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August 3, 2016

Best Practices: A Suggestion to Reduce Lender Responsibility for Borrower or Loan Agent Fraud

by Norman E. Greenspan

We have written in the past about the SBA Office of Inspector General’s activities in addressing fraud, waste and abuse in the SBA and the SBA’s loan programs. One of the criticisms of the SBA loan program is that because the lenders rely on the SBA loan guaranty for repayment upon default, lenders at times are not as vigilant as they should be in making the loans in the first place. Because no one makes money unless a loan is made, there is incentive for the lenders, and their SBA loan team, to push loans forward and relax the rules. This is short-sighted, dangerous, and potentially far more expensive than not having made the loan in the first place.

Presently, the unpaid principal balance of SBA guaranteed loans is $120 Billion, and growing. This potential liability is significant, not just to the SBA, but also to the SBA lending community. The SBA does not provide statistics regarding the loan purchase applications that it receives that are withdrawn by the lender at the SBA’s suggestion, for whatever reason. So, we do not know the extent to which lenders have assumed the liability for loans obtained by fraud, despite the guaranty. What we do know is that the SBA is putting more of an onus on the lenders to detect fraud in the loan process. The SBA published SBA Information Notice, 9000-1793, that describes the most common types of fraud identified in SBA loan fraud investigations, and the internal controls that a lender should consider putting in place to detect and/or minimize the likelihood of fraudulent activity. If you follow the SBA’s practice in evaluating loan purchase applications, it is clear that the SBA is not going to purchase a loan that never should have been made, for whatever reason, where the lender should have known something was wrong, or could have taken steps to detect the fraud but did not. What can a lender do to reduce the risk of being on the hook for a loan that the SBA will not purchase when the lender is the innocent dupe of an unscrupulous borrower or loan agent?

For years, the SBA OIG has published a hotline on its website seeking information about fraud and abuse, promising protection from retaliation for the caller – the “whistleblower.” However, the statutory protection from retaliation relied on by the SBA is limited to government employees, or employees of contractors of the federal government. How about employees of the lenders who the SBA is holding responsible for consummating loans where fraud is suspected?

The Federal False Claims Act (“FCA”) provides whistleblower protection, but only for those who report possible false claims to persons outside the lender for the purpose of making a claim under the FCA. The FCA includes a provision which protects whistleblowers from retaliation from their employers “. . . because of lawful acts done by the employee . . . in furtherance of an action.” 31 U.S.C. ยง3730(h). What about the employee who just wants to do the right thing despite being encouraged to look the other way by co-workers?

For the most part, protection of an employee of a private company from whistleblower retaliation is based on the law of the state where the employee is located. In most states, employees of private companies are “at-will” employees, allowing the employee to be terminated for any reason or no reason. Many “at-will” employment states bar employer retaliation for certain conduct as a matter of public policy. However, few states have included whistleblower protection in the conduct protected by public policy.

Even though there may be no law protecting employees of private companies who blow the whistle on their colleagues, some companies have made it policy to encourage internal whistleblowing. This is usually accomplished by a set of internal written guidelines that become part of the employees’ handbook that all employees are bound by, no matter where on the organization chart. A procedure is established for the submission of anonymous complaints of wrongdoing. Colorable complaints of the failure to adhere to best lending practices, or the SBA’s SOPs, get investigated by an outside, independent person. Any internal problems that are identified are rectified, and may be disclosed to the authorities if appropriate.

A responsible lender wants to do whatever it can to avoid liability for a non-performing loan. However, it is difficult to account for the occasional rogue employee or misdirected loan agent. At the same time, the SBA should want to encourage its lenders to employ a meaningful internal whistleblower program. It is therefore suggested that SBA lenders who implement and enforce an appropriate internal whistleblower program receive the benefit of the doubt when the SBA considers whether that lender “should have known” about a borrower’s or loan agent’s fraud when evaluating the lender’s application to the SBA to purchase the guaranty on a defaulted loan.

As a result, there should be fewer bad loans, and a lesser risk of the SBA and the SBA lending industry for the $120 Billion (and growing) unpaid balance of SBA guaranteed loans. For information on identifying and preventing fraud in your SBA lending program contact Norman at 215.390.1025 or at NGreenspan@starfieldsmith.com.