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July 6, 2016

SBA’s Final Rule: Changes to Affiliation Regulations

by Jessica L. Conn

On June 27, 2016, SBA issued a Final Rule on regulations related to affiliation analysis. This rule will be effective as of July 27, 2016.

As was true for the prior rule, the final rule frames affiliation in terms of control. It provides that “concerns and entities are affiliates of each other when one controls or has the power to control the other, or a third party or parties controls or has the power to control both. It does not matter whether control is exercised, so long as the power to control exists.” In determining whether control exists, lender must look at ownership, options and changes of legal structure, management, identity of interest and licensing agreements.

When analyzing ownership, under the new rule, SBA has clarified that control via equity ownership exists when one party has the power to control more than 50 percent of voting equity. This type of control can exist by actually owning more than 50% of the equity or when a minority shareholder has the ability under the corporate documents to “prevent a quorum or otherwise block an action of the board of directors or shareholders.” If no one party is found to control, SBA will deem the board of directors, president and/or CEO to control. Therefore, when lenders are analyzing a small business applicant for affiliation, they should be looking not only at ownership percentages, but also at whether (i) any documentation exists that permits a minority shareholder to prevent a quorum as described above or (ii) the absence of a majority shareholder would result in either the board of directors or an officer to be deemed to control the entity in question.

Another factor to consider for affiliation through common ownership is whether there are any stock options, convertible securities or agreements to merge that would impact control. In these cases, lenders must consider such options to be exercised when performing an affiliation analysis. If an agreement is simply to negotiate towards a possible merger, SBA will not deem the agreement to impact the affiliation analysis. Similarly, SBA will not consider options or agreements that “are subject to conditions precedent which are incapable of fulfillment, speculative, conjectural, or unenforceable under state or Federal law, or where the probability of the transaction (or exercise of the rights) occurring is shown to be extremely remote.”

Affiliation based on management exists when a CEO, president or other manger also controls the management of another entity. It can also exist when an individual or other entity controls or manages one or more entities, including when management exists through a management agreement. Control through management agreements has not been expressly addressed in previous SBA regulations, so lenders will need watch for further guidance from SBA on the specific criteria that will factor into a determination of affiliation based on a management agreement. That being said, for the time being, lenders should certainly be inquiring into whether the small business applicant is managed pursuant to a management agreement. To the extent that the manager under the management agreement also controls other entities, lenders should consider performing an affiliation analysis of the potential affiliates, or submitting the loan for general processing.

Under the new rule, SBA has clarified that affiliation by identity of interests exists when close relatives have “identical or substantially, identical business or economic interests (such as where the close relatives operate concerns in the same or similar industry in the same geographic area).” This type of affiliation can be rebutted with evidence that the businesses are, in fact, separate. Therefore, lenders should inquire about family members that operate in the same industry to determine whether any such business must be considered in the affiliation analysis.

With respect to the affiliation analysis of a franchise or licensing agreement, SBA has made two significant changes. The first is that the presence of a license agreement will not be deemed to create affiliation as long as the small business applicant “has the right to profit from its efforts and bears the risk of loss commensurate with ownership.” The second major change is that lenders must now only consider the franchise agreement of the small business applicant (and not franchise agreements of the small business’s affiliates) in its franchise affiliation analysis. Both of these changes will streamline the affiliation analysis process and allow better access to financing to small business franchisees.

Again, these and the other minor changes made by the Final Rule will be effective as of July 27, 2016, so lenders must be sure to be requesting the appropriate documentation to perform an accurate and thorough affiliation analysis. For more information regarding the Final Rule, please contact Jessica at 267-470-1188 or at jconn@starfieldsmith.com.