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August 24, 2011

Firm News for August 2011: Best Practices: Educating Third Party Lenders

By: Jessica L. Conn, Esq.

Entering into the world of 504 lending can be somewhat daunting for a lender since SBA has so many rules and regulations that apply to the third party lender’s portion of the transaction. That being said, the 504 program can expand a lender’s credit box to borrowers or projects that the lender could not or would not finance conventionally, while leaving the lender with a first position lien and a 50% loan to value ratio.

For starters, the third party lender should make sure that the terms of the third party loan are in compliance with the SBA regulations. The third party loan cannot mature earlier than 10 years from the closing of the 504 loan for a project that finances commercial real estate. For equipment loans, the third party loan cannot mature earlier than 7 years from the closing of the 504 loan. SBA also sets a maximum interest rate that the third party lender can charge. The maximum rates are changed by SBA from time to time, but currently the maximum rate is the lesser of: (i) the maximum rate that can be charged by state law in the state in which the transaction is occurring, or (ii) Wall Street Journal Prime plus six percent (6.00%). The third party lender also must fully advance the third party loan at or prior to the 504 closing. Once the 504 loan is closed, the third party lender may not make any future advances on its loan.

There are certain SBA regulations that require lenders to document and/or disburse their loans in a slightly different manner than if the loan were true conventional financing. For example, the third party loan must not be cross-defaulted or cross-collateralized with any other loans made by the third party lender. The SOP states that the loan documents evidencing the third party loan must not contain any provisions “which allow the third party lender to make demand prior to maturity unless the loan is in default.” Also, the third party lender must certify that the entire loan has been advanced prior to the closing of the 504 loan. Third party lenders may be tempted to disburse loan proceeds into an escrow account in order to make this certification, however, in the eyes of the SBA, the loan has not yet been fully disbursed since the proceeds have not been delivered to their intended beneficiary. This issue arises most frequently in the context of construction financing. For a variety of reasons, a state or local municipality may require that a borrower performing major construction post a letter of credit to ensure completion of certain elements of the project. In some cases, it is possible for a borrower to complete construction and obtain a permanent certificate of occupancy prior to the letter of credit being released. If the letter of credit is secured by either the third party loan documents or the interim loan documents, the 504 closing would be delayed until the letter of credit is released. This problem can be avoided by securing the letter of credit with a separate facility that is subordinate to the 504 lien on the project property.

The third party lender must also be sure to abide by those regulations designed to protect the SBA’s subordinate interest in the project property. For example, the third party lender must provide the CDC with written notice of a default within 30 days of the default and at least 60 days prior to foreclosure. Additionally, the portion of the third party lender’s lien that relates to late fees, default charges, default interest or penalties must be subordinate to the lien of the CDC. Also, SBA does not allow a third party lender to establish a preference for itself outside the context of the senior lien positions permitted by the authorization. In its loan application to SBA, the CDC should submit a bank letter, executed by the third party lender, which sets forth the terms of the third party loan. When preparing, or reviewing, this letter, the third party lender should make sure that the entire collateral structure of the third party loan is fully disclosed. Some items third party lenders should disclose in the bank letter include: whether the operating company is a co-borrower or guarantor; any additional guarantors, any stock or membership interest pledges, any collateral assignments of life insurance, any secondary collateral, and anything else that SBA may consider a preference. If the additional collateral is disclosed in the bank letter at the time of application and SBA approves or issues an authorization without requiring the CDC to take the same collateral, then SBA has consented to the preference.

Following these guidelines will help ensure that there are no delays in closing your 504 loan correctly. For more information regarding 504 loans, contact Jessica at jconn@starfieldsmith.com or 267-470-1188.