This program allows small businesses to take advantage of long term, fixed rate loans to refinance their higher interest or maturing real estate debt or existing debt on capital assets. Loans under the 504 Program are funded by the sale of ten-year and twenty-year bonds guaranteed by the SBA. Thus, a borrower is able to obtain attractive 20 year fixed interest rates, as low as 5.04% based on the January pricing.

With a traditional 504 loan, a bank holds the first lien position and their exposure is reduced through the Certified Development Company (CDC) which provides up to 40% (or an amount not greater than the bank) of the project cost and takes a secondary position to the bank loan. The small business borrower must either have at least 10% existing equity in the property or must inject equity of at least 10%. The amount of the bank loan must be at least as much as the 504 loan.

The bank’s first lien position, at a low loan-to-value ratio, makes partnering with a CDC on a 504 refinance loan a wise choice. The bank’s rates can be fixed or floating. The only stipulation is that the first lienholder loan must be for at least 10 years for a commercial real estate loan and at least 7 years for a 10-year equipment or machinery loan. The bank utilizes its own underwriting standards and sets its own terms, interest rates and fees.

While there is no maximum project size, the 504 second mortgage loan is limited to $5 million in most refinance projects just as with the traditional 504 loan. The upper 504 loan limit increases to $5.5 million for eligible manufacturing projects and energy saving technology entities.

The following are some of the primary requirements of the SBA 504 Refinance Loan Program:

• The small business must be for-profit and have a tangible net worth of less than $15 million and an after tax profit of less than $5 million for the previous two years.

• The small business must occupy at least 51% of the property at the time of the refinance application.

• The property must have been acquired at least two years ago with non-SBA commercial debt.

• The project structure must be based on the current appraised value of the collateral.

• Up to 90% of the current appraised property value may be refinanced.

• Existing government-guaranteed loans are not eligible to be refinanced.

• Expansion projects are not eligible to be refinanced (there is an option for refinancing under a modified version of 504).

EXAMPLE OF REFINANCING AN EXISTING NOTE
Current Appraised Value of Property $1,200,000
New Maximum Outstanding Balance of Debt $1,080,000 90% Loan to Value (LTV)

LOAN STRUCTURE:
ENTITY LOAN AMOUNT % OF LOAN SECURITY
■ New Bank First Trust Loan $ 600,000 50% 1st Lien
■ New CDC/SBA 504 Loan $ 480,000 40% 2nd Lien
■ Borrower Contribution (equity in property) $ 120,000 10%

Appraised Value of Property: $1,200,000

Like the traditional 504 Loan Program, the borrower may use its existing equity in the property for its 10% equity injection. The borrower is thus able to retain working capital in the business.

Should there be excess equity in the property, the small business can refinance other existing debt (including SBA Guaranteed Debt) or may use the excess equity (meaning, equity beyond the 10% minimum contribution) to obtain working capital for payment of recent or projected eligible business expenses. These expenses can include items such as rent, utilities, inventory and other business obligations.

Multiple refinancings of the original note ARE eligible. Borrowers must demonstrate that their loan is current and that they have successfully made all required payments under original or modified bank terms for the past twelve months. Such modifications of terms must have been entered into prior to October 12, 2011.

Do you have borrowers who could benefit from the new 504 Refinance Loan Program or instances where this program would benefit the bank? If yes, you can contact CDC New England for more information at 781-928-1100 or find one of our Business Development Officers in your area at www.newengland504.com

It’s important to remember to act fast; the program expires September 27, 2012, unless Congress acts to extend it.

The SBA is giving small business owners access to more funds through refinancing their commercial real estate loans.

The SBA wants to put some extra money in your pockets. To do so they’ve implemented a temporary program to help small businesses refinance commercial loans and restructure their debt. The SBA recently expanded the program and increased eligibility so that more people can take advantage of it before the program ends in September 2012.

The 504 Loan Refinancing Program—implemented under the Small Business Jobs Act of 2010—allows small businesses to refinance not only existing debt but use excess equity to obtain working capital that can be used to finance eligible business expenses, explains Steve Smits, associate administrator for the Office of Capital Access at SBA.

Some such expenses are utilities, insurance, and salaries. Though the SBA site simply states: “Any expense directly related to business operations.” It’s hoped the expansion will alleviate financial stresses while both protecting and creating jobs.

The temporary refinancing program is intended to aid the large number of small businesses that are expected to have their loans mature. Now a third-party lender only needs to match or exceed the amount provided by the SBA, instead of 50 percent of the project. Also borrowers are now able to finance the appraised value of available collateral (including applicable fixed assets) up to 90 percent.

It seems as though this opportunity to refinance comes at a good time. “Right now the commercial market—at least nationally-speaking—is undergoing a stabilization trend,” says George Ratiu, an economist for the National Association of Realtors. The demand for real estate space in the core property types: office, industrial, retail, and the apartment sector has stabilized and is turning positive, a relief since demand has been negative for the past three years.

The problem is that people are just unaware of this help from the SBA program. Several states have yet to take full advantage of the refinancing program. As of early November, 11 states had only one approved loan, 10 had not yet tapped into the program, and the average number of approved loans across the nation was nine.

This may seem surprising, given the SBA’s high expectations for the program, which ends September 27, 2012. According to the SBA, “As many as 8,000 businesses may participate in this program during the current fiscal year, which will provide up to $7.5 billion in SBA-guaranteed financing leading to total project financing of almost $17 billion.” Despite high hopes, as of early November only 365 loans had been approved in 40 states since application acceptance starting Feb. 28.

The low number also raises concerns about the money actually available for the program, as it’s completely funded through additional fees gathered from refinancing activities. It seems that many who could be benefiting from the program aren’t, possibly due to the restrictive nature of prior guidelines. But a look at the market shows no lack of need.

According to Ratiu, properties in the lower evaluation spectrum and inland geographies have been struggling with financing, prices, and capital availability, even through the recovery period. “Financing is still the No. 1 concern for commercial space in these markets,” he says. Businesses in these areas may very well benefit from the SBA program. Since the program was expanded in October, interest has at least increased. Inquiries into the refinancing program (from lenders) has gone from about four to over 45 a day in the processing centers.

Some entrepreneurs aware of the program don’t think it goes far enough to help struggling small businesses. Chris Hurn is one of those small business owners. He’s also the CEO and co-founder of Mercantile Capital Corporation, a commercial real estate lender, giving him a unique perspective on the matter. He thinks the program isn’t an absolute solution, but a step in the right direction—albeit a baby step. “It’s not the silver bullet we’ve all been looking for,” he says, “but it will certainly help a fair amount of small business owners out there to tap that embedded equity and use it for purposes that the business needs right now.”

He also sees ways the program could be improved.

Short of making it a permanent offer, Hurn thinks more businesses would benefit from the temporary program if it were extended until the funds are utilized. “They wrote the regulations so restrictively that it wasn’t until Oct. 12 that the program was actually able to do fully what it needed to do per the law,” he says. He wants the sunset lifted to maximize the opportunity: “Don’t penalize the small business guy. Give him a chance.”

Many (if not most) lenders approach the issue by determining the 20% or more owners of the applicant businesses and then assuming that all other businesses owned by those principals must be affiliated. That is not necessarily the case.
sbaOpen asks the user all the pertinent questions to determine whether or not a business is an affiliate of the business. The software knows what SBA’s criteria is for determining affiliation:

* Power of Control
* Identity of Interest

Power of Control

SBA defines control as at least 50% ownership OR whoever has the largest block of ownership in the business compared to the other owners. Also, control can be given “by agreement” regardless of ownership percentage.
Also, power of control must exist both in the applicant business AND in the other business for affiliation to exist. Consider this example:

* Two owners of the ABC company (applicant): Joe (50%) and Ann (50%)
* Joe also owns 80% of DEF company (and Jack owns the other 20%)
* Ann also owns 20% of XYZ company (and Jill owns the other 80%)

Based on power of control (specific to ownership %), ABC company is affiliated with DEF company, but not with XYZ company.

Identity of Interest

Affiliation can also occur regardless of ownership interest or power of control. If there is an “identity of interest” between the applicant and another business, SBA will consider these businesses as affiliates. SBA considers factors such as ownership, management, previous relationships with or ties to another entity, and contractual relationships when determining whether affiliation exists.

sbaOpen steps the user through this thought process, regardless of how convoluted the ownership is in the applicant and other businesses. A “smart” tool is good to have when moving through the “mine field” of SBA loan structuring and compliance.

Although life insurance is no longer mandatory, Lenders must now determine whether “repayment of the loan is dependent upon an owner’s active participation in the business. In other words, if the owner dies, will the business operations be adversely affected and the loan default?” If so, the lender must require life insurance unless the lender decides that it is unnecessary because of the adequacy of collateral and/or the presence of secondary sources of repayment. Although not mentioned in SOP 50 10 5(D), another factor to consider is whether the owner has a succession plan in place and the details of that plan. If the lender determines that, based on its analysis of the specific facts of the file, they are not going to require life insurance, they must document their file by including their decision in the credit memorandum. And as with any other decision that the SBA might question in a guaranty purchase review, Lenders should provide as much information as possible supporting their determination.

Although this change makes life insurance a credit decision instead of a mandatory SBA requirement, if there is a loss on the loan which the SBA determines is due to the death of the owner, and the lender did not require life insurance, the lender will be responsible for such loss. Therefore, lenders who choose to waive life insurance do so at their own risk.

SOP 50 10 5(D) also sets forth two smaller changes regarding life insurance: (1) Because the lender must ensure that the borrower pays the policy premiums, lenders may now set up an escrow account for the payment of the premiums on the policy. Lenders should follow the escrow requirements for commercial real estate taxes and insurance escrows which are set forth on pages 226-227 of SOP 50 10 5(D); and (2) The SBA has clarified that for SBA Express, Export Express and Patriot Express, lenders may follow their institutions’ internal policies for life insurance on conventional commercial loans of a similar size.

The SBA has always required that borrowers obtain flood insurance under the National Flood Insurance Program (“NFIP”) on real estate and business personal property if any portion of a building that is collateral for the Loan, or any business personal property collateral is located in a building that is in a special flood hazard area. The amount of flood insurance required for real and/or personal property collateral located in a flood zone should be the lesser of the maximum amount of insurance available, or replacement cost. It is important to note that the maximum amount of flood insurance available under NFIP programs is limited to a maximum of $500,000 each, for both building and contents coverage, respectively.

Although these flood insurance requirements have not changed, SOP 50 10 5(D) adds clarification that flood insurance requirements apply equally to condominiums and cooperative units. If a condominium or cooperative unit lies in a flood zone, the condominium association or the cooperative association must obtain flood insurance for the exterior shell of the entire building and the individual unit owner must obtain a separate flood insurance policy for his/her actual unit. What remains unclear is whether the flood policy from the condominium or cooperative association must list the lender as the mortgagee and provide a mortgagee endorsement, or if a certificate showing the coverage is in place is sufficient. Although most condo and co-op associations will not list the mortgagee for a particular unit as a mortgagee on the policy for the entire building, the SOP language is broad enough to make the Agency’s intent on this subject unclear. Until such time as this policy is clarified, the best practice is to ask for this coverage and document your file when the request is denied.

In a move to shore up the financial markets and the economy generally, the Federal Reserve and the rate-setting Federal Open Market Committee recently announced their intention to maintain short-term interest rates at their current low levels for the next two years. In its formal announcement, the Committee stated that it “currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

The Fed added that it would “continue to assess the economic outlook” and was prepared to employ policy tools “as appropriate,” an indication that it would consider further action, if and when it’s needed.

This action by the Fed was unprecedented in terms of its specificity and represents both good and bad news. For consumers and businesses, it provides much greater certainty regarding the availability of low-cost funds as they consider making investments or major purchases, which is clearly good news.

The bad news is, of course, that the Fed took the action in large part due to fears regarding the health of the U.S. economy, noting that “economic growth so far this year has been considerably slower” than expected and that threats to the economy have mounted.

Wall Street was quick to cheer the Fed’s move, but clearly no one can be sure about its ultimate impact. In some cases, it may give businesses a green light of sorts to move ahead with projects that had been on hold. In other cases, it may actually result in people delaying investment decisions, as they wait to see what happens to the economy during the next 12 to 18 months without fear of facing a rising interest rate environment.

Time will tell. As mentioned above, the good news is that, for both consumers and businesses, the interest rate environment is extremely attractive and will remain so for the foreseeable future.

To read more from SalemFive OnBusiness, visit them at www.salemfiveonbusiness.com

Hoping it might be useful to all small-business owners, I asked for specific guidelines that relate to the minimum requirements the bankers look for when considering a loan. I referred to the well known “Five Cs” of credit: character, cash flow, collateral, capital, and conditions. Basically, I asked the bankers to pretend that there were no public relations people or lawyers in the room and just tell us what they really want from us. For example, how do they define good character? Is it O.K. if you’ve been married four times? What if you don’t go to your son’s baseball games?

Somehow, the bankers managed not to answer any of my questions — although they did mention that it was a good idea to clean up your credit report. Gee, thanks! I can’t tell you that I understand the downside of giving owners some real insight into what banks are looking for. Maybe the bankers don’t want to take a chance on scaring anyone away, but it seems to me it could save us all a lot of time. And judging from the comments, I’m not sure they did themselves any favors. Because I think this is important information, I asked my own banker if he could shed some light on how his bank evaluates loans. He is Matt Sloan, from American Chartered Bank, a mid-sized bank that specializes in small-business lending and has locations around Chicago. Here are his thoughts:

Deciding whether to provide credit to a business can definitely be as much art as science, but there are some material factors to consider:
1. How much equity or net worth does the business have on its balance sheet? This is extremely important as we need to know what happens if the company has a rainy day or if our economy goes through another recession. Does the business have enough capital to survive if it loses a major client? On the same note, what is the overall leverage (debt to equity) of the company? Less than four to one? That’s fair. Three to one? That’s good. Two to one? Excellent. If a business makes $100,000 and the owners pull out $200,000 in distributions, then the company actually lost $100,000 from our perspective. (Believe me, we see this happen.)

2. What type of collateral is supporting the loan? I don’t see many banks providing unsecured loans in today’s climate so there have to be enough “eligible” receivables (90 days and under),
“clean” inventory (sellable), equipment and/or recently appraised real estate to cover the loan amount.

3. Cash Flow. The years 2008 and 2009 were rough for many businesses, so if you were able to survive and rebound in 2010, more power to you. We analyze the past three years to understand trends, but we completely understand how difficult the economy has been. So, if a company has turned the corner and can show that its cash flow can support its debt payments at a multiple of 1.2 or 1.3 (meaning that it is taking in at least 20 percent more than the debt payment), the it is a good banking candidate.

4. Character. Do I want a new client who doesn’t return phone calls and doesn’t treat me or my team with respect? No. I want to work with solid, ethical people who are looking to build long lasting relationships. End of story. It’s better for both sides.

5. Conditions are a tricky topic because a good company can perform well in a bad economy (and vice versa). So, let’s leave that one alone.

I hope this clears up some of the confusion surrounding the crazy banking environment we live in.
Thank you, Matt. I will add one more thing. I found American Chartered Bank through my accountant. He knows which banks are lending, what they are like to work with and what they are looking for. And he has a relationship with the banks that the banks don’t want to mess up. If your accountant can’t help you, and you need to borrow money, it might be time to consider finding a new accountant. If you are looking to borrow money, you probably need an accountant who does more than your tax return.

As part of the underwriting process for most SBA loans, lenders are required to obtain appraisals on real estate, equipment and/or a business as a going concern. It is imperative that lenders comply with the appraisal requirements described in the SOP and critically evaluate the results. Otherwise, the SBA loan guaranty will be jeopardized, either at the time of guaranty purchase or when the Office of the Inspector General conducts a post purchase review, which review can occur up to six (6) years after the SBA purchase date.

The SOP requires an appraisal of commercial real estate if the value of such property is greater than $250,000. In the event the commercial real estate is estimated to be $250,000 or less, an appraisal may be required if further evaluation of the collateral is required in order to make an informed credit decision or if a lender’s regulatory requirements otherwise require an appraisal.

In all instances, the appraisal must be requested by and prepared for the lender and the appraisal should be addressed to both the lender and the SBA. A recent existing appraisal may be updated and extended to the lender and the SBA; however, if an appraiser is unwilling to update or extend the appraisal in this manner then the lender is required to obtain either a new appraisal or a review of the existing appraisal by a different appraiser.

The appraiser must be independent and without conflict of interest and either State-licensed or State-certified, (if the estimated value of the commercial real estate is in excess of $1,000,000, the appraiser is required to be State-certified.) The appraisal itself should be in compliance with Uniform Standards of Professional Appraisal Practice and be delivered in either a self-contained or summary appraisal format.

If the loan proceeds will be used to finance new construction or substantially renovate (renovations are greater than 1/3 of the purchase price or fair market value of the real estate) an existing building, the appraisal must estimate the market value of the commercial real estate upon completion of construction, as set forth in the plans and specifications. Upon completion of construction, the appraiser must submit a statement to the lender that the building was built with only minor (if any) deviation from the plans and specifications that formed the basis of the market value appraisal. If the appraiser will not issue this statement, then the loan can not be closed without the prior written permission of the SBA.

If the loan proceeds are to fund the purchase of an existing building not requiring renovation or other construction, the appraiser should estimate the market value of the commercial real estate on an “as is” basis or, if the appraiser utilizes another basis for valuation, then the narrative must explain the rationale for such alternate valuation.

In September 2008, the Office of Inspector General issued a report based upon an audit of six (6) SBA guaranteed loans of a PLP lender where the Inspector General recommended full denial of the guaranty due to “Inadequate Appraisal”. In this instance, the loan authorization required a real estate appraisal showing a fair market value of at least $1,650,000 and the lender’s files contained an “as-is” market value appraisal of $1,750,000. Approximately $265,000 of the “as-is” value was attributable to the going concern value of the real property which therefore reduced the amount allocated to the real estate to $1,485,000. In addition to this deficiency, the real estate sold for $925,000 approximately two years after the date of the appraisal which provided further support for the Inspector General’s assertion that the appraisal was significantly overstated. See U.S. Small Business Administration, Office of Inspector General, Audit of Six SBA Guaranteed Loans, Report Number: 8-18, issued September 8, 2008, at pages 9-10.

For a business acquisition, and so long as it is not contrary to a lender’s policies and procedures, a lender may perform its own valuation of the business being sold if the amount of the loan (including any 7(a), 504, seller, or other financing) less the appraised value of the real estate and/or equipment being financed, is less than or equal to $250,000. In the event the amount of the loan (including any 7(a), 504, seller, or other financing) less the appraised value of real estate and/or equipment being financed, is greater than $250,000 or it is not an arm’s length transaction (i.e. the buyer and seller are related or are current business partners), then the lender must obtain an independent business valuation. In this instance, the appraiser must allocate separate values to the various components of the transaction including land, building, equipment and business (including goodwill and other intangible assets).

Recently, the Office of Inspector General reviewed four early-defaulted loans and found an improper payment of $37,696 by the SBA due to inadequate business valuations. The Office of Inspector General determined that the borrower paid more for the business than it was worth and reiterated that “determining the value of a business is a key component to the analysis of any loan application for a change in ownership.” In this case, the lender obtained a combined real estate appraisal and business valuation that valued the land at $775,000 and the business at $160,000. As the total project cost was $1,032,000 there was an obvious deficiency of $97,000. The loan officer ignored the independent appraisal and claimed that the appraiser was too conservative in its approach and therefore relied upon its in-house valuation. Interestingly, two days after approval of this loan, an executive vice president of the lender accepted the independent appraisal and specifically acknowledged that the in-house valuation was overstated, providing further support for the Office of Inspector General’s conclusion that there was an inadequate business valuation. See U.S. Small Business Administration, Office of Inspector General, Material Deficiencies Identified in Four 7(A) Recovery Act Loans Resulted in $3.2 Million of Questioned Costs, Report Number: ROM 11-05, issued June 29, 2011, at
page 6.

As the above examples illustrate, SBA lenders must carefully analyze appraisals in order to assure that the results conform to the Loan Authorization and the SBA’s rules and regulations.

RESUL TS IN BRIEF

Banco Popular did not adequately assess repayment ability for 12 SBA-guaranteed HLC franchise loans when approving the loans. Specifically, the lender accepted umealistic projected annual revenue figures that ranged from $483,000 to $650,025 as a basis for demonstrating the ability of the HLC franchises to repay their debts. The lender disregarded relevant and available data, which indicated that the franchises’ revenue projections were umeasonable. This was due, at least in part, to the lender’s perception that franchise loans required a lesser degree of due diligence because of the established business model of franchise systems.  Had the lender complied with SBA’s requirements to use and assess the feasibility of realistic projections, the 12 loans should have been declined. As of December 2010, there were 10 loans, with an aggregated outstanding SBA balance of $2.1 million, which had been transferred to liquidation.

We also noted that SBA’s loan database did not accurately track franchise loans guaranteed by the Agency. We tested 7 franchise brands among those with the highest guaranty purchase rates and number of franchise loans made as of March 2010, and determined that the number of loans for these franchises was inaccurately reported by an average of 17 percent. Program officials acknowledged the limitations of the existing database and attributed the discrepancies to lenders not entering the codes for franchise loans during the loan application process. The incomplete nature of franchise loan data negatively affected the Agency’s ability to assess whether franchise loans presented a higher than average risk of financial loss and identify potential risks within certain franchise brands. This data reliability issue could also negatively impact decisions made by lenders for loan approval and prospective borrowers that are considering franchise opportunities, as well as the ability of franchisors to attract new investors.

We recommend that the Agency: (1) seek recovery of the loan guaranties, less any recoveries, paid in connection with the 10 defaulted loans; (2) flag all Banco Popular HLC loans in SBA’s Loan Accounting System to ensure the identified underwriting deficiencies are considered in the event of future default; and (3) implement a plan to ensure the completeness and accuracy of data pertaining to existing franchise loans and those made in the future.

SBA agreed to (1) review the 10 defaulted loans and seek recovery as appropriate, and (2) flag all HLC franchise loans originated by Banco Popular so they will receive heightened scrutiny if they are submitted for purchase. With regard to implementing a plan to ensure the completeness and accuracy of franchise data, the Agency stated it would issue an Information Notice reminding lenders of the need to provide accurate data, and would incorporate our findings into its quality control procedures. SBA, however, did not address a plan to improve the quality of franchise loan data and therefore its response was not sufficient to fully address our last recommendation.

BACKGROUND

Section 7(a) of the Small Business Act authorizes SBA to guarantee loans made by lenders to small businesses. Existing SBA regulations require lenders to comply with Agency loan program requirements. 13 CFR 120.10 defines loan program requirements as those imposed upon lenders by statute, SBA regulations, any agreement the lender has executed with SBA, SBA’s Standard Operating Procedures (SOP), official SBA notices and forms applicable to 7(a) and 504 programs, and loan authorizations. Many of the small businesses that receive SBA loans are franchise-based companies which include various industry types (e.g., fast food restaurants, automotive shops, and health and fitness centers). These companies are independently operated by franchisees that have been granted the right to distribute the products or use the trademarks of franchisors in exchange for franchisor fees.

The Agency’s Office of Capital Access (OCA) is responsible for delivering SBA’s loan programs and monitoring the performance of lenders. Within OCA, the Office of Financial Assistance (OF A) is responsible for loan processing, servicing and liquidation functions, and for providing the policies and procedures that lenders use to accomplish these tasks.

The Agency’s Loan Accounting System captures data on all of its guaranteed loans including franchise loan activity. The Agency’s franchise loan statistics are made available to the lending community and ultimately to the general public. Consequently, this data may impact decisions made by lenders and prospective owners regarding franchise investments.

In FY 2007, there were 12 lenders that originated 25 SBA-guaranteed loans for the acquisition of HLC franchises using PLP procedures. Banco Popular approved 12 of those loans, 10 of which had been transferred to liquidation as of December 2010. The Agency paid $2.1 million to honor its guaranties on the 10 defaulted loans.

RESUL TS

Banco Popular Used Unrealistic Revenue Projections in Assessing Borrower Repayment Ability. Banco Popular did not adequately assess whether 12 HLC franchise borrowers had the ability to repay loans totaling $3.8 million.5 All 12 loans had umealistic revenue projections. As a result, most of the HLC borrowers defaulted on their loans and SBA paid $2.1 million when it purchased its guaranties. With one exception, these loans were made to fund newly formed franchises. The one remaining loan was for the purchase of an existing HLC franchise.

In accordance with 13 CFR 120.150, applicants must be creditworthy and loans must be so sound as to reasonably assure repayment considering past earnings, projected cash flow, future prospects, the ability to repay the loan with earnings from the business, and the effects of any affiliates. Guidance in effect at the time of the loans in question, SBA’s SOP 50 10 4, required lenders to use realistic projections of future earnings when historical financial information did not demonstrate borrower repayment ability. The SOP further required lenders to test the feasibility of projections against industry averages and historical information with an explanation for significant deviations.

In FY 2007, a total of 12 HLC franchises received SBA guaranteed loans from Banco Popular for the acquisition of their businesses. The loans ranged in amounts from $196,500 to $379,900. Banco Popular approved these loans based on first- year projections that showed that the franchises would generate revenues ranging from $483,000 to $650,025. This level of performance is questionable given that the HLCs, Inc. Franchise Offering Circular, which was effective April 1, 2006, and reviewed by the lender, showed that the average revenue of franchises in operation for one or more years was $468,442 in 2005. Nevertheless, the lender expected the newly formed franchises to not only meet this average, but to exceed it, with generally no explanation for how the businesses would achieve this level of performance.

Additionally, the lender did not adequately consider other factors impacting the franchises’ first year of performance. For example, one prospective borrower had nine other tutoring services within a 10-mile radius of the proposed center and yet the lender still expected the center to exceed the earnings of more established HLC franchises.

Through interviews and the review of loan files, we further validated the umealistic nature of the first-year revenue projections. These sources provided first-year revenue figures ranging from [FOIA Ex. 4] For example, we noted that one of the applicants was a change of ownership in an existing franchise that averaged revenues of [FOIA Ex. 4] for 2005 and 2006. In addition, we reviewed literature published by the Franchisor that showed that the actual average first-year revenue for HLC franchises in 2007 was [FOIA Ex. 4]. The projected revenues of the 12 HLCs approved by Banco Popular exceeded this average by as much as[FOIA Ex. 4] percent. We further substantiated the umealistic nature of the projections when we interviewed a former operations manager for the HLC Franchisor who told us that the targeted level of performance for new HLC franchises in FY 2007 was [FOIA Ex. 4] in the first year. See Appendix I for a list of the 12 HLC borrowers with their projected first-year revenues and the percentage by which their projections exceeded the actual average revenue for start-up HLC franchises.

Furthermore, the 12 HLCs’ projected expenses were generally significantly higher than the more realistic first-year revenue figures that we identified. These expenses ranged from $415,585 to $563,032, with fixed expenses averaging more than $400,000.10 This means that if the lender had used more realistic first-year revenue projections, it should have projected that the franchises would operate at a loss and be unable to repay their SBA guaranteed debts from business cash flow.

We spoke with a vice president at Banco Popular who stated that the only data obtained from the Franchisor was the UFOC11 - and as such - the lender was limited to the data reported in that document. According to the vice president, franchise loans require a lesser degree of due diligence because of the established business model of franchise systems. The vice president further stated that the upfront training and marketing assistance in franchise businesses increases the likelihood that businesses will achieve their projections. Banco Popular ultimately relied on the borrowers’ own statements that their revenue projections had been vetted against the operations of other HLC franchises. Moreover, the lender’s internal policy did not require that the revenue projections be supported by calculations or compared to the revenues of similar businesses. The vice president believed the latter was the responsibility of the borrowers.

If Banco Popular had complied with SBA’s requirements and used revenue projections that were realistic, the 12 HLC franchise loans should have been declined due to lack of repayment ability. Of the 12 loans approved, 10 loans with an aggregated outstanding SBA balance of $2.1 million had been transferred to liquidation as of December 2010. Four of the 10 loans defaulted within 18 months of disbursement, and as such, are considered early defaults by SBA’s definition. 12 The two remaining loans13 were current as ofMay 2011.

During the time that the 12 loans were approved, the lender’s loans to start-up companies were only made under the SBA program. Since that time, the lender discontinued the practice of making loans to any start-up franchises with or without an SBA guaranty.

OTHER MATTER – Incomplete Data Impairs SBA’s Ability to Monitor Franchise Loans

In our efforts to test the completeness and accuracy of SBA’s HLC franchise data, we queried the name Huntington in the FY 2006 through FY 2009 data that we obtained from the Agency’s loan database. As a result of our analysis, we concluded that the HLC loan universe was understated by 16 loans, or 17 percent. We expanded our scope to include six additional franchise brands among those with the highest purchase rates and number of loans made as of March 2010. We determined that the number of franchises for these brands was similarly underreported, as shown in Table 1.

SBA releases its franchise loan data to an industry organization that publishes reports on SBA’s annual franchise performance. This information is made available to the lending community and the general public. For example, CNN Money cited SBA’s 10 most popular franchises by loan volume and identified a number of the best and worst performing franchises based on the Agency’s franchise data. The Agency provides a disclaimer statement about the accuracy of its franchise data when it shares the data with external parties.

(ADD LINK)

FRANdata is a franchise information and research company that maintains SBA’s franchise registry. In a January 2007 report, Study on SEA Loan Performance in Franchising, FRANdata disclosed the incompleteness of the Agency’s franchise data. Our audit work shows that the issue of under-reported franchise loan data highlighted in FRANdata’s report remains an issue.

In October 2001, the Office of Management and Budget issued guidelines requiring agencies to adopt a basic standard of quality (including objectivity, utility, and integrity) as a performance goal and to take appropriate steps to incorporate information quality criteria into their information dissemination practices.14 Furthermore, SBA’s Strategic Plan for FYs 2011-2016 contains the objective of promoting the availability, analysis, and dissemination of the most current, accurate, and detailed statistics possible on small business.

Incomplete franchise loan data impairs SBA’s ability to assess the risks of franchise loans as compared to non-franchise loans. It also affects the Agency’s ability to identify and take actions regarding individual franchise brands that pose a risk to the Agency. Further, inaccurate statistics could negatively affect decisions made by lenders for loan approval and prospective borrowers that are considering franchise opportunities, as well as the ability of franchisors to attract new investors. SBA management acknowledged the limitations of the existing database and attributed the errors to lenders who did not input the codes for franchise loans during the loan application process. The Agency, however, had not taken action to address this issue at the time of this report.

CONCLUSION

Banco Popular did not adequately assess borrower repayment ability when originating HLC franchise loans, and SBA paid $2.1 million when it purchased its guaranties on 10 of these loans. Furthermore SBA’s franchise loan data is incomplete and impairs SBA’s ability to monitor franchise loans. This data reliability issue could also negatively impact decisions made by lenders for loan approval and prospective borrowers that are considering franchise opportunities, as well as the ability of franchisors to attract new investors.

RECOMMENDA TIONS

We recommend that the Associate Administrator, Office of Capital Access:

1. Seek recovery of the loan guaranties, less any recoveries, paid in connection with the 10 defaulted loans and their associated lines of credit.

2. Flag all Banco Popular HLC franchise loans in SBA’s Loan Accounting System, along with any associated lines of credit, to ensure the identified underwriting deficiencies are considered in the event of future default.

3. Improve the quality of franchise loan data by implementing a plan to ensure the completeness and accuracy of data pertaining to new franchise loans made in the future and correct existing incomplete loan records.

AGENCY COMMENTS AND OFFICE OF INSPECTOR GENERAL RESPONSE

On April 6, 2011, we provided a draft of this report to SBA for comment. On May 26,2011, SBA provided written comments, which are summarized below and contained in their entirety in Appendix II. It is not clear from SBA’s response whether it agreed or disagreed with recommendations 1 and 3, but it did agree with recommendation 2.

Recommendation 1

SBA stated that the National Guaranty Purchase Center (NGPC) will review the 10 defaulted loans by July 25,2011 and will seek recovery of all purchase amounts disbursed if recovery is appropriate under the facts of each case and consistent with SBA loan program requirements. If the NGPC concludes that recovery is not warranted, the cases will be referred to the Office of Risk Management for resolution. These proposed actions are responsive to the recommendation. However, we also recognize that SBA typically only reviews early-defaulted loans for weaknesses in a lender’s repayment ability analysis. Given the systemic issue noted in this report and the clear violation of SBA’s policies and procedures by Banco Popular in originating HLC franchise loans, we believe all 10 defaulted loans should be reviewed with the same heightened scrutiny and the lender’s inadequate repayment ability analysis should be considered material to the default of these loans.

Recommendation 2

SBA stated it would flag all HLC franchise loans originated by Banco Popular so they will receive heightened scrutiny if they are submitted for purchase. This proposed action is responsive to our recommendation.

Recommendation 3

SBA stated it will issue an Information Notice reminding lenders of the need to provide accurate data to SBA and will specifically mention the necessity of indicating whether a loan is being made to a franchisee. Additionally, SBA stated that our audit findings will be incorporated into the Quality Control procedures at the centers.

SBA’s comments were only partially responsive to our recommendation. Specifically, the response did not address a plan to improve the quality of franchise loan data. Furthermore, issuing an Information Notice will only help to obtain more complete and accurate data for new franchise loans and will not correct the problem for existing loans. Consequently, SBA’s proposed actions are not sufficient to fully address our recommendation and we will work with management to resolve this issue during the audit follow-up process.

“The OIG remains very concerned about fraud by loan agents, including brokers and packagers, in the 7(a) program,” says Harris. “While most brokers are honest businesses, we’re concerned about the few – but nonetheless impactful – incidence of agent/broker and borrower fraud. Over the past decade alone, the OIG has conducted criminal investigations in cases cumulatively totaling almost $300 million in loans involving fraud by loan agents.

“Our focus is on detecting agent and borrower fraud, and referring wrongdoers to the DOJ for prosecution and conviction and/or to the SBA for administrative corrective action at the regulatory level. Lenders and the government are their victims. SBA lenders can be our first line of defense.”

As an SBA lender, what are you required to do?

SBA regulation 13.§ C.F.R. 120.197 <http://r20.rs6.net/tn.jsp?llr=ppkh9odab&et=1106664479541&s=665&e=001f-KowmCQcKRXRy_2QdHvqoHSjg_MLToN1Q7xwgHmp9mht1p3DTVjH3wNiTQq0gCB0bqtmP1n-x3QfqQvm6R6tD7ANRf7uT4Dp6VoDGXytq6fpbdB9Z3zFfLp-Y5h3cdthaJl-SOEel0Npb_7JBm6kUrnwBioRTWOmPdfLuEDqNcsIdf_j4wHjzMxSRVam9rWCJH8xJVN25i6hpXb-u6jtVCqr5SQFXz12PTtUhVnW3DpPYwnqg8efJX-KjAccRmcckrLXd_iwfJ_H_mwKjTccxhoP_vHz4E9fTS9TOZQTER2F4nf4-Sq1sWNNlbxM3Kf7fqxFOAcFrseEP66_XVJBw==>  requires all lenders, CDCs, borrowers and others to notify the OIG of any information indicating that fraud may have occurred in connection with a 7(a) or 504 loan. This would include reporting possible fraud by loan agents.

New procedures issued in October 2010 make it clear that the SBA is serious about cracking down on loan agent misconduct. These new provisions in the Lender Enforcement SOP 50.53 <http://r20.rs6.net/tn.jsp?llr=ppkh9odab&et=1106664479541&s=665&e=001f-KowmCQcKQnpn53OlTl5MgaXfBxfH_xyy7cIbYWWKjM7pHKI89EQ3xz3rqq85vuENwhKHjB7yzV1uCc9WVcb4p6bJPV963MDxvGkqFH9A-4r8qwyxUBgzEb467j8J6NikZnHETyRHLPhdI48RsCciDZIhN61fNJqbllx8nVe_o=>  contain procedures for the director of the Office of Credit Risk Management to “… exercise authority under 13 C.F.R. Part 103 <http://r20.rs6.net/tn.jsp?llr=ppkh9odab&et=1106664479541&s=665&e=001f-KowmCQcKTJ914gLImv4jliE-5xBYDvmtxbjHcpxEg5d1IRo-3d9TwbZCdWqbGFmMolkyxW6QtxmrOunXJWcIOeYBJ9AVpCdtw5PGWfUe2aAtJbr98PiWf3FmYx4IBWKwXE-UqU0_j5oMZRAnrwZsHfv4Q2oKzTatK0mJlixO1no0edUxtiyLbeazpXd4Aqt2_MV03DPETjSjx3SvywiMKkTrGXS4iImUIyHmkVfhcPZHT4Jj3OgbcA1lncodQO4I0vtTDWcRKDlLuRxnGeeXJlwwMxQekZ93js_-o2O-M=>  to suspend or revoke an agent’s privilege of any agent to conduct business with the SBA … for unlawful or unethical activity.”

It has been a longstanding SBA policy that lenders must complete a 159 7(a) Form for every agent/broker involved in their 7(a) loans. This form requires full disclosure of all fees paid the agent/broker (by the borrower or the lender) and certification by the lender that all parties know the fee amount, that the fees are reasonable, and the information provided is accurate.

The SBA recently issued SBA Procedural Notice 500-1177 <http://r20.rs6.net/tn.jsp?llr=ppkh9odab&et=1106664479541&s=665&e=001f-KowmCQcKRBN_ZtZi0m-U12XOz-OLFUNWtnv31Iu2YOlM3zH0lj88s27E6MdwJwViKWQzIQYkRoeEEnW0wx8r0FJMOQo_4Ldyi70cDSoEWOOSAoTOoxUhSus4c7jz19EOjZsxN4hXTf-g7VWqvHHnwidF7JaZVCZhF6qeKh7TY=>  requiring that all lenders submit 159 Forms to Colson, the SBA’s Fiscal Transfer agent, and Information Notice 5000-1200 <http://r20.rs6.net/tn.jsp?llr=ppkh9odab&et=1106664479541&s=665&e=001f-KowmCQcKTAuomklgdZgmZVtLpG9Ssesa8wHzEu_nNr3WJZNWa344R-I3lrQg7AQlSNR_AO6ShzjYHvsbQcY8Xvj3vshR7cbGcImx9uKXYGQ-ILSrW8ZyLCZweqzi11V0S3is982VR8nA9i1FS7Wx2gAQGhzjGhY-HtYQi2zk4=>  which helps explain these new requirements.

The OIG has taken additional steps, encouraging the SBA to step up its tracking and enforcement.

The OIG’s Report No. 11-01 <http://r20.rs6.net/tn.jsp?llr=ppkh9odab&et=1106664479541&s=665&e=001f-KowmCQcKQKC-eNQw0lQuWejQd9C3gmKo_Z5UhKEinb-hDr5wc1WmSWpp6Z_6fraeJkq1Djyrf9gf9jOHeTFKOEzQ0l8UYL7fNqawyGo6ZeNyTFAwpXvMulthZnanSi7RiSJ_HqecOyys7sc-GWSyJff1UuOse5GR5EiOWRuKE_9WcesFx13Q==>  issued in October 2010 details “… the Most Serious Management and Performance Challenges Facing the Small Business Administration.” The Report’s Challenge 7 focuses on the need for more effective tracking and enforcement by the SBA to reduce financial losses from loan agent fraud. Challenge 7 notes that the SBA has made progress, yet states clearly that more proactive action is needed: “… However the Agency also needs to establish a more effective enforcement program to deter fraudulent loan agent activity.”

“At the OIG, we want to work with lenders in detecting and reporting suspected improper conduct and criminal fraud – and further – to encourage the SBA to have an even greater enforcement focus,” says Harris.

The change requiring submission of the 159 Form requiring full disclosure is an important first step. How else can you help stem the tide?

Thoroughly vetting all potential brokers will help cut off fraud before it begins. Ongoing portfolio management, rigorous documentation, and regulatory compliance to regulations will protect your SBA portfolio – and your PLP status. At the same time, be on the look-out for fraud! The regulation requires SBA lenders, borrowers and other parties to notify the SBA OIG of any information indicating fraud in connection with a 7(a) or 504 loan. Reports can be made anonymously, and confidentiality can be requested, yet Harris noted that knowing the source of the report will greatly assist the OIG’s investigation.

Here are ways you can report suspected fraud and/or criminal wrongdoing:
*       Go to www.sba.gov <http://r20.rs6.net/tn.jsp?llr=ppkh9odab&et=1106664479541&s=665&e=001f-KowmCQcKSZc00LipSpspQPBP7QpMEQY8eVjSbi9dM7rRvvOJxXPiiARdz8jmDQw2su0-yW4ChWp5NfIxLy8vXFPZBtFYx0RgDd2QTCmts=>  and click on “Report Waste, Fraud, and Abuse,” which will take you to the online OIG complaint submission form.
*       Email the OIGHotline@sba.gov
*       Call the OIG Hotline, 1.800.767.0385