SBA Hot Topic Tuesday — New Inspector General Audit Denies Another $2.7 Million SBA 7(a) Guaranty

March 22, 2016

By Bob Coleman
Editor, SBA Hot Topic Tuesday

SBA Hot Topic Tuesday — New Inspector General Audit Denies Another $2.7 Million SBA 7(a) Guaranty

Continuing cost overruns pushed the construction of a fitness club from $5 million to $12.3 million.

In 2011, California Bank & Trust approved a $2.7 million SBA 7(a) construction loan to help construct the loan. Unfortunately, the loan defaulted within 18 months — only five interest only payments were made — and SBA’s Inspector General audited the file as part of its High-Risk Loan Review Program.

The OIG faulted the lender in three areas:

  • Failed to monitor the construction project
  • Failed to address and mitigate adverse financial changes of the borrower.
  • Failure to document borrower’s equity injection

Writes SBA’s Inspector General

Both the borrower and the landlord were to share in the construction costs to build the fitness center, with the borrower providing the exercise equipment. The borrower’s share of this project was to be financed by the $2.7 million SBA loan and a $1.6 million equity injection. The original construction cost estimate for leasehold improvements of $5 million was provided in the lender’s credit memorandum dated July 22, 2011

However, per the construction contract executed on June 1, 2012, this estimate had increased to almost $9.2 million. The borrower’s share of the construction costs at this time was estimated to be approximately $4.4 million, with the landlord responsible for the other $4.8 million under a separate contract. By October 2012, construction costs alone had more than doubled from the original estimate of $5 million to $12.3 million. After this cost increase, the borrower’s portion of construction costs rose to $7.5 million. The rise in construction costs also resulted in the lender increasing the borrower’s required equity injection from $1.6 million to $2.8 million.

To address these rising costs, the landlord issued a separate loan to the borrower for $2.75 million so it could pay its portion of the construction. Ultimately, the borrower paid for construction costs totaling approximately $7.5 million from three different sources: the SBA loan of $2. 7 million, the loan from the landlord of $2.6 million, and its equity contributions of $2.2 million.

The borrower did not open for operation and defaulted on the SBA loan on May 7, 2013, after making only five interest payments. SBA purchased the loan on June 23, 2014 for approximately $2 million.

Lender Did Not Monitor Project Progress

The lender did not comply with material SBA requirements regarding new construction of and improvements to an existing building.

We determined that the construction contract, dated June 1, 2012, noted that construction had commenced, even though the contractor had not received final plans and specifications that clearly defined the entire scope of work.

SBA procedures state that prior to the commencement of any construction, the lender must obtain a copy of the final plans and specifications from the borrower. Additionally, SBA requires that along with a copy of the contract, the lender obtain an agreement that the borrower will not order or permit any material changes in the approved plans and specifications without prior written consent of the lender. Finally, the SBA loan authorization states that the lender must take all normal construction loan safeguards appropriate for the loan.

Nevertheless, we confirmed that the lender did not obtain final plans and specifications for the project. Further, while change orders occurred, we found no evidence that the lender obtained an agreement with the borrower requiring its approval of any contract change orders or that these change orders were approved by the lender.

We also determined that the lender did not perform oversight of the construction progress in accordance with SBA requirements. Specifically, the lender did not perform interim or final site inspections to verify that the work was performed as planned. SBA procedures state that the lender must make interim and final inspections to determine that construction conforms to the plans and specifications.

Evidence in the loan files supported that the lender intended to hire a construction control company to perform project cost reviews, project work inspections, and disbursement control for the construction loan. Instead, the lender relied on statements from the borrower and lien waivers from the contractor to supply them with critical information about the progress of the project.

Based on the borrower’s statements and the lien waivers, the lender disbursed one lump sum payment of $3.9 million on November 7, 2012, approximately 5 months after execution of the construction contract.

The use of a lien waiver in lieu of the required site inspections and documentation, however, was not sufficient to verify that the construction progress conformed to the plans. For example, the lender’s post-default site visit on July 25, 2013, approximately 8 months after loan closing, confirmed that construction had been slow and was still ongoing. Specifically, a significant amount of work remained on the two main workout floors and the floor that would include the lockers, whirlpools, and saunas. The lender’s noncompliance with SBA’s requirements to effectively monitor the progress of this construction project placed SBA and its guaranteed loan at substantial risk

Lender Did Not Remedy Adverse Changes to the Project and Borrower’s Financial Condition

The lender also failed to address and mitigate adverse changes affecting both project control and the borrower’s financial condition, further compounding the risk to SBA.

As noted above, the construction costs more than doubled from $5 million to $12.3 million prior to loan disbursement. This increase resulted from construction delays and cost overruns. Given that the borrower was unable to provide funds to complete its share of the construction, it received financing (Mezzanine Loan) from the landlord in the amount of $2.75 million on October 11, 2012.

The conditions of this loan resulted in both borrower and lender relinquishing any further control over the construction project. Specifically, upon funding the loan, the landlord automatically became the construction manager for the completion of the project including all landlord work, tenant improvements, and shared cost improvements.

Further, the borrower was not allowed to communicate with the contractor or visit the construction site without prior consent of the landlord.

This adverse change prevented the lender from complying with SBA’s requirements for construction loans. The SBA loan authorization stated that the guarantee is contingent upon the lender having no evidence of any unremedied adverse change in the financial condition, organization, management, operation, or assets of borrower or operating company that would warrant withholding or not making further disbursements.

Nevertheless, the lender disbursed the loan in full on November 7, 2012.

The lender also did not effectively monitor the financial condition of the borrower prior to loan disbursement, which also put SBA at a risk of loss. At origination, the lender determined that the borrower could rely on revenue generated by its affiliates to service all debts, including the new location. Once construction costs began to rise, however, the principal of the borrower was required to inject an additional $1.2 million into the project.

The borrower funded this equity increase by transferring $1.2 million from its affiliate. This transfer exhausted the cash available to the borrower, and the lender did not discuss how this adverse change in cash would impact the borrower’s ability to cover operational costs and debt during the start-up period.

Adequate working capital was especially important given that the borrower was a start-up (opening a new location) and the facility was still under construction and not operating.

After the loan was disbursed, the lender noted the negative impact of the cash transfer and increase in construction costs on the borrower’s financial condition. Specifically, in March 2013, an amendment to the lender’s credit memorandum stated that cash for the affiliates and owner of the borrower had been depleted based on the 2012 financials. As a result, the borrower had no further financial resources, and it became even more critical to ensure the ocation opened.
The lender’s negligence in monitoring both this project and the borrower’s financial condition resulted in loan disbursement with the business never opening for operation.

Ultimately, the SBA guaranteed loan helped fund luxury improvements, including a rooftop pool and spa, for the exclusive use by the landlord and its clientele.

Inadequate Support for Equity Injection

Finally, we noted that the lender did not provide evidence to support the source for $1.5 million of the borrower’s required $2.8 million equity injection. While the borrower funded construction project expenses from the borrower’s bank account, loan documentation did not include bank statements along with cancelled checks to show the original source of these funds. This was especially important because the borrower’s facilities were still being constructed, and the April 2012 interim financial statement showed sales of only $48,000.

SBA procedures require the lender to verify the injection prior to disbursing loan proceeds.

Verifying a cash injection requires evidence, such as a check or wire supporting that funds were moved into the borrower’s account. It also requires a copy ofthe bank statements for the account from which the funds are being withdrawn.

SBA requirements state that lenders must analyze each application in a commercially reasonable manner, consistent with prudent lending standards. In addition, SBA will not purchase the guaranteed portion of a loan when a lender does not provide sufficient credible evidence to support it made the loan in accordance with SBA loan program requirements and prudent lending practices. Further, SBA is released from liability on the guaranty (in whole or in part) if the lender fails to comply with any material SBA loan program requirement, failed to make, close, service, or liquidate a loan in a prudent manner; or the lender’s improper action or inaction has placed SBA at risk.

Consequently, the lender’s material noncompliance with SBA requirements while making and closing the loan to the borrower for this construction project resulted in a loss to SBA of over $2 million.

View the audit here.

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