While the SBA’s Eligible Passive Company (“EPC”) guidelines are well established, lenders continue to encounter SBA compliance issues that may threaten the SBA guaranty. The EPC rule is a limited exception to SBA regulations prohibiting financing for passive businesses and passive investments. Under SOP 50 10 8, an EPC may generally use loan proceeds only to acquire, refinance, improve, or renovate real or personal property that it leases to one or more Operating Companies (“OC”) for the OC’s business operations, or to finance a change of ownership between the existing owners of the EPC. SBA interprets EPC eligibility requirements strictly, and any violation of the EPC rules may result in a full denial of the SBA guaranty in the event of default. Accordingly, it is important for SBA lenders to recognize common fact patterns that may create EPC eligibility concerns before the loan is funded.

Subleases

SBA prohibits EPCs from engaging in any business activity other than owning and leasing 100% of the subject property to the OC. This restriction can be easily overlooked, particularly when a borrower is unfamiliar with SBA’s EPC requirements. For example, a borrower may incorrectly list the EPC as a landlord when subleasing a portion of the subject property to a third-party tenant. By directly leasing to a third party, the EPC would violate SBA guidelines. If not corrected, these errors may create eligibility concerns. To prevent a potential repair or denials, lenders must ensure that 100% of the subject property is leased to the OC.

Use of Proceeds

An EPC may not receive working capital funds because doing so conflicts with the fundamental purpose of the EPC/OC structure. The EPC is intended to function solely as a passive holding entity and should not have operational expenses such as payroll, inventory costs, or other working capital needs.

Lenders may inadvertently violate this requirement if excess loan proceeds are disbursed directly into the EPC’s bank account at closing. One common way this occurs is when there are excess funds from closing owed back to the borrower and a title company is handling disbursement. Often, the only borrowing entity a title company deals with is the EPC, and therefore, the title company may defer to disbursing excess funds back to the EPC. Even where the parties intend for the funds to benefit the OC, SBA may view the disbursement itself as evidence that the EPC improperly received working capital funds. To avoid this issue, lenders should ensure that all settlement statements clearly identify working capital proceeds as payable to the OC.  Additionally, lenders should confirm that any working capital funds are wired directly to the OC’s designated bank account and coordinate with the settlement agent or title company before closing to ensure the disbursement is handled properly.

Change of Ownership Between Existing Owners of an EPC

A less common issue that may create EPC eligibility concerns involves SBA’s restrictions on financing a change of ownership between existing owners of an EPC. SBA permits an EPC to use loan proceeds to finance a change of ownership between existing owners only if the selling owners of the real estate or personal property have held the property for at least 36 months. This issue may arise in partner buyout transaction where the business operations are held in one entity and the real estate is held separately in an EPC. For example, if the owners of the EPC acquired the property two years ago, the remaining owners may not use SBA loan proceeds to buy out the departing owners’ interest in the EPC. Because these transactions are relatively uncommon, lenders may overlook the holding period requirement during underwriting which may result in a guaranty denial.

Many EPC violations arise from seemingly minor documentation or disbursement errors that can easily be overlooked during underwriting and closing. By carefully reviewing the EPC’s activities, use of proceeds, and ownership structure prior to funding, lenders can significantly reduce the risk of SBA eligibility issues and help protect the SBA guaranty.

For further assistance please contact the SBA attorneys at Starfield & Smith, P.C. at 215-542-7070 or email us at info@starfieldsmith.com.