Best Practices: Pitfalls of Equity Injection Documentation

For SBA lenders, proving equity injection is a critical part of the due diligence process since failure to properly do so can result in a denial of the guaranty on early default loans. With that in mind, below are some tips on avoiding common pitfalls related to equity injection documentation.

SOP 50 10 5 (K) requires that lenders obtain the following documentation:

1. “A copy of a check or wire transfer along with evidence that the check or wire was processed showing the funds were moved into the borrower’s account or escrow;
2. A copy of the statements of account for the account from which the funds are being withdrawn for each of the two most recent months prior to disbursement showing that the funds were available; and
3. A subsequent statement of the borrower’s account showing that the funds were deposited or a copy of an escrow settlement statement showing the use of the cash” [SOP 50 10 5 (K), pg. 234].

For starters, it is important that lenders obtain statements for the correct time periods to avoid any issues later in proving the funds were seasoned. By way of example, assume that a borrower issues a check for a deposit on a real estate purchase on March 28, 2019. The funds aren’t withdrawn until April 5, 2019. In this instance, the bank should obtain the February, March and April statements to show that the funds were available when the check was cashed.

A common problem with equity injection documentation stems from borrowers that provide documentation from several different accounts. The borrower may claim that they have enough funds in the aggregate to cover the equity injection, but when the funds are actually used or brought to closing, they may not actually come from the account that lender sourced. It is critical that lenders track the actual source of injection and that they do not rely on this “aggregation” argument. If transfers were made between borrower’s accounts, lenders should obtain documentation to show each move before the money was used.

Another common problem arises when the funds in the borrower’s account are not seasoned and the bank statements disclose large deposits. This can happen, particularly when the account used for injection is the operating account of the business. Lenders should consider the type of account and industry to determine what deposits will need to be sourced and which will not. If the account used is an operating account and it is clear that the deposits (even if they are large) are customer payments, then no further documentation is typically needed to prove source. If the deposits are not from an  identifiable source, such as customer payments, further inquiry should be made into the source of the funds.

Things can get complicated when the source of the large deposit is a related party. If the funds are transferred from an account of an affiliate of the borrower, the lender should obtain bank statements from the account of the affiliate to determine the source of the funds. Further, since transfers between companies are not gifts, under these circumstances, lenders should obtain documentation verifying that the funds are a loan on full standby. If the funds are a capital contribution of a shareholder, lender must obtain bank statements for the account of the shareholder as well. This is true, even if the shareholder is a minority shareholder that is not a guarantor (eg. an investor).

When looking at the bank statements, remember that one of the core purposes of equity injection is to demonstrate that the borrower has “skin in the game.” Therefore, SBA is looking to see that the funds being injected into the project are, in fact, borrower’s funds and are not borrowed. In order to do this, lenders must obtain bank statements to support each deposit and look beyond the starting and ending balance to see what funds were available in the account.

For assistance with SBA compliance matters, contact the attorneys at Starfield & Smith at 215.542.7070 or visit our website at www.starfieldsmith.com.