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June 29, 2011

Firm News for June 2011: Best Practices: Adequate Collateral

By: Kimberlee Knopf, Esq.

Lenders are unable to extend conventional commercial loans to those Small Business Applicants who, though able to demonstrate repayment ability, lack collateral to repay the loan upon liquidation. SBA guaranteed lending programs enable lenders to extend loans to such Small Business Applicants; provided that an SBA guaranty is not “to be used as a substitute for available collateral.” SOP 50-10-5(C) p. 190.

An SBA loan is deemed to be fully secured when the collateral has a combined “Liquidation value” up to the loan amount. SOP 50-10-5(C), Subpart B.II.A. defines “Liquidation value” as “the amount expected to be realized if the lender took possession after a loan default and sold the asset after conducting a reasonable search for a buyer and after deducting the costs of taking possession, preserving and marketing the asset, less the value of any existing liens.” Business operating and trading assets (i.e. cash, inventory and accounts receivable) should not be assigned a value in excess of 10% of their current book value because such assets have little or no value upon liquidation.

In order for a lender to be assured that it is in compliance with these provisions, an SBA loan must, to the maximum extent possible, be collateralized with all available assets of a Small Business Applicant, including the available assets of the principals and their spouses, if the business assets are insufficient to fully secure the loan. Personal residences, deposits and securities of the individuals should be considered available assets for these purposes. If the equity in the personal residence of a principal(s) is more than 25% of the fair market value of the property then the principal(s) will be required to grant lender a lien on such real property as collateral for the loan. Subject to any applicable exemptions for publicly-traded assets, a lender should also consider certificates of deposit, securities and other investments not held in a retirement account, as collateral for its loan.

When an individual, or an individual and their spouse together own 20% or more of the Small Business Applicant, assets owned both jointly and individually must be considered as collateral for the loan. Even if a principal’s spouse does not have an ownership interest in the Small Business Applicant, if the loan will not be adequately secured after review and analysis of the available assets of both the business and the principal, the assets of such spouse should be considered as collateral for a loan.

A lender must also consider the anticipated use of proceeds of the loan in its collateral analysis. When funding an asset purchase, a lender must, at a minimum, secure its loan with a first priority lien, mortgage and security interest in the assets being acquired by the Small Business Applicant. In the event a loan is intended to refinance existing indebtedness, the loan must, at a minimum, be secured by the same assets securing such refinanced debt.

A lender should be not be deterred in the event another lender will have a priority security interest in certain assets of the Small Business Applicant. For example, a lender may be funding a change of ownership resulting in 100% ownership by the purchasers. While the collateral must include a first priority lien upon the assets of the business, so long as a lender has considered all available assets to secure its loan, the lender may agree to take a subordinate lien on the accounts receivable if there is a reasonable justification for doing so (i.e. supporting the working capital needs of the business). It is noted, however, that any collateral subject to prior liens is not allocated any value in the determination of “Liquidation value”.

So long as a lender is able to demonstrate that it has conducted a thorough analysis of the assets of the Small Business Applicant, the principals of the Small Business Applicant and their spouses in accordance with the foregoing and all other applicable provisions of the SOPs, rules and regulations, then its loan should meet the test for adequate collateral. Failure to obtain all available collateral on an SBA loan that is not otherwise fully secured will result in a repair or denial of the SBA guaranty.

For more information on SBA collateral requirements or other SBA related issues, contact Kim at kknopf@starfieldsmith.com or 267-470-1226.