Best Practices: Using an SBA 7(a) Loan to Refinance 504 Project Related Debt

By Jessica L. Conn, Esq.

Jessica L. Conn, Esq.

       The SBA has a vested interest in the performance of loans on the secondary market and recent policy changes demonstrate that the SBA is subjecting lenders that they consider to be "higher risk" to increasing levels of scrutiny and oversight.  When an SBA loan is sold on the secondary market, the nature of the SBA guaranty changes for the SBA. Before a loan is sold, the portion of the loan that is guaranteed by the SBA (the "Guaranteed Portion") is conditional -- conditioned on the lender's compliance with SBA regulations.  To the extent the lender does not comply with the SBA regulations, SBA may repair the Guaranteed Portion, meaning SBA reduces its guaranty by any amount SBA deems lost due to the lender's non-compliance with SBA regulations, or may deny the guaranty altogether.  However, once the loan is sold on the secondary market, the Guaranteed Portion becomes an unconditional guaranty by SBA with respect to the secondary market investor, meaning that upon default, unless the lender repurchases the loan from the investor, the SBA has an unconditional obligation to repurchase, regardless of the lender's compliance with SBA regulations.  If SBA is required to purchase the Guaranteed Portion of a loan back from the secondary market following a default, SBA will conduct a post-purchase review of the file and will pursue the lender for any part of that Guaranteed Portion that would have been subject to a repair or denial.

       Since 2009, SBA has required increasing levels of scrutiny before allowing "higher risk" SBA lenders to participate in secondary market sales. Lenders that are subject to "(i) a Cease & Desist order, (ii) a Consent Agreement affecting capital or commercial lending issues, or (iii) other supervisory action that cites unsafe and unsound banking practices or other items of concern to SBA , or (iv) where the SBA Lender's auditor issued a Going Concern opinion in the audited financial statements" ("Regulatory Actions") are considered to be a higher risk (SBA Procedural Notice 5000-1205).  SBA is concerned that if a lender subject to Regulatory Actions, is placed in receivership by the FDIC, SBA's ability to recover the repaired or denied funds would be impaired. This concern led SBA to initiate a policy whereby it would conduct a pre-sale review of each loan that a high risk lender wanted to sell on the secondary market. However, due to the number of lenders requiring such review, the process has become too burdensome for SBA -- often resulting in significant delays for lenders.

       To address this situation, effective June 30, 2011, in lieu of reviewing each individual loan file prior to sale, SBA will require lenders subject to any Regulatory Actions to enter into a reserve account agreement (the "Reserve Account Agreement") prior to requesting approval to sell loans on the secondary market. Pursuant to the Reserve Account Agreement, lenders will be required to establish a reserve account with an initial deposit of either: (i) two times SBA lender's average 7(a) loan size if the lender's gross dollars outstanding for its active loans is $10 million or greater, or (ii) one time the lender's average 7(a) loan size if the lender's gross dollars outstanding for its active loans is less than $10 million. Additionally, for each loan that will be sold on the Secondary Market, the lender will be required to deposit an amount equal to the "total gross dollar amount of the Guaranteed Portions to be sold, multiplied by the greater of (a) SBA's overall 7(a) Loan guarantee repair/denial rate as calculated by SBA for the most recent available quarter or (b) the SBA lender's 7(a) loan guarantee repair/denial rate as calculated by SBA for the most recent available quarter" (SBA Procedural Notice 5000-1205).

       In addition to the creation of a reserve account, lenders that are subject to any Regulatory Actions must abide by additional restrictions with respect to sales themselves. The lender may not sell the Guaranteed Portion of a loan within 6 months of the final disbursement date of the loan if the lender's 7(a) loan portfolio exceeds any two of the following performance indicators by one and one-half times the average for the portfolio, as calculated by SBA. The performance indicators are early default rate, past due rate, delinquency rate, liquidation rate and 12 month purchase rate. Additionally, the lender may not sell the Guaranteed Portion if (i) any payment of principal or interest has been past due (one payment cycle late) or deferred on the 7(a) Loan during the six month period prior to the sale date; (ii) at the time of the sale, the borrower is not making payments as scheduled under the original terms of the 7(a) Loan note (for the Guaranteed Portion); or (iii) the Guarantee Portion to be sold is part of a 7(a) Loan that is classified by SBA Lender as special mention, substandard, doubtful or loss or has been restructured" (SBA Procedural Notice 5000-1205).

       The new SBA regulations are designed to mitigate risk to the SBA portfolio and to provide higher risk lenders that want to sell their loans on the secondary market with a process that will provide a more streamlined and predictable mechanism for conducting secondary market sales.  Lenders that are or become subject to a Regulatory Action must be aware of these new regulations and must comply with them in all respects in order to sell in the secondary market. For further information, please see SBA Procedural Notice 5000-1205 or contact Jessica Conn at jconn@starfieldsmith.com or 267-470-1188.

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