Best Practices: Exploring the revisions to SOP 50 57 (3): Modification of Collateral

SBA lenders must be careful to not only follow the updated guidance in SOP 50 57(3) for liquidation and guaranty purchase, but also for SBA loans in regular servicing.

While many changes to the standards of Modification of Collateral – Chapter 8 of the SOP 50 57 (3) were typographical in nature, a few substantive additions merit examination.

Substitution of Guarantor:

One addition in Chapter 8 involves analyzing a request to release or substitute a guarantor.  Previously, the SOP stated only that Guarantors must not be released without SBA’s prior written consent.  Now, the same rule applies, but adds an exception: “except for limited guaranties taken to secure an owner’s interest in collateral.”

Presumably, this exception was added to enable lenders to address a common request where, for example, a guarantor wants to sell investment or residential property that previously secured the loan, and the substitute/replacement property will not be owned by the same parties who originally owned the old collateral.  Perhaps an investment property had been co-owned by a full guarantor and his brother, who had been a limited guarantor only due to his ownership interest in the investment property, but had no involvement or ownership in the Borrower / business entity, and the new investment property will be owned solely by the full guarantor.

Assuming the request met all other conditions, a lender should have been able to release a limited guarantor without SBA’s prior written approval, because the ownership interest in the old collateral would no longer exist.  The prior version of the SOP 50 57 did not allow such an easy result.

Incidentally, the Servicing and Liquidation Actions 7(a) Lender Matrix (the “Matrix”) still does not reflect this change, among others.  The last time the Matrix was updated was February 25, 2020.   The Matrix is intended to serve as a servicing guide for Lenders; however, the summary provisions of the Matrix as of the date of this article do not reflect the above change from SOP 50 57 (2) to SOP 50 57 (3).  Lenders should be careful in referring to the Matrix when evaluating servicing and liquidation actions through E-Tran, and should review the relevant revised provisions of 50 57 (3) in full before taking any servicing or liquidation actions, until an updated Matrix is released.

Leasing Real Property Acquired with SBA Loan Proceeds:

Another addition to Chapter 8 is a new provision stating that, essentially, a violation by Borrower or Operating Company of the occupancy requirements of 13 C.F.R. § 120.131 may result in SBA taking action including accelerating the Note and demanding payment in full.

Moreover, SBA’s review of any future application for an SBA loan from not only Borrower or Operating Company, but also any Associate[1], “will take into consideration any prior failure to comply with SBA Loan Program Requirements, including occupancy requirements, in connection with an outstanding SBA Loan.”

This new language represents a departure from prior treatment by SBA of a non-payment, “technical” default. A technical default, such as Borrower not being able to occupy at least 51% of the real property acquired with loan proceeds, may mean that the Borrower is in or is headed for financial trouble, eventually leading to a payment default on the loan.  Historically, however, SBA has declined to repurchase a loan guaranty based solely on a technical default.

Should SBA choose to enforce this provision, it may enable lenders to act more quickly in taking servicing action against a troubled Borrower, where an actual payment default may not occur for several months in the future.   This may also help enforce the prohibition on using an SBA loan to finance investment property, by preventing a Borrower from “over-renting” its commercial property merely to obtain more rent from subtenants.

Moreover, any individual or entity that qualifies as an Associate under the relevant definition may be prohibited from undertaking additional SBA loans in the future, at least so long as an existing SBA loan is in technical default. This would give potential future lenders and SBA another tool to evaluate Borrower applicants not just for failure to pay a prior loan, but for performance and adherence to SBA eligibility requirements on their existing loans.

It should be noted that this new technical default language is discussed nowhere else in the SOP 50 57 (3). It is unclear whether these new provisions will be enforced or will add any new tools to lenders’ enforcement powers.

For additional assistance navigating the changes to the SOP 50 57 (3), please contact the attorneys of Starfield & Smith, P.C. today.

[1] The definition of Associate includes any “officer, director, owner of more than 20 percent of the equity, or key employee of the small business.”