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SBA C-Suite Tips Wednesday — Demonstrate That Borrowed Funds are Not Used for the Equity Injection

August 21, 2019

By Caity Witucki
Contributing Editor, C-Suite Tips Wednesday

SBA C-Suite Tips Wednesday — Demonstrate That Borrowed Funds are Not Used for the Equity Injection

On August 14, 2019, the SBA OIG High Risk 7(a) Loan Review Program released an evaluation of two SBA 7(a) loans. According to the report, a loan for $975,000, was found to be non-compliant with SBA’s loan origination and closing requirements because the lender did not adequately support the equity injection in their credit memo.

According to the OIG report, the loan authorization for the $975,000 7(a) loan required a cash injection of at least $230,000. The lender indicated that the source of the injection would be funds from the sale of a business previously owned by the guarantors. The guarantors also had a fully drawn home equity line of credit in the amount of $200,000 with another bank. The lender’s file contained bank statements from this bank for a new account showing a sufficient balance to support the injection prior to disbursement. After the loan was disbursed, the borrower made 13 payments before defaulting.

The OIG investigation revealed that this loan should not have been approved because the lender did not fully document the source of the equity injection. Specifically, the documents in the lender’s file did not adequately support that the funds came from the sale of the business that took place almost 2 years prior to the opening date of the new account. Additionally, the OIG investigation did not find evidence that the guarantors had an outside source of income to support their home equity line of credit. Therefore, it was prudent for the lender to demonstrate that borrowed funds were not used for the equity injection.

Although the SOP allows a borrower to use borrowed cash as a source of injected equity, it is crucial that the lender address the source in their credit memo and take other factors – i.e. the type of business, the experience of the management, and the level of competition in the market area – into consideration. SOP 50 10 5(H) states: “The source of the injected equity must not be cash that is borrowed unless the small business applicant can demonstrate repayment of the personal loan from sources other than the cash flow of the business.”

When the SBA learns that an institution failed to verify the source of an equity injection after the institution has already been paid the guaranty, the SBA will often require the institution to bring loan into compliance or reimburse the SBA for the full amount – “plus interest.”

Sources:
SOP 50 10 5(j) (Pages 174-175)

SBA Inspector General Management Advisory Report Number 19-16.

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