As many know, the purpose of the SBA 7(a) loan program is to help provide access to capital to small businesses who may not otherwise secure loans through conventional means. As a government agency funded by taxpayer dollars, the SBA must serve as good stewards of public funds and ensure due diligence and compliance of all participants, including lenders. To ensure compliance and due diligence form lenders, the SBA utilizes its Office of Inspector General (OIG) and Office of Credit Risk Management (OCRM) and Lender Oversight Committee to provide oversight for high-risk lenders and high-risk loans. Their primary goal is to minimize the participation of high-risk lenders in both the SBA 504 and 7(a) programs and to mitigate losses from early defaulted, high-risk loans.
Who is considered a high-risk lender?
In 2015, the OCRM developed a methodology for determining the risk rating of lenders. It is a composite methodology that looks at factors such as portfolio management, asset management, regulatory compliance, risk management, as well as portfolio size, SBA concentration rates, and other special factors.
The Process of Lender Oversight
Lenders considered high-risk are subject to three different levels of review, depending on the OCRM’s assessment of the previous year. Those levels of review are:
- Full Review: This is an onsite review that dives deep into each of the factors of risk and a review of SBA loan files, which are chosen at random.
- Targeted Review: This review can be conducted onsite or virtually and looks at one or more of the factors of risk. It can also include the auditing of certain loan files.
- Safety and Soundness Examination: This onsite review looks at all aspects of the lender’s operations and a review of loan files. Some items may also be conducted virtually.
Based on the findings of the review, the SBA will reach one of the following conclusions:
- Acceptable – no action needs to be taken
- Acceptable with Corrective Action(s)
- Marginally Acceptable with Corrective Action(s)
- Less Than Acceptable with Corrective Action(s)
Corrective actions can include implementing, modifying, altering, changing, or ceasing a specific action deemed non-compliant or high-risk by the SBA.
The OIG recently conducted an audit of the OCRMs performance and found that many of the recommendations for corrective actions it made to the lenders it evaluated over the last three years were “inadequate and inconsistent.” The OIG provided its own recommendations to bring the OCRM into compliance, which the office has agreed to and has resolved. You can read the full report here.
What is considered a high-risk loan?
A high-risk loan is one “approved for $500,00 or more that defaulted within 18 months of the initial disbursement.” Under this definition, a construction loan or other loan with multiple disbursements may not be fully funded at the time of default and assessment. To assess and mitigate losses from these loans, the High Risk 7(a) Loan Review Program was launched in 2014. The purpose of the program is to evaluate those loans to ensure that lenders complied with the SBA’s loan requirements. If the lender did not comply, their request to recover guaranty funds may be denied or if already disbursed, the SBA may seek recovery for all or part of the guaranty.
The Process of High-Risk Loan Assessment
The Review Program looks at specific loans meeting the above criteria to determine if:
- Lenders provided “adequate documentation to support their use of their delegated authority” and
- Borrowers met all SBA requirements as it related to “eligibility, repayment ability, size standards, franchise agreements, business valuations, appraisals, equity injection, and debt refinance”
Loans that meet the high-risk criteria are subject to a full audit, which can occur virtually or onsite. Lenders are given the opportunity “to obtain additional information to bring the loans into compliance. If that is not possible, SBA plans to seek recovery from the lenders.”
Recent Findings from the OIG’s Assessment of Defaulted Loans
In 2019, eight loans went into early default and met the criteria for the High Risk 7(a) Loan Review Program. Of the eight, only three were deemed as having “no reportable deficiencies.” The other five were found to have notable deficiencies. The OIG office released a report detailing the findings of two of those loans.
A $4,000,000 7(a) loan was secured to purchase commercial property, an existing business, and working capital for a hotel franchise. Five deficiencies were noted:
- Inadequate review of franchise agreements: The borrower sought the loan in order to operate two competing hotel franchises at the same physical address. This directly violated clauses contained in each franchise’s agreements and created a clear conflict of interest.
- Lender did not obtain required business valuation: In addition to the real property, the transaction included a change of ownership. All change of ownership transactions requires a business valuation. The SOP outlines that if the business value, minus real property and equipment, is less than $250,000, the lender may conduct their own valuation. The loan in question included the transfer of intellectual property, licenses, and other intangible personal property which was not supported by a valuation of any kind.
- Inadequate assurance of repayment ability. According to the SOP, the primary source of repayment must come from cash flow and not the liquidation of collateral assets. The lender must demonstrate that the loan commitment can be met through cash flow only, including providing all assumptions for projections. The borrower’s historical data showed that they did not have “adequate debt service coverage” and the lender relied on unsupported projections with inadequate assumptions to presume future cash flow.
- Inadequate support for equity injection. The SBA does not allow injections to come from borrowed funds and requires sufficient documentation to verify the source of all injections. The lender did not provide documentation for the source of funds for the full injection amount.
- Inadequate appraisal for commercial property. Loans for commercial property require an appraisal by a licensed/certified appraiser. Existing property must also be valued on an “as-is basis.” In this loan, the lender utilized an appraisal that derived value based on comparable franchise hotels, instead of on the as-is condition of the property, which included two separate buildings that needed to be appraised individually. Thus, the appraisals provided did not total enough to support the fair market value of the property.
As a result of their findings, the OIG is requesting that the lender bring the loan into compliance by providing the adequate documentation or they will seek recovery of $3,000,297.
To view the full appendix detailing the findings of this loan, you may download it here.
The purpose of this loan was to provide $3,315,000 to purchase land and improvements, refinancing debt, and working capital. The review found two deficiencies:
- Inadequate support for equity injection. The lender utilized leasehold improvements completed to the property two years earlier as a source of injection. The sources of funds were stated to be gifts, but there was no documentation to support and verify where the funds originated.
- Inadequate support for debt refinance. The SBA has two key requirements for debt refinancing. First, the new installment for the debt to be refinanced must be 10% less than the existing installment amount. Second, the previous loan must meet SBA eligibility requirements, which requires proper documentation to verify. Upon auditing, it was found that the loan documentation maintained by the lender “did not contain the note or other sufficient documentation to verify the terms for this debt or its original service.”
As a result of their findings, the OIG is requesting that the lender bring the loan into compliance by providing the adequate documentation or they will seek recovery of $2,335,493.
To view the full appendix detailing the findings of this loan, you may download it here.
To act as good stewards of public funds, the SBA and participating lenders must exercise due diligence and provide all supporting documentation in order to meet all requirements outlined by the SBA 7(a) program. Failure to comply and support compliance with adequate documentation by the lender can result in penalties. Ongoing training on SBA requirements is necessary to ensure adherence to SBA rules and regulations. Many organizations, including NAGGL, provide valuable training as does your Lender Service Provider.
We always work closely with our lending partners to ensure that each borrower and loan meets the guidelines put forth by the SBA. If you ever have any questions about new loans or would like assistance auditing an existing/previous loan to make sure the loan file meets SBA compliance standards, please contact us.