One of the basic tenets of SBA lending is that an applicant must be an active operating business. SBA prohibits financing assets that are held for their passive income, with one exception – the Eligible Passive Company (EPC) Rule. Because the EPC Rule is an exception to SBA’s general policies, the SBA interprets it strictly. Any variation from the EPC Rule may result in a full denial of the SBA guaranty if the loan defaults.
Most SBA lenders are familiar with the following general requirements of the EPC Rule which are set forth in 13 CFR § 120.111:
- An EPC must use loan proceeds to acquire or lease, and/or improve or renovate, real or personal property that it leases to one or more of its Operating Companies (OCs) for conducting the OC’s business. An EPC may also use loan proceeds to finance a change of ownership between the existing owners of the EPC in certain circumstances. An EPC can not receive any working capital loan proceeds.
- Only one EPC is permitted per transaction.
- The OC must be an eligible small business and must be a guarantor or co-borrower on the loan (depending on whether the OC is receiving the benefit of the loan proceeds).
- The EPC and OC must be “small” under SBA regulations.
- The EPC must lease 100% of the property to the OC and the OC can sub-lease a portion of the property in accordance with the SBA’s occupancy requirements set forth in SOP 50 10 5 (K). The lease must be in writing, subordinate to the SBA’s mortgage and have a term at least as long as the term of the SBA loan. The rent payments can not exceed the SBA loan payment plus a reasonable amount to cover the EPC’s expenses associated with holding the property (e.g. maintenance, insurance and taxes) – in other words, the EPC can not make a profit. All rents must be assigned to the SBA.
One element of the EPC Rule that sometimes gets overlooked is the prohibition on the EPC engaging “in any business activity other than leasing the property to the OC.” See SOP 50 10 5 (K) page 124. In our experience, this restriction is sometimes forgotten. Accordingly, SBA lenders must perform their due diligence on a proposed EPC to make sure that the EPC does not own any other real or personal property or engage in any business activity other than leasing the subject property to the OC.
There are other caveats and nuances of the EPC Rule which SBA lenders should familiarize themselves with that are not discussed in this article. Because a misapplication of the EPC Rule could result in SBA’s denial of the SBA guaranty, it is imperative for lenders to understand and fully comply with the EPC Rule. For assistance with SBA compliance and loan closing matters, please contact the attorneys at Starfield & Smith, P.C. at 215.542.7070.