Best Practices: Loan Proceeds and Associates: A Compliance Trap to Watch

A common issue that arises in SBA loan reviews is the improper use of proceeds for the benefit of “associates” of the borrower. SOP 50 10(8) provides that, payments, distributions, or loans to an Associate are ineligible uses of proceeds, except for compensation for services actually rendered at a fair and reasonable rate or to facilitate a change of ownership. Under 13 C.F.R. § 120.10, an “associate” of a small business is (i) any officer, director, owners of 20% or more of the equity of the small business, or key employee; (ii) an entity in which one or more of these individuals noted in (i) owns or controls at least 20 percent; and (iii) any individual or entity in control of or controlled by the small business (except a Small Business Investment Company licensed by SBA).

An associate relationship is determined by looking back six months prior to the date of a loan application and continues for the life of the loan. The only exception to this rule is when an associate completely divests their interest in the small business applicant.

This rule can come into play in many ways during underwriting and closing. For example, 7(a) loan proceeds cannot be used to pay down debt that is in the name of an associate of a small business borrower unless (i) that associate is a co-borrower on the loan, (ii) the debt was incurred for the business and (iii) otherwise meets the SBA debt refinancing rules. Similarly, loan proceeds cannot be used to compensate a key employee except for services rendered in the operation of the business. Even indirect benefits, such as improvements to property owned by an associate who is not obligated on the loan, may create eligibility problems.

In many cases, vigilance on the front end can help avoid last minute changes. Open communication with borrowers about these restrictions can help avoid misunderstandings and set expectations. In addition, Lenders should ask questions and obtain supporting documentation as early as possible regarding payments to be made with loan proceeds to confirm they meet all SBA eligibility requirements.

Lenders also need to be cognizant of changes made at the time of funding. A common issue that is often missed in the chaos of closing is payment of working capital to an associate or individual owner who are guarantors on the loan. Lender should carefully review closing statements to confirm disbursements – especially working capital – are being paid to an operating company which is an eligible borrower.

If SBA determines that loan proceeds were paid to benefit an associate, the agency may seek to repair or deny its guaranty. Because these issues are often fact-specific and fact-intensive, they can surface during SBA guaranty purchase reviews, long after the loan has closed.

Ultimately, careful attention to the treatment of associates throughout the loan process is critical to preserving SBA eligibility and protecting the guaranty. By recognizing how broadly the rules apply and by documenting borrower relationships early, lenders can reduce risk, avoid costly surprises at guaranty purchase, and keep loans compliant from origination through closing.

For assistance with SBA loan matters contact us at 215.542.7070 or info@starfieldsmith.com