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February 18, 2011

Firm News for February: Best Practices: Guaranty Purchases and the Materiality Standard

By: Ethan W. Smith, Esq.

SBA lenders that are facing loan defaults are often daunted by the SBA guaranty purchase process. Much of this uncertainty results from lenders’ lack of familiarity with the guaranty purchase process utilized by the National Guaranty Purchase Center (“NGPC”) in Herndon, VA. In addition to the unfamiliarity with the process, lenders are often concerned about the standard of review that is employed by NGPC personnel in conducting their purchase reviews. Of particular concern to lenders is how to address deficiencies that they identify in their files, and how to assess the magnitude of these deficiencies in determining how best to proceed.

The standard of review employed by the NGPC is one of “materiality.” Simply put, the NGPC will only recommend repairs or denials of the SBA guaranty for deficiencies that are “material” in nature. But what does “material” mean to the SBA? Based upon conversations with Agency personnel, a deficiency is “material” if it caused or significantly contributed to the cause of the loss to the lender and/or the SBA. Some examples of material deficiencies would be: failing to obtain the proper lien position on collateral; failing to properly verify the financial records and tax returns of the borrower and/or seller; failing to maintain hazard insurance on collateral that is subsequently destroyed; failing to perform a timely site visit after default where collateral is removed by the borrower or damaged; and other similar types of deficiencies. Non-material deficiencies would include: failing to obtain an acknowledged collateral assignment of life insurance, where the insured did not die; failing to perfect a lien on collateral that has declined in value; failing to maintain hazard insurance on collateral that was not destroyed; and other “no harm – no foul” events. Although the application of the materiality standard seems quite straightforward, there is one critical nuance that lenders must keep in mind in analyzing their loan files.

Specifically, lenders must remember that the SBA does not apply the materiality standard to eligibility determinations. For questions of eligibility, SBA employs a strict compliance standard, instead of a material compliance standard. This means that from the SBA’s standpoint, any deviation from the eligibility guidelines, however small, renders the loan ineligible, resulting in a recommendation for a complete denial of the guaranty. In some instances this standard is easy to comply with: i.e. size standards; eligible types of businesses; personal resources. In these situations it is usually quite easy to see what side of the eligibility line your loan falls on. Other eligibility determinations are less clear, such as franchise/jobber/license eligibility determinations. The subjective nature of a franchise eligibility analysis begs the question of whether a PLP lender should ever perform such an analysis on its own, since the chances that the SBA may reach a different conclusion as to the franchise’s eligibility is quite high. Until the SBA implements a materiality standard for franchise eligibility reviews, the only way for lenders to ensure that their non-registry franchise loans are eligible, is to submit them under General Processing.

Whatever the issue, it is critical that lenders be precise and exacting in making eligibility determinations as the standards are so strict (strict compliance, not material compliance), the margin for error is so razor thin, and the consequences of an incorrect determination are so dire. By employing the correct compliance standard in making eligibility determinations, lenders can preserve and protect the SBA guaranty and avoid denial recommendations.

For more information on SBA guaranty preservation and guaranty purchase reviews, contact Ethan at esmith@starfieldsmith.com, or 215-542-7070.