Best Practices: Highlights from the Results of the Office of Inspector General’s High Risk 7(a) Loan Review Program in 2019

The Office of the Inspector General (“OIG”) established the High Risk 7(a) Loan Review Program in 2014 to minimize losses on high dollar/early-defaulted U.S. Small Business Administration (“SBA”) guaranteed 7(a) loans, and to confirm compliance with SBA program requirements. In 2019, the OIG chose to review 8 high dollar/early defaulted 7(a) loans as part of this Program.  As a result of the review, OIG identified material lender origination and closing deficiencies in 5 of the 8 loans.  The SBA, in turn, will require the lenders who made these loans to either bring the loans into compliance or, if that is not possible, seek recovery from these lenders.  This article briefly discusses some of the OIG’s findings in relation to the 5 problematic loans.

Four of the five problematic loans were singled out for inadequate support for equity injection.   The findings cited various deficiencies, including: (i) failure to prove injection funds came from the sale of a prior business 2 years prior to the loan, (ii) failure to prove that a guarantor had an outside source of income to support a home equity line used towards injection, (iii) failure to address the source for all injection funds (only had source of part of injection), (iv) failure to fully prove injection was used to complete improvements to a building 2 years prior to the loan (had invoices stamped paid, but no cancelled checks or documentation to prove source of those funds), and (v) failure to obtain proof that injection funds were gifted from family members.  These findings highlight the importance of thoroughly documenting the source of any required equity injection and properly demonstrating the use of such funds.

Two of the problematic files were cited for inappropriate use of delegated authority.  The first inappropriate use involved a lender that submitted a loan guaranty request under delegated authority knowing that the borrower already had an existing SBA loan approval from a different lender.   Additionally, it purposely lowered its loan amount so as to not trigger the SBA’s maximum guaranty threshold.  The other file’s inappropriate use related to lender’s failure to require an equity injection of at least 25% of the selling price when the business valuation showed intangible assets in excess of $500,000.  The lender’s SBA Authorization showed no injection requirement at all.

Interestingly, one file was found to be non-compliant for, among other things, an inadequate review of franchise agreement.  In this loan, the borrower was using loan proceeds to divide one hotel franchise, which consisted of two buildings, into two different franchise hotels located at the same address.  One of the franchise agreements contained a clause that stated owners/officers with 25% or more equity interest in the hotel may not own, operate or franchise any guest lodging facility other than this franchise in the protected territory.  The owner of the hotel was 100% owner of both hotel franchises, so borrower would be violating this clause.  The other franchise agreement contained a clause that stated the franchisee and its owners shall not divert or attempt to divert any present or prospective customer to any competitor.  If the borrower’s one franchise location was full, then it is likely the Borrower would direct the customer to its other franchise hotel, thereby violating this provision.   Since lender didn’t address the fact that borrower would be in violation under the executed franchise agreements, the lender didn’t meet the SBA’s credit underwriting requirements.

Other deficiencies pertaining to these five files included (i) failure to obtain business valuation, (ii) inadequate appraisal, (iii) unsupported projections, (iv) inadequate support for debt refinance, (v) affiliate not considered for size determination, and (vi) inadequate assurance of repayment ability.

For more information on the OIG High Risk 7(a) Loan Review Program results and SBA compliance, contact the attorneys at Starfield & Smith at 215.542.7070 or email us at info@starfieldsmith.com.