SBA Hot Topic Tuesday – SBA Inspector General Recommends $3 Million 7(a) Guaranty Denial

July 23, 2019

By Bob Coleman
Editor, SBA Hot Topic Tuesday

SBA Hot Topic Tuesday – SBA Inspector General Recommends $3 Million 7(a) Guaranty Denial

A recent OIG review of nine “high risk” SBA 7(a) loans — over $500,000 and defaults within 18 months has resulted in the recommendation of denying the guaranty of two loans.

This $4 million loan defaulted after the borrower made only 12 payments. SBA honored the guaranty and purchased the loan from the secondary market for $3,024,679. Unless the lender can correct the following deficiencies, the lender will be required to reimburse SBA for the full amount — “plus interest.”

Inadequate Review of Franchise Agreements

The borrower used loan proceeds to divide one hotel franchise, which consisted of two buildings, into two different franchise hotels that were located at the same address. Both franchise hotels were on the SBA franchise registry and that the lender obtained the franchise agreements for both hotels. However, the franchise agreements contained clauses that when executed together would prevent the operation of the hotels. Specifically, the franchise agreement for one of the hotels stated that officers or owners with 25 percent or more equity interest may not own, operate, or franchise any guest lodging facility other than the facility in the protected territory.

The borrower owned 100 percent of both hotel franchises. As a result, the ownership of the two hotel franchises at the same address was a violation of the franchise agreement.

The other franchise agreement contained a clause that stated the franchisee and its owners shall not divert or attempt to divert any present or prospective customer to any competitor. The borrower owned another franchised hotel and intended to operate it simultaneously on the same property, which subsequently created an inherent conflict of interest that violated the agreement.

Lender Did Not Obtain Required Business Valuation

The lender removed the business valuation requirement prior to disbursement, stating the transaction was completely reliant on real property. However, the transaction included transferring business intangibles which qualifies as a change of ownership. The lender did not obtain a business valuation to support the intangibles acquired in the business purchase, as required for change of ownership transactions.

Inadequate Assurance of Repayment Ability

The historical financial information showed the borrower did not have adequate debt service coverage. Specifically, the historical debt service coverage ratios for the previous 3 years were 0.59, 0.72, and 0.68, which were less than the required 1.15. The lender relied on projections to determine the borrower’s repayment ability.

However, the lender did not adequately support the projections. Specifically, the operating expenses from 2014 compared to year 1 projections decreased from approximately $2,185,000 to $1,415,000, or by approximately 35 percent. This resulted in an increase in net income from $31,000 to $716,000, or 2,222 percent.

The lender stated that the decrease in projected operating expenses was because the borrower would have hands-on operators. The OIG determined that this explanation was not sufficient to justify the large decrease in operating expenses, especially given that the company hired a management company to run the hotel.

Inadequate Support for Equity Injection

The lender did not fully document the source of a $760,000 cash injection. Instead, the lender only addressed $200,000 in its credit memo. .

Inadequate Appraisal for Commercial Property

The loan authorization required an appraisal for the commercial property showing a fair market value of at least $5,300,000. The subject property contained two existing buildings, operating as one hotel franchise. However, per the lender’s credit memorandum, the borrower intended to operate the two buildings under separate hotel franchises. One building had 96 rooms and the other had 50 rooms. The lender provided an “as-is” appraisal for the 96-room building, which showed a value of $2,800,000.

The lender did not obtain an adequate appraisal to support the value of the 50-room building. Specifically, only minor renovations were required prior to opening the hotel. Therefore, the lender was required to obtain an appraisal with an estimated market value on an as-is basis. Instead, the lender provided an appraisal of the building that was based on assumptions of other performing similar franchised hotels. Further, the appraiser noted that certain events needed to occur before the property was ready for business, which included cosmetic improvement such as painting, signage, and décor. The appraisal report stated the building had an as-is value of $2,000,000.

The OIG does not believe the appraisal appropriately represented an as-is value because the appraisal was based on assumptions of other similarly performing franchises, and improvements were needed before the building could operate as the franchise hotel.

The lender provided two separate appraisals, which included a total as-is value of $4,800,000 for both buildings. This amount did not fully support the required total fair market value of $5,300,000.

SBA Inspector General Management Advisory Report Number 19-15, July 10, 2019