Last week in our article, Best Practices: The Affiliation Rule Change, we discussed how lenders are no longer required to review matters of control when performing an affiliation analysis, and that affiliates are determined primarily through common ownership. As a part of this change, SBA removed provisions stating that management agreements must be reviewed to assess whether affiliation exists. When the Affiliation Rule and Procedural Notice was released, it was clear that prior sections requiring lenders to review management agreements had been removed, but what was unclear (and remains unclear) is how this impacts the prohibition on lending to passive businesses.
CFR 120.100(a) states “To be eligible for an SBA business loan, a small business applicant must…be an operating business (except for loans to Eligible Passive Companies)”.
SBA previously gave clear guidance on interpretation with respect to how a management agreement could result in a business being passive. SOP 50 10 6 states:
[b]usinesses that have entered into a management agreement with a third party that gives the management company sole discretion to manage the operations of the business, including control over the employees, the finances and the bank accounts of the business, with no involvement by the owner(s) of the Applicant, are not eligible.
While the recent procedural notices did not address any changes to this section, SOP 50 10 7 has removed it completely. While this makes sense for affiliation (since management is no longer a factor in determining affiliation), it is concerning that it was removed from the section defining a passive business. On its face it implies that the presence of a management agreement can no longer result in an applicant being deemed to be passive. However, this doesn’t align with the longstanding principles of the SBA loan programs.
Is it the intention of the SBA to allow loans to be made to companies whose owners have no involvement in operating the business? Does SBA consider the management companies to be benefitting from the loan if they have sole discretion to manage operations? And if so, should management companies be required to be an obligor even if they are not considered an affiliate?
And since SBA can still refuse to honor the guaranty if a lender fails “to make, close, service or liquidate the loan in a prudent manner,” will SBA consider it prudent for a lender to close a loan without reviewing a management agreement and assessing whether it believes the borrower is passive?
It is important for lenders to keep in mind the timing of when these rules go into effect. The changes to the affiliation sections are in effect now, but the changes to how a passive entity is discussed in the SOP will not go into effect until August 1, 2023. Also, matters of eligibility are not subject to how a lender would act on its similarly sized non-SBA loans, so conventional policies should not be given deference in this analysis.
Although management agreements do not need to be reviewed for affiliation, lenders should continue to review them to confirm that the small business is not passive, is otherwise eligible, and include any payments in its cash flow analysis. While there is certainly less to evaluate, management agreements should still be reviewed for the reasons set forth above.
For more information on SOP 50 10 7, contact Katherine Tohanczyn at firstname.lastname@example.org or 215-542-7070.