Best Practices: SBA’s Final Affiliation Rule and Franchise Lending

The new SBA final rule “Affiliation and Lending Criteria for the SBA Business Loan Programs” (the “Rule”) is set to change the landscape of SBA franchise lending. Effective on May 11, 2023, the Rule will remove affiliation based on management and control, franchise or license agreements, and identity of interest for most of SBA’s loan programs. Additionally, SBA will no longer publish the Franchise Directory and will eliminate SBA’s Addendum to Franchise agreement once the Rule is effective. SBA’s reasoning for removing these provisions and processes is to simplify the affiliation analysis, as it is often a complex process that burdens both SBA Lenders and borrowers.

After May 11^th, SBA Lenders no longer need to consider whether a franchisee borrower is affiliated with their franchisor when determining if a borrower meets SBA’s size standards. While the Rule will streamline the affiliation analysis, SBA Lenders should still obtain the franchise agreements of their loan applicants to determine other eligibility considerations.

First, the franchise agreement can provide insight into the business model of the franchisee applicant. SBA Lenders can review the franchise agreement to determine whether the applicant is engaged in an ineligible business under SBA’s standards. Some examples of ineligible businesses include:

• Life insurance companies
• Pyramid scheme companies
• Marijuana or certain CBD businesses
• Businesses that restrict patronage or have discriminatory hiring practices
• Businesses providing prurient material
• Passive businesses

Identifying whether a business engages in discriminatory hiring practices or is pyramid scheme may require more than a surface level review of the business. A review of the applicant’s franchise agreement can ensure that the applicant is not engaged in any ineligible practices and protect the Lender’s SBA guarantee.

Additionally, careful review of franchise agreements can help ensure that the SBA Lender’s interest in its collateral is protected. Without the protections of the SBA Form 2462 Addendum to Franchise Agreement, SBA Lenders will need to consider the impact if a franchise agreement provides that a franchisee may be forced to sell its real estate if there is a default under the franchise agreement. Further, franchisor may record restrictive covenants on the property where the franchisee operates which may make resale of the property difficult. Startup franchise businesses are typically secured by a first lien on the borrower’s personal property purchased with loan proceeds.  Many franchise agreements include provisions that grant the franchisor a security interest in the franchisee’s collateral. These provisions can potentially interfere with the Lender’s lien position if the franchisor also files a UCC-1 financing statement before the Lender and does not agree to subordinate its lien. It is best practice for SBA Lenders to identify early in the closing process whether a franchisor plans to take a lien on the borrower’s assets and what rights the franchisor has over the borrower and its collateral in the event of a default under the franchise agreement by reviewing their borrower’s franchise agreement,

Overall, the Affiliation Rule will eliminate some of the burdens of franchise lending, but Lenders should not abandon the practice of obtaining and reviewing their borrower’s franchise agreements for eligibility and prudent lending considerations.

For more information on SBA’s new Affiliation Rule and its impact on franchise lending, please contact the attorneys at Starfield and Smith at 215-542-7070.