date of execution: b. Q On entire buildinR ) On part of building, cente Starting date Term (in months) d. Total area to be leased square feet; consisting of: ( I ) Bui Iding _ square feet; and square feet, including parking area SBA FORM 00OA DEVIOUS EDITIONS ARE OBSOL 254 (I) Pursuant to lease - Minimum payment per . period: (monthly, quarterly, etc.) for each of (first) periods; for next periods; for next periods. Amount for entire term: $ Is there provision for additional percentage or escalatii rental ? j | Yes | | No If yes, explain terms: (2) To be guaranteed ■ (monthly, quarterly, etc.) for each of (first) for next _^_^__ for next installments of: periods; . periods; . periods. Total amount of guarantee: $ Above installments to be guaranteed are due From (month, day and year) To (month, day and year) f Types or kinds of businesses or lessees prohibited from occupying the leased premises pursuant to the leas 7 Bank references of lessor Commitment time requested: J 3 months | | 6 months j~~| 12 months j | other: , months The following documents must be submitted in duplicate with this application: a. Ccpy of lease or lease agreement to be guaranteed. b. Copy of ground lease, if any. c. If proposed construction, plot plan, plans and specifications, contractor's estimates of cost broken down into components. d. Available evidence of conformance to federal, state and local regulations, codes and ordinances e. Survey of site showing easements, improvements if any, public ingress and egress. f. Dated photographs of premises to be leased, improvements, surrounding area, streets and highways. g. City and neighborhood maps showing location of premises to be leased and also showing location of comparable type competitive establishments. h. Feasibility study, including market data on trade area and description of neighborhood. (Lessees or lessor to furnish when proposed development involves 3 or more leases of premises.) i. Rent comparables and other pertinent market data j. Chattels - description of furnishings and equipment to be installed by lessor on premises to be leased, k. List of business tenants or types of other tenants anticipated. I. If existing building, center or complex, submit history and background, for past 5 years, including rents, description of past tenants of premises to be leased, and reason for termination of these tenancies. 10. Name and address of building, center agreements containing provisions for complex management. (Submit copy of lease and any management contracts or sii inagement for the building, center or complex.) Mar i Address (Street, City, State and ZIP Code) Telephone No. Certification: The undersigned lessor(s) hereby certifies(y) that all information contained in this application and in the documents attached hereto are true and correct to the best knowledge of the lessor(s) and are submitted for the purpose of inducing SBA to guarantee to the le sor(s) rent payments due or portions thereof pursuant to its lease; and further that without such guarantee, lessor(s) would be unable to enter into an acceptable lease with lessee(s) because of inadequate: I 1 Business Experience r_~J Credit Rating ("JJ Financial Strength [~_~J Other (Specify); Agreement: The undersigned applicant permits SBA to release any or all information in this application or that developed by SBA to any insurance company participating with SBA. Check one: .__! Permits "H Disapproves 13. DISCLOSURE CF SPECIAL INFORMATION REGARDING PRINCIPALS List below the names of an> Small Business Administration employees or SBA advisory board members who are related by blood, marriage or adoption to, or who have any present or have had any past, direct or indirect, financial interest in or in association with, the applicant, or any of its partners, officers, directors or principal stockholders (such interest to include any direct or indirect financial interest in any other business entity or enterprise). (Use seperate sheet if necessary.) If none, check here: f Name Address Details of Relationship or Interest 14. "The undersigned applicant agrees that this application made pursuant to Title IV of the Small Business Investment Act of 1958, as amended. 15 U.S.C. 692. and Title 13. Part 106, Code of Federal Regulations and that the cited law and regulations shall control trans- actions between the insurer and the applicant." Dated at . 19. (City (State) (Individual, general partner, trade name, or corporation) (Title) Whoever makes any statement knowing it to be false for the purpose of obtaining for himself or for an applicant any lease guarantee or for the purpose of influencing in any way the action of SBA, or for the purpose of obtaining a lease guarantee under the Small Business Investment Act, as amended, shall be punishable under Section 16(a) of the Small Business Act, as amended, by a fine of not more than $5,000 or by imprisonment for not more than two years, or both. FORM B00A 14-681 GPO 942-306 255 INDEX Accounts receivable, 54, 162, 179 Acquiree, 59; evaluating, 52, 54; financial condition of, 52, 60; tax considerations. 56 Acquisition of existing firm, 14, 52-65 "Action" organizations, 20 Agreement, employee, 65; lease purchase, 83, 223; manage- ment-retailer, 223; wholesaler-management company, 223 Agriculture, U.S. Department of, 11 American Industrial Bankers Association, 174 Antitrust laws, 117 Arms-length relationship, 24 Assets, 61; acquisition, 55; fixed, 54; inventory, 53; tax basis, 56 Association, unincorporated, 75 Audit, 53 Balance sheet, 54, 127 "Balloon maturity," 166 Bank pool, 167, 246 Banks, 162, 166-173. 174, 245 Black Economic Union, 171 Blue sky laws, 150, 156 Bonding programs, 108 Bonds, industrial revenue, 145; municipal, 145; tax exempt, 145, 147 Book value, 53 Bootstrap financing, 58 Borrowing, 174-183 Breach of contract, 63 Broker-sponsor role of LEDC, 3-8 Businessmen's associations, 13 Buyer problems, 52 By-laws, 26, 28, 31, 44, 51 Capital gains, 56 Cash flow, 126 Chain-independent retail stores, 81-87 Change, adverse, 60, 164 "Chapter S" corporation, see "Subchapter S" Charitable organization, 17, 18 Charities, "public," 20 Checklist, for consultant interview, 193; for grant proposals, 131; for lease purchase agreement, 223; for loan applica- tion, 229; for management agreement, 223; for shopping center, 224; of corporate activities, 3 Church group investments, 135-137; 229 Civil Rights Act of 1964, 31 Closing, 61,63, 178 Collateral, 162, 175-176 Community, as broker-sponsor, 3-8; control, 32, 50, 51, 113; participation, 27; representation, 168; trust, 34 Compensating balance, 176 Conditional sale contract, 182 Conflict of interest, 6, 7, 24, 41 Contingent payout, 58 Contract, franchise, 71; termination of, 116 Contributions, 128 Convertible securities, 160 Coperative Assistance Fund, 133 Cooperatives, 74-80 Co-owner, 64 Corporate organization, 26, 30, 47, 110, 112 Corporate purpose and power clause, 26 Corporation, compared with cooperative, 74; membership, 26, 194, 202 Counseling, business, 11 Covenants, 61, 62, 136, 165, 177 Credit, 174-183 Credit pool, 170 Credit union, 76 Cumulative voting, 29, 32, 43 "Cushion" clause, 62 Debentures, 161 Debt subordination, 177 Default, 136, 137, 168, 170, 172 Directors, election of, 27, 28, 43; removal of, 28 Disclosure requirements, 150, 176 Discount transaction, 176 Discrimination, reverse, 118 Down payment, 57 Economic Development Administration, 11, 111, 138, 139-141 Equal Opportunity Loan Program, 1 1, 142 Employee-ownership plans, 120-124 Employee participation, 124, 224 Employment agreement, 65 Endorsements, 177 Equity capital, 39 Factoring, 175, 179 Federal Home Loan Bank, 163 Federal Housing Administration (FHA) programs, 99 Federal Reserve Board (FRB) Regulation G, 165 Federal sources of financial assistance, 98, 138-144 FIFO method of inventory valuation, 53 Financial assistance from LEDC, 5—8 Financial condition of acquiree, 52, 60 Financial statements, 52, 60, 127, 164; analysis of, 53 Financing, 126-127; bank, 166; bootstrap, 58; construction, 89; leasehold, 178; LEDC, 5; real estate, 177; State and local, 145-149; with company assets, 174 Fiscal management, 126-127 501 (c) (3) organization, see Section 501, etc. 502 organization, see Section 502, etc. Ford Foundation, 133 Foundation, charitable, 7, 128, 133-134; as source of grants, 130-132; as source of loans, 227-229; private, 20 Franchise checklist, 69 Franchising, 66 Fringe benefits, 49 "Front money," 89, 94 Government programs, 111, 138-142, 145 Grants, and loans for public works, 141; Model Cities; multiplier effect of, 131; proposals, 130 Guarantees, 117, 161, 177, 246 141; Housing, 19, 93-109, 137, 160 Housing Act of 1949, 106 Housing and Urban Development Act of 1968, 94, 108 Housing and Urban Development, U.S. Department of, 98, 141 Income and loss statement, 53, 54 Incorporation, articles of, 26, 202; certificate of, 51, 194, 207; identity of persons involved, 43; of cooperative, 77; of profitable venture, 115; of stock corporation, 30, 42; resolutions, 29 Indemnification, 61, 62 Indian reservations, 138, 139 257 Industrial projects, 110-119 Industrial revenue bonds, 145 Inspection, rights of, 29 Installment sales, 181 Institutional sources of funds, 159-165 Insurance, 179; industry as source of loans, 160, 185 Intangibles, 174; financing of, 181 Interchurch Center, 137 Interest, 107, 136, 142, 167, 176 Internal Revenue Code, 18, 19, 30, 32, 34, 121, 128, 196, 200 International Council of Shopping Centers, 91 International Franchise Association, 67 Intrastate stock offering, 151, 158 Inventory, 53, 81, 162, 182 Joint venture, 92, 111 Labor relations, 64, 118 Labor, U.S. Department of, 11, 138 Landlord, rights of, 223 Lease, 64, 91, 162, 166; guarantee, 143, 184-187, 250; pur- chase agreement, 83, 223 Leasehold financing, 178 Leasing, 182-183 "Letter" stock, 151 Leverage, 5, 36, 122, 166, 174 Liabilities, 54, 60 Liability, limitation of, 112 Licensee, 36, 38, 40 LIFO method of inventory valuation, 53 Loan, agreement, 164, 190; application, 137, 168; assistance, commercial, 166-173; bank, 162; church, 136; corporate, 174; criteria for granting, 166; equipment, 178-179; Fed- eral, 103, 140, 142, 172; foundation, 133; institutional sources of, 159, 236; participating, 161; SBIC, 36, 38; terms of. 134, 164, 167 Lobbying, 20 Loss and income statement, 53 Management, company, 81, 223; problems, 65; training, 14 Managerial assistance, 9, 11, 117, 192 Membership corporation, 26, 64, 194, 202 Minority business enterprise, 9, 50, 67, 161. See also Office of Minority Business Enterprise. Minority Enterprise Small Business Investment Company (MESBIC), 10, 36, 37 Minority representation, 111 Mission Enterprise and Investment Loan Fund (MELIC), 137 Model Cities Program, 141 Mortgage, and lease guarantee, 184; application for, 91; below-market interest rate loan, 107; financing, 161; long- term commercial, 169; processing, 96; second, 177; shop- ping center, 89 Multiplier effect, 131 National Business League, 171 National Council of Churches of Christ, 132 National Housing Act, 100 National Labor Relations Act, 118 Nonprofit status, 24, 26, 27, 152, 160, 202 Notes (of indebtedness), 58 Office of Economic Opportunity (OEO), 24, 138 Office of Minority Business Enterprise (OMBE), 9-10, 36, 68, 138 OMBE, State, 10 Operating statement, 54 Operation Connection, 137 Opportunity Funding Corporation, 143 Partnerships, 47, 115; limited, 112 Preemptive rights, 30, 32, 43, 51 Private placement, 150 Profit and loss statement, 69 Profit-sharing plan, 124 Proprietorship, 47 Prospectus, business, 166 Public Works and Economic Development Act of 1965, 139, 141 Purchase, agreement, 59, 62, 115; structuring, 55 Real estate, 40, 177 Redevelopment areas, 138, 140 Registration under SEC Act, 150, 157, 158 "Regulation A" stock offering, 152, 154, 232 Religious organizations, 135, 230 Representations and warranties, 59, 136 Retailer, 81, 83, 86 Sale and leaseback, 183 "Section 501(c)(3)" organizations, 17, 129, 169 "Section 502" LEDCs, 5, 141 Securities Act of 1933, 150, 154 Securities, classes of, 50. See also Stock. Securities Exchange Act of 1934, 150, 154, 155 Securities and Exchange Commission registration, 150, 157, 158 "Seed money," 94, 106, 128 Service Corps of Retired Executives (SCORE), 11 Shareholders, see Stock Shopping centers, 88; checklist for, 224 Site, acquisition of, 89; selection, 66 Small Business Administration (SBA), 5-6, 11, 14, 36, 68, 81, 83, 141, 161, 171, 175, i 84 Small Business Investment Act of 1958, 5, 6, 36 Small Business Investment Company (SBIC), 5, 6-7, 36-45, 141, 175, 209 Social welfare organizations, 23 Special Impact grants (OEO), 138 State Business Development Corporation, 231 State industrial development authorities, 148 State and local government sources of financing, 145, 148, 231 Statement, financial, 52; operating, 54; profit and loss, 69 Stock, 44, 50, 122-123, 150-158, 232; acquisitions, advan- tages and disadvantages of, 55; bonus plan, 123; distribu- tion to employees, 123; intrastate offering, 151, 158, 235; "letter," 151; options, 51, 123, 155; preferred, 50; registra- tion, 150; State regulation of, 156-158 "Subchapter S" corporation, 30, 114 Subcontracts, 1 15 Subordination of debt, 58, 177 Subsidiary, 110, 111 "Survival" clause, 62 Tax abatement, real estate, 106 Tax considerations, 56-57, 114, 121, 128 Tax-exempt, bonds, 145, 147; organizations, 17, 128, 194; status, 17 Tax Reform Act of 1969, 128 Taxes, 22, 48,78, 111, 128-129 Technical assistance, 9, 10, 81, 85, 106, 117, 141, 192 Tenant obligations, 223 Training, 9, 13. 15,66. 192 Transferability of interests, 1 12 Trust, community, 34 258 Truth in Lending Act of 1968, 177 Underwriting agreement, 154 Urban Coalition, 11, 136, 171 Urban Land Institute, 92 Urban League, 171 Urban renewal, 95, 103 Usury, 176 Venture capital, 39 Veterans Administration (VA), loan guarantees, 143 Voting rights, 29 Warranties and representations, 59 Wholesaler, 81, 84 "Workable Program," 98 Zoning, 90 259 ■:■ U. S. GOVERNMENT PRINTING OFFICE : 1971 X31-99V171 PENN STATE UNIVERSITY LIBRARIES mini i mini AD0DQ7Q c m22S5