While a credit memorandum may primarily be a way for lenders to memorialize their own underwriting of a loan, it is important to keep in mind that this document is one of the primary documents that SBA reviews to ensure that a lender is in compliance with SBA 7(a) regulations. SBA’s compliance audits of loan portfolios, and guaranty purchase reviews for early defaulted loans, will include an assessment of the credit memo to determine, among other things, whether the lender is sufficiently analyzing the credit worthiness of the borrower. Because of the scrutiny given to these documents by SBA, it is critical that lenders ensure that they comply with all SBA requirements when documenting a credit.
Since the 7(a) lending program is a cash flow based loan program, an analysis of the borrower’s debt service coverage is critical. This analysis must include several components. First, lenders must include an analysis of historical financial performance for existing businesses. The historical debt service for an existing business should be supported through a review of tax returns and an interim financial statements. If the historical performance does not show sufficient debt service coverage, or for new businesses, lenders must analyze 2 years of detailed, independently supported, projections. For any projection analysis, lenders are required to be support assumptions as much as possible. Failure to provide independent support for the projections (e.g. RMA data or franchise data) may result in a finding in an audit or may jeopardize the guaranty in an early default situation.
Another area that can be overlooked or not explicitly outlined by lenders in the credit memorandum, is in the working capital analysis. SOP 50 10 5 (K) requires lenders to provide an “analysis of working capital adequacy, at a minimum over the next 12 months” (pg. 180). Again, when SBA reviews a credit memorandum for working capital, they are looking to see whether lender properly assessed the borrower’s working capital needs in conjunction with its ability to service the debt. Failure to address working capital when considering a borrower’s ability to run the business and repay the debt may lead to losses to both the lender and SBA. Even if this analysis is performed, it must also be clearly and explicitly written up in the credit memorandum. If the SBA is not able to readily find this analysis, particularly in an early loan default scenario, the SBA may take the position that lender’s failure to properly analyze the working capital needs of the business resulted in a failure to properly underwrite cash flow, thus causing the failure of the business and/or loan. Such a position likely would lead to a recommendation for a denial of the guaranty. Therefore, it is critical that lenders explicitly outline this analysis in their credit memorandum.
One last area lenders must not overlook in the credit memorandum is the credit elsewhere analysis. Demonstrating the need for credit (or the lack of credit from non-federally guaranteed sources) speaks directly to eligibility. SBA requires that the analysis of credit elsewhere be more than just “checking the box” for an acceptable rationale. All credit memoranda should include a narrative discussing the specifics of the borrower’s access to credit, including liquidity of owners of 20% or more of the applicant, spouses, children and the applicant itself. It also must discuss why credit is not available from conventional sources. If any of these pieces are missing, SBA may raise a finding in an audit.
With proper templates and training, lenders can ensure that their credit memorandum narratives will pass muster when it comes to reviews by SBA. For questions about audits and guaranty purchase reviews, please contact the attorneys at Starfield & Smith at 215-542-7070.